• The US economy to retain its role as the engine of global growth in 2016
• The Federal Reserve to proceed on a very gradual tightening path as rising wage momentum feeds into inflation.
• Global central bank divergence is likely to be a dominant theme. The Bank of England will be keen to follow the Fed’s lead of beginning the path of rate rises, but the ECB and Bank of Japan will continue with their quantitative easing programmes.
• Developed sovereign bond yields are expected to rise moderately and we may see steeper curves.
• Investors should expect lower returns across credit markets, although select valuation opportunities are available for fundamental investors.
In many ways, our cautious fixed income view was challenged through the course of 2015 as we looked towards a market environment that would begin to respond to a new era of Federal Reserve tightening, albeit a slower and shallower trajectory of rate hikes. However, US growth disappointed in a weather-related blip in the first quarter and, more significantly, midway through 2015 on slowing emerging markets growth and a strong US dollar. Some of these concerns are now dissipating, as we anticipated.
Indeed, we believe that some investors became overly bearish about the US through the course of 2015 and, notwithstanding the softer trajectory in the third quarter, data releases in the fourth quarter are pointing to an economy that is alive and kicking. We expect the US economy to retain its role as the engine of global growth in 2016. Importantly, while job creation has been strong, tighter labour market conditions are beginning to feed into wage growth; we believe we are now at an inflection point where reduced labour market slack will start to place upward pressure on wages. Hitherto, economic activity has been bifurcated between robust services activity and a manufacturing sector hurt by the strength of the US dollar and slowing emerging market growth. There are signs, however, that the contraction in manufacturing activity is beginning to trough as external headwinds abate.
Meanwhile, US consumer spending has been resilient in the second half of 2015, and no doubt the support of lower energy prices coupled with a strong labour market should continue to underpin spending over the next year. Headline inflation pressures are low, but we believe that lower energy-price effects to be transitory, and prices should begin to see upward momentum over the next 12 months. Core inflation has remained steady, sustained by services inflation, such as housing and health care costs.
Given the supportive economic backdrop, we would expect the Federal Reserve to proceed on a very gradual tightening path, stopping at a point that is likely to be significantly lower than seen in previous cycles.
The UK economic and interest rate cycle has closely followed the US, but some would now describe UK policy to be in a quandary. Domestic demand has been firm but, like many other economies, it is the manufacturing sector that has taken the pain.
Market pricing has pushed out a first Bank of England rate hike to late 2016/early 2017. As the Federal Reserve embarks on its tightening path, however, we believe there is a risk that the Bank of England will be keen to follow its lead. Price pressures in certain parts of the economy, such as property and services, are rising, and headline inflation should begin to rise as lower energy-price effects dissipate through the course of 2016.
The Federal Reserve, and quite plausibly the Bank of England, will be deviating from the very accommodative policy of most other central banks, including the European Central Bank and the Bank of Japan. Many expect the latter two banks will be compelled to inject more stimulus into the markets if growth and inflation falls short of expectations. While the balance of probabilities is weighted in favour of more action in 2016, we believe there is no guarantee. In particular, we have been encouraged by the turn in credit trends in Europe, which are now at the early stage of the recovery cycle, and provide some evidence that the ECB’s stimulus programme is working. Moreover, domestic demand has held up particularly well in 2015, given concerns around Greece and broader financial market volatility.
In Japan, the macro picture has been lacklustre, but we are not convinced that Governor Kuroda and his fellow policymakers are keen to extend the qualitative and quantitative easing programme any further; indeed, how far can banks keep administering the medicine without the desired outcomes? The spring wage negotiations will be important for Japan’s near-term inflation outlook, and recent activity data is pointing towards broad-based improvements across the economy. Moreover, as Chinese growth trends stabilise, as we expect and are starting to see, this should also relieve the external pressure on Asian economies more generally.
Furthermore, the People’s Bank of China has the room to ease policy further to support China’s transition to a more domestic demand orientated economy.
Global central bank divergence is expected to be the dominant theme of 2016 influencing developed sovereign bond markets. US and UK treasury yields are likely to rise moderately across the curve in response to gradual central bank tightening. If history is any guide, we should expect to see a steeper yield curve as rates rise; in other words, shorter-dated maturities rise less than longer-dated bonds. This Fed tightening cycle, however, is more unpredictable than in the past. The outlook is also clouded by declining levels of liquidity, which have the potential to amplify yield moves. The US dollar is likely to sustain its strength versus the major currencies, although given the significant move over the last year we expect it to stay within a stable range.
The investment grade corporate bond market is likely to encounter a more challenging environment than in previous years, as interest rates rise and fundamentals weaken at the margin, due to higher leverage ratios in some sectors. We may continue to see corporates engaging in more shareholder-friendly activity, such as mergers and acquisition and buybacks. All that said, demand for investment grade corporate bonds continues to remain strong on the part of institutional investors, life insurers and pension funds, and any potential sell-off is likely to be contained.
It is also worth noting that although both investment grade and high yield credit spreads have widened in the second half of 2015, the absolute level of yields remain historically low. Typically, high yield bonds benefit from a recovering economy as the prospects of default fall. But this is an atypical recovery, and given the very low level of absolute yields, the cushion available to absorb capital loss as interest rates rise is much shallower through lower coupon rates. Nonetheless, for active investors, we believe there are select valuation opportunities in certain areas of the high yield market, such as energy, where the sell-off has been indiscriminate and the fundamentals of many issuers have been overlooked.
Over the last year we have taken a cautious view of the emerging market debt asset class, given our concerns about the strength of the US dollar and perceptions of Federal Reserve tightening. Economic fundamentals have deteriorated broadly across the asset class (for both hard and local currency markets) as financial conditions have tightened in many emerging countries. We retain our cautious outlook over the next six months, but also recognise that central banks in emerging markets will be better positioned to continue with their programmes of supporting growth and inflation as we see more certainty surrounding Fed policy.
Furthermore, should the strong US dollar trend stabilise, over the longer term this market should begin to show more interesting opportunities.
Based on our expectations of the unfolding macro environment and interest rate cycle, we continue to believe it is prudent to maintain a short duration profile in fixed income, holding exposure to shorter-dated bonds and constraining our market weight to this asset class. While our duration view remains consistent, our credit view has evolved to reflect shifting dynamics. We believe there are select valuation opportunities in this market, but that there will be fewer opportunities across the broader credit universe than in 2015, as fundamentals weaken on the evidence of shareholder-friendly behaviour and higher debt burdens among corporates.
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