By Robert Michele, Chief Investment Officer, J.P. Morgan Asset Management
Powerful policies are forcing bond investors to sell bonds back to the central banks and redeploy those assets, and we cannot forget how much this supports risk assets.
Drivers for the world’s bond markets
Since the beginning of the year, U.S. Treasury rates have fallen, nearly $2 trillion of government debt across the globe is trading at negative yields and more than 20 central banks have eased. Falling levels of inflation are persistent across the globe, with nearly 30% of the world’s countries experiencing disinflation, and a similar percentage with core inflation less than 1%.
Falling inflation has caused real yields to rise, exactly what most central banks do not want, or need. In an effort to keep rates accommodative and to stimulate growth, policy makers continue to flood the markets with liquidity.
2015 is on track to be a year dominated by aggressive divergent central bank monetary policies.
In moving towards raising interest rates, the Fed is trying to soften the blow with calm and guidance, hence their most recent statement was surprisingly dovish. The Fed realise that the economy may be recovering, but it’s not very robust. The labour market is improved and emergency liquidity is seemingly unnecessary. But the Fed also recognizes that there’s very little pressure on core inflation, and that a strengthening dollar has already tightened financial conditions. So, they are not trying to lean into a lot of growth and inflation, but instead trying to get the fed funds rate closer to a real zero rate. They want to be cautious. What’s interesting for the Fed this time around is that they can raise the fed funds rate and maybe front end yields rise a bit, but the long end should be supported by flows out of Europe and Japan, raising the possibility of a very benign normalisation process.
US Dollar outlook
The pace of dollar appreciation over the past 12 months has been extreme, yet the dollar may have further room to run. Certainly, if the U.S. is the one central bank that begins to raise rates, that will add more strength to the dollar. We think that the dollar can appreciate another 10-20% from here. While dollar strength has been helpful to this point, an even higher dollar could become destructive as it begins to negatively impact U.S. growth and exacerbates problems in the emerging markets.
Investment Opportunities
So how should global bond investors be allocating in today’s markets?
We like high yield – both in the U.S. and in Europe. Corporate balance sheets look great. Defaults are low, companies are very practical in the way they’re managing their leverage, and credit spreads are pricing in a multiple of where default rates should be. U.S. high yield is priced at a yield of 6.25%, which is not only attractive to US investors, but also to investors in Europe where their alternative is to leave money on deposit at a yield of -0.2%.
European financials are also attractive at the moment, specifically hybrid bank debt. Alternative Tier 1 securities and CoCos (Contingent Convertibles) are great value because European banks face regulatory pressure to increase capital and to reduce businesses with greater risk and consequently higher capital charges. They’re being forced to clean up their balance sheet, and the ECB is providing almost unlimited liquidity for them to fund themselves.
Opportunities in the emerging markets are more limited. Commodity prices remain a major headwind; the effects of a strong U.S. dollar have yet to be fully priced in; and the specter of a Fed hike may increase the risks for EM crises. Differentiation is the key, countries that have less borrowing needs; that are commodity importers, not exporters; and that are addressing structural reforms present the best value.
With an expectation that rates will stay range-bound, and with near-term Fed reinvestments providing technical support, we like U.S. agency mortgages as an inexpensive substitute for long government bonds.
One thing we are mindful of is that the second and third quarters typically see lower liquidity and higher volatility, creating bouts of profit-taking, but also re-entry opportunities. Despite a fairly benign forecast, investors should be cognisant of the risks inherent in above-trend growth signals.
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