It was unlikely that the relative calm that had characterised markets in the latter part of 2013 was going to last. Most notable has been the correction in equities, with the bullish tone punctured, perhaps only temporarily, by the US Federal Reserve pursuing its tapering of asset purchases and fresh fears about the strength of emerging markets.
Citi’s widely-followed US economic surprise index has dipped slightly but its still elevated level betrays the fact that the media have been quick to promote negative stories and linger on earnings disappointments even when much of the hard economic and earnings data remains positive. This is not too surprising given that a change in tone is eminently more readable than a continuation of yesterday’s news.
In our view, little has fundamentally changed. Our key strategic themes remain as previously. We continue to expect the global recovery to strengthen, led by the US, Japan and the UK. Europe should be better in 2014 than last year albeit still facing the headwinds of a banking system that needs to shrink and the ongoing requirement to implement structural reforms to improve fiscal sustainability.
Whilst core government bond yields pulled back in January, they are likely to resume their rising trend if, as expected, the US economy continues to improve and tapering is completed by the end of the year. That said, we are closely watching inflation, which is forecast to remain at low levels, particularly if disinflationary forces emanate from emerging market economies.
The current environment lends itself to some key themes within our portfolios. Core European bonds are expected to outperform US bonds given the divergent growth and monetary policies of the two regions – Europe is at an earlier stage to the economic cycle than the US and this gives the European Central Bank greater capacity for further monetary policy accommodation. We expect higher yields in the long end of the UK rates markets. We also expect a steeper European yield curve (rates lower for longer at the short end but longer maturity bonds underperforming) versus a flatter yield curve in the US where we expect the 5-year part of the curve to come under pressure as an improving economy puts upwards pressure on rates.
In emerging markets, we have been relatively cautious on local debt markets in general, although expressing bullish views in Mexico. We started to acquire some short maturity bonds in selected emerging markets that are offering value i.e. where we do not expect the degree of rate hikes currently priced in to be delivered, for example in South Africa. We may have been a little early, given the broader emerging market sell-off but we have kept some powder dry because of just such a possibility.
At the currency level our preference is to be long the US dollar, whilst short the Australian dollar, Euro and yen.
Within credit markets, the longer-term theme of low interest rates and improving economic data continues to lead demand for higher-yielding corporate securities, particularly in Europe. With low default incidence and good corporate liquidity, that should sustain the popularity of lower-rated corporate bonds over 2014. We are, however, aware that credit markets have been more resilient than equities in the latest shake-out so there is some near term vulnerability for credit should the ‘risk-off’ phase be prolonged.
In our Euro credit strategy, we are continuing to favour subordinated bonds, BBB-rated bonds and high yield because these sectors of the market have a higher spread and lower interest rate sensitivity. Investment-grade non-financial sector valuations are less compelling than a year ago and consequently we are more cautious about these sectors, particularly the cyclicals. Another aspect of non-financials is the degree of potential event risk from merger and acquisition activity and re-leveraging, especially in the telecoms sector. This may offer some upside in the high yield market but in investment grade the key will be to avoid the poor performers rather than picking winners.
Looking ahead, with duration the bigger threat to bond returns than defaults, floating rate and multi-asset credit strategies are likely to remain in vogue given their lower rates sensitivity and attractive yield.
Philip Apel, Head of Fixed Income at Henderson