Outlook on fixed income: bonds from a strategic viewpoint

Bull

  • Lacklustre economic growth means interest rates are unlikely to rise.
  • Demand for shorter-dated bonds to remain robust.
  • Modest but stable economic growth is helpful for corporate bonds.

Bear

  • Inflationary pressures could begin to constrain the Federal Reserve from the spring.
  • Default rates in the corporate bond market have edged higher (although they haven’t spiked).
  • Political uncertainty could place strains on the bond market.

Monetary policy supported demand for bonds in 2019

For much of 2019, market sentiment swung between fear of imminent recession and hope that growth in the global economy would stabilise. Crucially, however, these swings took place amid a progressive easing in monetary policy: as interest rates were cut and quantitative easing reignited, yields on government bonds fell. From this point, however, the direction of travel – in both growth and monetary policy – looks far less certain.

Rates might not have too much further to fall

While data appears likely to point towards a further slowing in the US, we only expect one more rate cut from the Fed, likely in the first month of 2020. After that, a possible lifting of tariffs in a ‘phase one’ trade deal, coupled with a bottoming out in manufacturing data globally, should mean that economic growth starts to gather pace.

Inflation may pick up

Inflation could start to constrain the Fed from the spring. A number of what Jerome Powell described as “transitory” factors – such as lower prices for clothing and some financial services – depressed core inflation in 2019. As those factors drop out, short-term inflation may trend higher.

Moreover, we have seen subtle signs of a shift in the balance of power away from capital and towards labour. A sharp rise in the frequency of strikes suggest that the sense that labour lacked any ‘scarcity premium’ is now disappearing – and not only in the US. The global financial crisis had such a profound effect on job security that workers remained afraid of demanding higher wages for a long time. That finally appears to be changing.

Why we anticipate a steepening of the yield curve

The market impact of higher inflation and the increased bargaining power of labour, we believe, will see a steepening of the yield curve. Higher wages mean higher inflation, placing pressure on long-term yields to rise.

A further contributing factor to a steepening of the yield curve is the apparent shift in attitudes towards fiscal stimulus. The UK is leading the way in reversing its former fiscal discipline: government spending looks set to ratchet higher. The resulting increased supply of government bonds coupled with a greater fiscal boost to growth should also contribute to a steepening in the yield curve.

Short-term rates to remain low

This dynamic is not limited to the UK. With policymakers acknowledging that monetary policy has run out of road, the pressure is mounting on governments in Europe to loosen the purse strings.

Such policy shifts may cause yields at the longer end of the curve to rise, but we don’t foresee short-term interest rates increasing in the immediate future. Growth rates across the global economy should stabilise at modest levels, thereby ensuring central banks keep interest rates very low. Inflation looks set to tick up but not quickly enough to panic policymakers.

We are positive on shorter-dated credit

In the credit market, default rates have edged higher but we don’t envisage a scenario in which rapidly deteriorating balance sheets lead to a spike in defaults. For us, the first part of 2020 is likely to represent a positive environment for credit spreads as the global economy continues to stabilise.

Given our view that the yield curve is likely to steepen, we will maintain our focus on holdings towards the shorter end of the curve and seek credits whose cashflows seem secure.

Bond investors should be wary of complacency in 2020

Our concerns lie in what might unfold after the first quarter. We suspect that markets will come to realise that – in some areas – monetary policy can no longer justify valuations. Central banks will be constrained and economic growth will not be strong enough to pick up the slack. Geopolitical risks may continue to create strains in the market, as proven by the recent assassination of Soleimani. An uptick in political uncertainty surrounding the US election could also present a challenge for investors.

Our expectation, therefore, is that we will need to remain nimble through 2020 as markets evolve and as investors begin to price in new risks.  


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