Late cycle caution warrants careful selection across sectors
More From Our 2018 Mid-Year Global Market Outlook
Global bonds may face headwinds in the second half of the year due to monetary tightening, but growth and inflation fundamentals should remain favorable. At the start of the year, we made the case for modest upward pressure on interest rates and yields, but no bear market in bonds. Since then, we have seen US Treasury rates break above the symbolic 3% threshold, credit spreads widen, international trade tensions rise and more volatile equity markets. Nonetheless, the wage inflation fears that sparked the February sell-off have faded somewhat, the outlook for global growth is positive and there are no signs of runaway inflation, despite near-full employment in several major economies and higher oil prices. Against this backdrop, we expect fixed income as a whole to perform solidly but with lower absolute returns than in the past five years, and with a greater dispersion of returns, meaning investors may wish to be more selective.
In the context of higher US Treasury yields, we are keeping an eye on the shape of the yield curve, which captures the difference between long- and short-term rates. Two-year rates have been going up even faster than 10-year ones, flattening the curve. In the past, this has often been a precursor to the inverting of the curve, which typically signals a market downturn and recession. So far the curve has remained in positive territory and is therefore not an immediate cause for concern; but if inflation ramps up, we could see short-term rates spike and the curve invert, potentially heralding the end of the credit cycle.
The current cycle has been prolonged by historical standards, thanks to underlying structural forces such as central bank intervention. This prevented the collapse of the financial system in 2008 but caused the normal conduit between savers and borrowers to break, limiting growth. Bank regulation post-crisis initially constrained lending, but US financial deregulation could now increase credit availability nine years into the recovery. There has also been a surge of private capital into the credit markets in recent years through securitizations and direct financing. While the debt market has grown larger, bank balance sheets have shrunk (although technically better capitalized), so liquidity may become an issue if higher-risk bonds come under pressure, potentially leading to greater price volatility. US tax reform, meanwhile, has provided further stimulus at the latter stages of the credit cycle, encouraging firms to increase hiring and capital expenditures.
From a cyclical standpoint, credit fundamentals — especially in the US — have deteriorated and corporate risk taking is on the rise, but not necessarily to a point at which investors should be overly concerned and, as noted, credit availability and increases in capital investments will likely extend the cycle. Expectations for default rates are benign following the commodity mini-cycle in 2014–2016 and consumer and business confidence is improving. All these factors mean that while credit availability is still good, as interest rates tick upwards, investors may wish to be more selective about their fixed income exposure. We have already seen greater dispersion of returns across fixed income sectors (Figure 2) and we expect this to persist, both at the asset class and individual company level.
Higher Treasury yields present a buying opportunity, in our view, given anemic trend productivity and labor force growth, volatile equity markets and contained inflation. Additionally, domestic pension funds continue to be attracted to 10-year Treasuries at the 3% level, while a large number of short positions in the Treasury market could create buying pressure as these shorts are covered. But investors should be cognizant of a potential longer-term squeeze on government bonds. There are a number of factors at play. Treasury supply is rising to fund the US fiscal deficit, while European and Asian yield hunters, who had been buyers of US Treasury debt, are now finding the cost of dollar hedging prohibitive.
Inflation-linked bonds (TIPs) may protect against further consumer price rises in the second half, but longer-term inflation trends are mixed.
For European and Japanese bonds, the interest rate cycle is further behind. An added complication is the recent political uncertainty in Italy and Spain. Until recently European bonds had been rallying despite expectations that the European Central Bank would roll back its quantitative easing program in the autumn. Given weaker growth and divergent economic performance in Europe, those plans may have to be postponed. Bond prices may therefore continue to be supported by policy, even if European economic growth falters. Low inflation in Japan is likely to keep ultra-loose policy in place for some time yet.
US and European investment grade bonds have underperformed so far this year as spreads have widened. While inflation remains in check and the credit cycle has further to run, spreads should tighten, providing an opportunity for better returns.
High yield historically trades with lower duration than stated. At present, strong earnings mean interest coverage remains healthy at above 4.5 times, offsetting some concerns from the overall large increase in debt levels. While default rates may fall further, we are underweight high yield in our tactical portfolios, with a preference for quality names higher up the credit spectrum given the lower compensation available for the amount of risk taken.
Emerging market (EM) debt in local currency had a great run in 2017. More recently, the asset class has suffered from trade tensions and US tariffs, country-specific risks in Russia, Turkey and Argentina and renewed dollar strength. Nonetheless, the outlook remains positive in our view. EM growth should benefit further from global economic expansion and oil price recovery, additions of EM countries to the Global Aggregate Bond Index and a mixed but broadly supportive policy environment. EM debt still provides investors with a spread (Figure 3) over US Treasuries, and lower US interest rate risk than USD hard currency EM bonds, though investors may need to be more selective over the next six months.
At this later stage in the credit cycle, we continue to watch for recession triggers that could result in a sharp rise in credit risk premiums. The typical pattern when a recovery reaches this stage of maturity is for credit availability to diminish, which pushes borrowing costs higher and profitability lower, eventually raising default risk. However, in our view, we are not there yet. Easy money from central banks has helped lengthen the credit expansion phase,but this period is reversing, implying a higher risk premium for credit. This will likely be offset by plans for lighter regulatory requirements and fiscal stimulus, which could help extend the cycle a bit longer.
The expansion and subsequent contraction of access to credit over a period of time.
The gap between two bonds with the same maturity but different quality.
The process by which central banks manage the cost of borrowing in an economy. Tight monetary policy means interest rates are going up, whereas loose monetary policy means interest rates are going down.
Important Risk Information:
The views expressed in this material are the views of Niall O'Leary through the period ended June 6, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Investing involves risk including the risk of loss of principal. Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. An Increase in real interest rates can cause the price of inflation-protected debt securities to decrease. Interest payments on inflation-protected debt securities can be unpredictable. Investing in high yield fixed income securities, otherwise known as junk bonds, is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Foreign investments involve greater risks than U.S. investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets. The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information. This document may contain certain statements deemed to be forward-looking statements. Please note that any such statements are not guarantees of any future performance and that actual results or developments may differ materially from those projected in the forward-looking statements.