The fixed-income world has not changed dramatically over the past three months. In fact, a familiar trend held up: while economic data surprised on the upside, inflation remained shy of expectations. We expect yields to continue their slow-motion increase, as monetary policy becomes gradually less accommodative. In the United States, we forecast two more rate hikes in the coming 12 months and a shrinkage of the Fed balance sheet. In Europe, we believe that the European Central Bank (ECB) will scale back its bond purchases from early 2018 on, whereas the Bank of England (BoE) may raise rates once by the end of this year. We doubt, however, that the BoE will follow that up with more hikes in 2018.
Against this backdrop, we have little appetite for the ultra-long end of developed-market sovereigns. We continue to see opportunities in investment-grade and high-yield (HY) corporate bonds of these regions, which are supported by still high demand and solid economic fundamentals. Solid fundamentals, combined with supportive financial conditions, should help to keep default rates in the HY sector at historically low levels. We are, however, concerned about the pricing and the surge of covenant-light issues in this space, so selection is critical.
Emerging-market (EM) sovereigns remain compelling, due to both long-term improvements and a benign short-term picture. Reforms have been progressing since the Asian financial crisis of the late 1990s. Several Asian and Latin-American countries have embraced fiscal discipline, floating exchange rates and structural reforms in order to better absorb economic or external shocks. Many of them now generate decent economic growth without high inflation rates. For central banks, this has resulted in comforting monetary leeway. We believe that bonds are an appropriate vehicle for investors to profit from this development. The country universe of EM sovereigns is much more diverse compared to EM corporate bonds or equities. Its benchmark # includes 65 different countries borrowing in hard currency. This can provide diversification benefits across ratings, regions, economic-growth models and the degree of commodity dependence. And while risks may be higher in the EM space, many of those risks are specific to the country in question. That said, many hard-currency sovereigns are fairly illiquid. Therefore, choosing the right regions, maturities, currencies, while keeping an eye on liquidity, are key. Active management certainly appears advisable in this segment.
Obviously, we are not the only ones noticing structural improvements in EMs. Furthermore, EMs have benefitted from easy monetary policies that have encouraged a hunt for yield across all risky assets. Tightening monetary policies in developed markets could thus cause some turmoil. During the 2013 taper tantrum, EMs were hit hard by the mere prospect of the Fed curtailing its bond-buying program. The selling was fairly indiscriminate, and bonds took a while to recover. This would justify some investors' concerns now, as we expect less accommodative central banks.
But investors do not seem to be too concerned for the moment. In June, Argentina was able to issue a 100-year bond. Given its long history of defaults, the last one as recent as 2014, this seems like a sign of market froth. Another worry, paradoxically, is that it has been quite a while since the last full-blown EM crisis. Sizeable defaults of publicly-traded sovereign bonds are not all that common. Two recent exceptions were aforementioned Argentina in 2014 and Ukraine in 2015. But optimists see silver linings even in such instances; for example, there was a haircut of only 20% on Ukrainian bonds.
For now, we still believe that the reasons for concern are very limited. The current stabilization of commodity prices, solid global growth rates and a weakened dollar helped countries such as Brazil and Russia to recover faster than anticipated. China's economic data has been equally supportive. Our preference is for EM bonds with longer maturities, in local currency and with a bias towards higher yields. The second chart on the right shows how strong this segment has performed over the past two decades. Active management has the potential to add another layer of performance.
One more for the road. 2018 is likely to be the last year of - albeit slightly - expanding central-bank balance sheets.
Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 10/4/17
Over the past 20 years, EM sovereign bonds have clearly outperformed EM equities, U.S. equities and U.S. high-yield bonds.
The dollar has seen massive swings in 2017. At the start of the year, all looked well for the Greenback. For three years, investors had been betting on a stronger dollar, especially against the euro. After the U.S. election, these bets increased further, as can be seen by net non-commercial futures positions. Since then, markets have had to digest a dismal start for the U.S. economy into 2017, while European data surprised positively. When French voters sent Emmanuel Macron into the Elysée Palace, investors had to scale back their bets on a stronger dollar. By doing so, they have sent the dollar on a dive.
The market is currently betting on a stronger euro – and might once again find itself wrong-footed. Hopes are running high that the old continent might make a great leap forward towards a "fiscal union." We are skeptical. European institutions just do not work that way. With 19 Eurozone member states, there is always scope for negative political surprises somewhere. Catalonia's attempts to move towards independence and next year's elections in Italy are just two examples. Also, the ECB's tapering might not run as smoothly as expected. Meanwhile, we still see a decent chance of some sort of U.S. tax cuts eventually being enacted. Given subdued market expectations, signs of congressional progress on that should be dollar-positive, whatever the eventual outcome. Add the increasing yield differential between U.S. and European bonds, and we certainly shouldn't count out the dollar just yet.
Investor optimism on the euro is at its highest in years, as shown by net positions unrelated to currency hedging in futures markets.
Source: Bloomberg Finance L.P.; as of 10/2/17