Fixed income markets gear up for an unpredictable year

The fixed income market is not as hotly debated as equities or property in Australia, and investors often remain under-allocated towards this asset class. 

The last few months, however, have proved once again that this component of a portfolio still has a big role to play by offering some insurance and counterbalance to riskier allocations, particularly when equity markets struggle. 

So, what does the fixed income market look like, and can investors find opportunities there?

It’s just a slowdown

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While some economists and experts have recently become more alert to the probability of global markets entering a recession, with JP Morgan Asset Management raising that probability of recession from zero to 10 per cent in its global fixed income outlook for the first quarter of 2019, most fund managers don’t expect an imminent crisis.

The main concerns for the market are geopolitical risks, including the possible escalation of the US/China trade war; problems in Europe and how countries would handle Brexit; and major central banks’ policies. 

Anthony Kirkham, head of Western Assets Australia, an affiliate fixed income manager of Legg Mason, said that despite somewhat lower gross domestic product (GDP) numbers across main economies and a general slowdown in global growth, it was definitely too early to talk about the recession.

“It’s more just a slowdown,” he said. “We are not on the verge of the recession at this point in the cycle so we are not as negative as I guess some of the economists out there.”

According to him, the solid returns from bonds in 2018 relative to negative results in equities was a prime example that the relationship between equities and bonds was still working. 

“Certainly, last year no one has expected the outcome that occurred, with such a strong outperformance by bonds,” he said.

Over the last few months, a fixed income portfolio component also continued to provide some insurance against more volatile assets like equities.

“Fixed income has served over the last 12 months a very good job for investors in terms of providing, I guess, the offset to riskier assets like equities which clearly had a tough year last year being very volatile,” Kirkham said.

However, David Choi, head of Australian Macro at Aberdeen Standard Investments, said while recessionary risks were high last year, he’s a little more optimistic now. 

“Our thoughts are evolving,” he said. “Late last year we saw a higher risk of a policy mistake and likelihood of a recession. But now, our outlook has changed.

“We see global growth stabilising in Q2 and expect it to pick up in H2. China has been actively easing policies and the Fed has paused in response to a global slowdown. The risk of a policy mistake has fallen materially.” 

And the Fed is not the only bank to adopt a more dovish stance, Choi stressed. 

“Even the RBA [the Reserve Bank of Australia] has recognized the extent of global slowdown and has dropped its hawkish bias,” he said.

On the other hand, according to Anujeet Sareen, portfolio manager for Brandywine Global’s global fixed income and related strategies, the possibility of a recession was a very important question given that the current stage of the cycle would, in June this year, mark the longest global economic expansion in post-war history. 

However, he did not believe expansions would end simply because they get old and, in his view, a global recession would be catalysed by two factors that were not yet evident today.

“One is global recessions are precipitated by synchronised monetary tightening. Although the Federal Reserve has raised interest rates over the last few years, other central banks have not similarly tightened policy – for example we do not have the synchronized monetary tightening cycle we saw in 2008 and 2000,” he noted.

Sareen also warned that global recessions are precipitated by a major misallocation of capital. 

“In the last cycle, excessive investment in housing markets around the world and excessive financial engineering in banking systems precipitated the severe crisis in 2008.

“Although there are pockets of excess in certain parts of the world today, there is no major misallocation of capital that is likely to catalyse a significant contraction in economic activity,” he said.

Should investors be looking to jump in the market?

Bob Michele, chief investment officer and head of global fixed income, currency and commodities at JP Morgan Asset Management, has no doubts that the bond market is in a very good state right now, given economic growth has slowed and central banks have turned dovish in response.

“You look at corporate bonds, you look at emerging market debt, you look at high yields securities and in a stable yield environment – that’s a pretty good time to invest in those markets.

“For the first time in a number of years, it feels like the central banks are supporting the bond markets,” Michele said.

But going forward, he warned, a lot in this market would depend on how the global events unfolded. 

“If you don’t get some compromise on the trade and it escalates into a trade war or you’ve had a hard Brexit or there’s more problems with central government shutdown – any combination of these things, then it will push you closer to a recession.

“And stable central bank policy isn’t going to offset that and they would probably be forced to reduce rates and maybe increase the size of the balance sheet – so right now it feels like they’ve taken their foot off the brakes.

“That’s what the markets and investors are trying to figure out, how much time are the central banks buying, and right now that feels pretty good, but you need to see some improvement on some of these other issues, otherwise the probability of recession goes up significantly.”

Aussie market still hit by geopolitics

According to fund managers, the Australian market has not emerged unscathed from the effects that major global events had on global bond markets.

In fact, Australian investors were faced with a number of domestic issues such as the concerns around the housing market on top of negative geopolitical activity.

However, active fund managers had a number of tools they could use to counterbalance these risks, and when the bond market is rallying, then duration always becomes one of the factors that draws investors’ attention, Kirkham said. 

Credit similarly looked interesting, and with assets like equities being on a downward trajectory in 2018, Kirkham said how investors positioned themselves within credit became even more important.

Commenting further on the Australian fixed income market, Kirkham said that there was no problem with liquidity in this market in Australia.

“The Australian market has always been less liquid so the change is less dramatic but in terms of moving bonds we’ve have no issues at all with liquidity. It’s fine.”

Sareen reminded that last year was shaped to a large degree by factors such as the Fed’s policy and the strong performance of the US dollar, which highlighted the sheer strength of the US economy.

However, at the same time, dollar strength brought some negative implications for the emerging market countries, in particular those that relied on access to that easy money, he said.

“Unfortunately, dollar strength was also a conduit for transmitting US renormalisation stresses to the developing world. Still early in the evolution of their business cycles, emerging markets bore the brunt, and the impact was particularly punishing for those countries that indulged in easy money.”  

Choi was of a similar opinion and said that this situation had also translated into the Australian market where the funding costs increased sharply, despite the RBA doing nothing.

“Likewise, the outlook for emerging markets is more positive for this year compared to last year. Not only does the growth outlook supports emerging markets but USD liquidity is less of an issue this year. The Fed is likely to hike only once this year (relative to four hikes delivered last year) but is also actively considering a floor on the size of its balance sheet.”

EMs look valuable

So does a run of a strong US dollar coupled with weakening Chinese demand and the potential trade disputes mean more challenges for the emerging world? Not necessarily. 

“Emerging markets look attractive for a couple of reasons,” Michele said.

According to him, it is not so much about the external dollar-denominated debt but the “the real play is in the local currency debt”.

On top of that, real yields are very high across emerging markets, close to on average five per cents, making those markets quite attractive. By comparison, the average yields in developed markets were about zero.

“The currencies [of emerging markets] are also oversold in our view,” he said.

“The trade negotiations between China and the US are going to be magnified in this market, they’re going to move the currency one way, and force the bond market to react another way.”

Also, a trade war isn’t helping either economy, with both economies slowing down and both administrations concerned, he stated.

“I think there’s a lot of value there but, as I said, it’s not quite as easy as owning US treasuries or 10-year Aussie Government bonds or European high-yield which should be relatively stable. It’s going to be more volatile and you have to be willing to live with that volatility.”

Sareen reiterated that that the US and China—along with the rest of the emerging world—could be trading places, with the former slowing and the latter stabilizing and maybe even seeing a small uptick in growth by year end.

“Self-preservation on both sides of the trade war argues for some kind of a deal, which should bring further relief to global markets in the form of a softer dollar,” he said.

“The outlook for developing economies and their respective financial markets would receive a huge boost if there is a soft landing in the global economy, an end to normalization efforts in both the US and China, and stabilization in the dollar.”

At the same time, capital markets outside of the US have priced in a lot of bearish sentiment on the global economy, which has manifested in extreme discounts across a wide range of emerging market bonds and currencies, and commodities, he said.

The outlook for 2019

Going forward, experts agreed that there would be a few areas requiring careful monitoring. One of them would be the non-financial corporate sector in the US and how it has increased debt levels over the last decade.

“Although interest costs remain low and the US economy remains in reasonable health, there is higher risk in corporate America from this increase in gearing,” Sareen said.

The second issue would be the expected slowdown in the Chinese economy over the past year, which reflected the tightening of domestic monetary and fiscal policies.

However, even though Chinese policymakers could decide to reverse many of these policies to help support future growth, the country’s debt levels and a lack of commitment to significantly ease monetary policy might mean its economy would slow somewhat further, according to Brandywine Global’s portfolio manager.

The third factor would be the final outcome of the US/China negotiations and how both parties would handle and resolve this issue.

“Recent trade negotiations between the US and China suggest a preliminary agreement is forthcoming, but this is unlikely to address the full range of issues between the two countries on economic and political fronts.” 

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