A strengthening global economy and some surprisingly hawkish rhetoric from the world’s central banks has led to mixed returns across global bond markets over the past few months. Hints that the European Central Bank (ECB) could start to gradually unwind its current stimulus measures as economic growth gathers pace sent bund yields surging towards the end of June. In contrast US Treasuries have held up relatively well over the past few months, suggesting that the prospect of further gradual rate rises is at least partly priced in. Corporate bonds have also proved resilient, with spreads continuing to grind tighter across most parts of the market.
The key question now turns to the next steps of the world’s central banks and what this means for fixed income investors over the coming months and years. As well as considering whether growth is sufficiently robust to withstand a withdrawal of stimulus, policymakers also need to take account of the slight softening in global inflation over the past few months, and whether this is just a blip or the start of a longer-term trend.
Europe – turning a corner
The economic situation in Europe in particular looks considerably brighter compared to this time last year. While still elevated, the unemployment rate continues to steadily fall, and is now back below 10% for the first time since 2011. Meanwhile, business surveys point towards a further steady pick-up in growth, with a recent record print for the German Ifo suggesting growth of around 3% in the second half of 2017.
Political tensions have also eased, with Emmanuel Macron’s decisive victory in the French election providing a further boost to sentiment in recent months. While Italy’s lagging economic performance and upcoming general election offer the potential for an upset, for the time being the eurozone does not seem to be embracing the populism that has swept across other parts of the developed world.
Notwithstanding the improved economic and political situation, we believe the ECB will proceed very cautiously on the monetary policy front. For the moment there is little sign of firmer growth yet translating into a meaningful pick-up in core inflation and on this basis we think policy is likely to remain accommodative for some time. We think the combination of an accelerating economic recovery, modest inflation and supportive central bank policy should continue to provide a supportive environment for European corporate bonds going forward.
Despite strong gains this year, we believe it is still possible to find pockets of value in European corporate bond markets. A key theme at the moment is in subordinated financials, with European banks well placed to benefit from an environment of steeper yield curves. In addition, the fact that many of these issues have not been included in the ECB’s bond-buying programme means that valuations in this part of the market tend to have been less distorted by central banks actions.
Fed – on course to deliver further rate hikes
In the US, we think the Federal Reserve remains on course to push through further gradual rate rises over the next couple of years as the economic situation improves. However, even though the US economy is moving ever closer to full employment – with initial jobless claims as a percentage of the working age population at record lows – US interest rates remain at historically low levels. In this sort of environment we think Treasury yields are likely to remain on an upward trajectory and we believe a short duration position is still warranted. Instead we are focusing our attention on parts of the US corporate bond market that stand to benefit in a rising yield environment, such as US dollar-denominated floating rate bonds from blue-chip banks and financial issuers.
We also see good value in Treasury inflation protected securities (TIPS) which we think are currently under-pricing inflationary pressures in the US. We believe the recent softness in US inflation was largely due to energy base effects, with last year’s rise in oil prices now falling out of the year-on-year inflation figures. There has also been a combination of idiosyncratic factors at play, such as a sharp drop in medical fees and the well-advertised fall in US wireless plan prices. However, in the medium term, we think economic fundamentals will come to the fore, and a strengthening US labour market and growing wage pressures suggest that US inflation will move higher over the medium term.
While we think the Fed remains on a hiking path, it should be acknowledged that the market has recently become a little more dovish in its outlook for US rates. As well as the slowdown in inflation, this is also likely to be a reflection of the Trump administration’s difficulties in pushing through its proposed tax cuts and increased infrastructure spending. As it stands, the market is now pricing in a slightly above 50% probability of a further Fed rate hike this year.
Nonetheless, over the medium-term we expect global bond yields to drift gradually higher from this point. In our view, we are entering a period of normalisation, with the return of both growth and inflation. While inflation numbers have been more muted recently as energy base effects fade, we expect inflation to remain a theme going forward. In this environment we believe a short duration stance and a selective exposure to credit will be key to generating positive returns over the next few years.
Jeik Sohn is investment director for M&G Investments
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