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Don't write off bonds

Corporate and emerging-market bonds should continue to provide solid returns in 2018. We expect slightly rising interest rates.

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Editorial

Fixed Income

Don't write off bonds

Corporate and emerging-market bonds should continue to provide solid returns in 2018. We expect slightly rising interest rates.

Looking back at 2017 evokes a sense of déjà vu. Despite surprisingly strong economic figures, inflation once again surprised to the downside. The inflation rate in Europe of 1.5% is still some way below the European Central Bank's (ECB's) target of 2.0%. This raises the question as to whether a Eurozone rate hike can really be expected in 2018. Yields on 10-year German Bunds moved sideways in 2017, while those on U.S. Treasuries are likely to end the year at lower levels than back in January. However, the skeptics also have to admit that yields in both countries in 2017 clearly moved away from their lows reached in mid-2016. We believe this trend will continue in 2018, based on our economic forecasts and expectations for monetary policies. We expect global growth to accelerate further to 3.8% in 2018. As we also expect slightly higher inflation figures in many parts of the world, we think that monetary policy will be gradually tightened.

We expect one interest-rate hike in the United States in December this year and two more in 2018. Furthermore, the Fed is likely to reduce its balance sheet by about 7%. Meanwhile, it is no longer the only central bank among the G7 countries that has initiated the interest-rate hiking cycle. Its counterparts in Canada and the United Kingdom have already joined in. Meanwhile, the ECB has announced a reduction of its bond purchases from the current 60 to 30 billion euros starting in January 2018, followed by another - perhaps final - cut in September. We do not expect any interest-rate increases before 2019. However, investors may well start to fret about that prospect from mid-2018 onwards. Another point of concern will be the upcoming replacement of three of the six ECB Executive Board members, including Mario Draghi. Together with unusually high staff turnover within the Fed, this leaves plenty of scope for communication mishaps, if not downright surprises, in global monetary policy. The timing is slightly unfortunate: by the end of 2019, markets will most probably have to deal with a net withdrawal of liquidity by central banks for the first time since the financial crisis.

For our forecasts, however, all this results in surprisingly little need for adjustments. We enter the new year with optimism, but we remain vigilant. To put it briefly, we feel most comfortable with corporate bonds and emerging-market bonds. Government bonds from European core countries are likely to experience a slight yield increase. We expect the yield for 10-year Bunds to reach 0.80% by the end of 2018. Due to the related price losses, this would result in a negative total yield. We see the yield for U.S. Treasuries at 2.60%, which would mean a total return close to zero. In the government-bond segment, we therefore prefer bonds with shorter maturities. However, a balanced portfolio should still include longer-term bonds, because they provide better protection in the event of a surprising decline in yields. We expect the U.S. yield curve to flatten further. Growth skeptics are likely to monitor this development closely. So far, every recession in the United States has been preceded by an inverted yield curve. However, there have also been inverted yield curves that were not immediately followed by a recession. As central banks are likely to have significantly distorted yield curves, we think the flattening this time around has more to do with lingering concerns about long-term growth prospects than bond markets starting to price in a U.S. recession.

In the corporate-bond segment, we note that some sectors in the United States are already reporting higher debt ratios than in 2008. The interest coverage ratio (earnings before interest, taxes, depreciation and amortization, divided by a company's interest expenses) of the S&P 500 has been on a downward path since 2015. However, it remains significantly higher than in 2009. The situation for smaller companies (Russell 3000) is not as favorable, but we do not think there is cause for immediate concern. Based on the solid economic environment, we forecast only low default rates in 2018. Corporate bonds are not expected to benefit as much from narrowing credit spreads as in previous years, but some scope still remains. We see a higher return potential for U.S. corporate bonds than for their European counterparts.

Corporate bonds: focus on coupons in 2018

Although credit spreads have already narrowed considerably, they might decrease even further in 2018.

Interest coverage ratio in big and small U.S. firms

We do not believe U.S. companies in general will have problems servicing their debt. However, we are keeping a close eye on individual sectors.

Sources: FactSet Research Systems Inc., Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH as of 11/22/17
*Using average EBITDA
**Excluding financial and real-estate companies, using median EBITDA

Currencies

Less euro weakness ahead

We are trimming our forecast for the euro to weaken against the dollar. On a 12-month basis, the euro's downside now looks limited.

The U.S. dollar had a dismal start into the year. Market positioning had been tilted towards a stronger dollar. This contributed to a decline of the greenback against other major currencies. It got worse after another weak first-quarter performance of the U.S. economy and ongoing political turmoil in Washington. Simultaneously, Eurozone growth data came in surprisingly strong. Coupled with a smooth win by Emmanuel Macron in the French presidential elections, this boosted the euro. In fact, looking at late August exchange rates, it was the dollar's weakest start into the year since 1986. We argued that this selloff was overdone, and saw a good chance for a rebound. To an extent, this is exactly what happened.

Now, however, shifting our forecast horizon out by three months to December 2018, we have to consider the state of the world's markets in late 2018. By then, we expect the ECB to be largely done with its asset-purchasing program. Markets will be trying to evaluate the upcoming changes at the top of the ECB (in 2019, the terms of three board members will expire, with the president being the most important one). In such an environment, we expect discussions about the likely timing of the first rate hike in the Eurozone to intensify. Hence, while keeping most other currency pairs unchanged, we are lifting our euro exchange-rate forecasts to 1.15 vs. the dollar and 132 vs. the yen.

An unusually weak greenback

By historical standards, 2017 has been an unusually bad year for the dollar.

Source: Bloomberg Finance L.P. as of 11/20/17

* The underlying sample consists of daily USD/EUR exchange-rate values between 1974 and 2016

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