10th April 2015 by Chris Iggo
Bonds have continued to deliver positive returns in 2015. Thanks to the European Central Bank (ECB) and other central banks. Yields in Europe are grinding lower and more of the market has a negative yield to maturity. Our preferences remain for high yield and less liquid fixed income products where there is still some decent spread. For the time being we have little to say. The macro environment is benign, the Federal Reserve (Fed) is still not sure to raise rates yet and volatility seems to be on the decline again. In normal times we would say just keep on clipping the coupon, but the coupons today are very skinny. Q2 has potential to deliver some excitement – the UK election, more clarity on the Fed, inflation upside surprises – but the market is very much in wait and see mode. So enjoy the early Spring.
Another quarter of good bond returns – Q1 is over. We’ve had the beginning of QE from the ECB. The Fed has still not raised interest rates. Greece remains within the euro area/European Union and Russia mostly isolated from the international community. In the mainstream bond markets, European inflation-linked government bonds have had the best performance so far in 2015. Inflation linked? In Europe? How can that be when the main concern at the beginning of the year was deflation? Well, it’s all about yields. On the Bank of America/Merrill Lynch European Inflation Linked Government bond index, the yield has fallen roughly 100bp since the beginning of 2015. This has been the main reason why the total return has been 5.9% – much stronger than the S&P500, Bunds or European high yield bonds. The fact that euro linkers are eligible for purchase by the ECB and that there is a sense that the ECB may actually have some success in putting a floor under inflationary expectations has created a favourable environment for this asset class to perform well. Elsewhere, total returns from bonds have reflected the strength of central bank intervention in markets globally (in Q1 alone we had significant action from the Swiss National Bank, Swedish and Danish banks, the Reserve Bank of Australia, the Bank of Canada as well as the ECB). Government bond returns are anywhere from 1.8% (US Treasury index) to 5% (European peripherals). Not bad considering yields are so low. Can it be sustained? Of course, we doubt it, especially if the data is improving, inflation is bottoming and the Fed is closer to raising rates. But never say never. There’s a whole lot of buying going on.
Election, does anybody care? – UK fixed income has performed well in the first quarter as well. Gilts returned 2.3% and investment grade sterling credit 3.4%. Sterling is also stronger on a trade weighted basis having moved by some 7% against the euro. So despite the concerns about political uncertainty in the UK and what a hung parliament or a Brexit referendum would imply, investors appear to be been relatively sanguine at the moment. I’m not sure that will remain the case as we get towards the actual election date. The opinion polls currently put the Conservatives and Labour parties neck and neck but how this falls out in terms of the allocation of seats in the House of Commons is unusually complicated and unpredictable. At least there does seem to be some distance between the two leading parties on a number of key issues, particularly the balance of fiscal policy. It’s hard to see a really market friendly outcome but maybe a very close election with no party gaining an overall majority (which appears to be the most likely outcome) does not do that much to the level of interest rates or sterling. After all, the outlook for rates it going to be determined by what happens to UK inflation expectations and how the Bank of England reacts to that, rather than who is fighting to get into Number 10. But I guess there are scenarios that are quite negative for UK assets if there is the prospect of a minority government with an agenda of favouring tax increases over spending restraint. UK equities have lagged European bourses this year and while some of that is probably explained by the weakness of oil and commodity related stocks and lingering concerns about UK rates, the Brexit question may also be on investors’ minds. Awkwardly for markets, an outcome to the election that, on the face of it, is business friendly will also be one that creates more uncertainties about where Britain stands in the wider business world. With Europe showing signs of recovery I wouldn’t bet that sterling can get that much stronger against the euro, at least not until the election is out of the way.
The Fed is still the train coming down the track, but very slowly – However, the point remains that volatility is lower than many would have imagined given the divergences in monetary policy and the plethora of political event risk. No-one is really sure what will happen with Greece but there has hardly been a ripple in other peripheral bond markets. Russia seems to be as belligerent as ever but recently Russian debt prices have rallied. The VIX index is well below the volatility peaks of early this year and last year while the MOVE bond volatility index is also on the decline again. This could be the calm before the storm – the storm being the increase in US interest rates – but even the timing on that remains uncertain and the minutes of the Federal Open Market Committee (FOMC) meetings from March 18th show just a mild preference for a June hike. The message from the Fed continues to be that decision making on rates will be data dependent. The decline in non-farm payroll growth to 126,000 in March (relative to the 12-month average of 270,000) and some softer Q1 data has made the outlook even less clear. Maybe one way to read the weaker payroll data is that firms can’t hire the right people now after more than 4 years of solid employment growth and declining unemployment rates. If that is so, we should start to see more evidence of wage growth picking up in the months ahead. It would be ironic if a weaker data point on employment growth was a signal that the economy was close to full employment and that interest rate hikes should start soon. As I have said before, when the Fed does start it is likely to target getting the Fed Funds rate back to zero in real terms (at least) which means something like 150bp of hikes in the first one or two years. That will lead to higher US yields across the curve. On the other hand, the strong dollar might be the reason why the US growth rate has come off the boil. Q2 data will be important in giving us more to work with in terms of what the Fed might do in June.
More aggressive credit phase – I can’t help but be moderately bullish on the economic outlook. At our forecasting in March, the macro factor was not seen as particularly significant in terms of return expectations – not strong enough to warrant a short term change in interest rates or inflation and not weak enough to warrant any concerns about default rates in credit markets. Real goldilocks stuff. No wonder equity markets like the current environment. And so do company managers it seems. Merger and acquisition (M&A) activity is continuing to be significant with the announcement of the Shell/BG deal this week following the large deals we saw in 2014. So far this has not been a large negative for credit markets but the combination of stronger bank balance sheets, more securitization of loans and historically low interest rates is likely to see the credit cycle enter a more aggressive phase. A large proportion of the new issues launched in Europe this year have been from US companies taking advantage of low borrowing costs in Euros and swapping the liability back into US dollars for an all in cost that is more beneficial than borrowing directly in dollars. In the US dividend growth has been impressive in the last year or so and companies may be tempted to increase leverage in order to support dividend payments and stock prices through a period of rising interest rates. Certainly, if there is going to be any widening of credit spreads in investment grade markets it is more likely to be in the US than in Europe, although to a large extent it has happened last year. It does seems reasonable to assume that there is going to be more M&A activity globally in order for the corporate sector to take advantage of the window of extremely low interest rates.
Viva growth – Back to Europe. I was in Spain over Easter and one really gets the sense that things are improving. Looking at the data there is very positive momentum in that economy with the purchasing manager composite index up at 56.9 in March compared to languishing around 42 at the height of the crisis in 2012. The property market has also started to move with housing transactions up more than 15% compared to a year ago. There has been consolidation and recapitalization in the banking sector and there generally seems to be improved business confidence. Sure, unemployment remains a problem and ordinary Spaniards have suffered some loss in living standards, but the upside is that Spain has seen a genuine improvement in competitiveness. Its current account moved into surplus in 2012 and that surplus has generally been expanding since. Growth is now above the average government borrowing cost so debt dynamics are also moving in the right direction. There is still a lot of debt and there are political concerns with general elections later this year, but the economy was already in a good position to benefit from QE and appears to be doing so. Spanish debt is expensive though, with a 10-year yield of 1.2%, but there are probably interesting opportunities in residential mortgage backed securities (RMBS) as the real estate market improves. The story on Spain though is that, even without QE, there has been an improvement in fiscal and sovereign credit risk fundamentals. Peripheral Europe remains highly indebted and there is limited scope for fiscal policy to boost growth, but low rates and improving growth prospects are very favorable.
Boring bonds – It is difficult to have strong short term views on bond markets. The Easter period has been quiet and markets are directionless which is not surprising given how low yields are and how narrow spreads are. There is no real catalyst for a bearish move in bonds especially with the ECB’s presence. If nothing much happens, 10-year bunds will likely have a negative yield pretty soon and this will inevitably bring peripheral spreads lower, especially if there is a positive resolution to the Greek situation. I’m already very uncomfortable with the valuations in fixed income markets but this would make things even worse as sourcing income from bonds (what they are supposed to be all about) will be nigh on impossible. For the bond business this means the only realistic source of flows will be into higher beta assets (high yield) and strategies (unconstrained, flexible funds) to be followed by a painful period of negative returns when we get the eventual re-pricing. Rather sobering for those of us that make our living investing in the bond market. So rather than dwelling on that, what about some sport.
Nirvana – It’s weekends like the one coming that make me so glad I am a sports fan. There is a feast ahead – the Masters from Augusta (come on Rory), the Grand National (sure fire way to lose a tenner), the University Boat Race on the Thames and the Manchester Derby. United are above City in the Premier League and, rather surprisingly, pushing for second place. A victory for the Reds will raise confidence for the visit to Chelsea a week later. Six points from those two games sets it up for a very exciting end to the season. The combination of our diminutive Spanish midfield, the big hairy Belgian and an on-form Rooney is delivering the goods at the right time. So, a perfect weekend would have Rory win his Grand Slam, a 16-1 winner in the National, Cambridge (starting from my son’s school’s boathouse) winning the Boat Race and United putting an end to City’s season. And the sun is shining – “Spring is nature’s way of saying – Let’s Party” – Robin Williams.