Work in progress (Archived)
Thomas Higgins, Standish & Isobel Lee, Insight
With most global economic commentators predicting a rise in interest rates in the influential US market next year many fixed income managers are already pricing in this expectation.
While any fresh pronouncement from the US Federal Reserve (Fed) on the ‘tapering’ of its quantitative easing (QE) programme can have a major impact on fixed income investments, a raft of other economic data can also help fixed income analysts predict potential future trends and likely reactions from both central banks and the wider market.
Given central banks such as the Fed strive to maintain high employment levels while keeping inflation under control, it pays fixed income investors to keep a particularly watchful eye on the latest wage and labour market statistics.
Commenting on the importance of these figures Isobel Lee, head of global fixed income at Insight, says: “From both a global and national perspective the labour market is a key determinant of consumer demand and can have a major bearing on inflation so it will always be very important to both central banks such as the Fed and the wider market.”
Insight keeps a close check on global wage and employment trends for early indications of inflationary pressures and potential interest rate rises that may impact the fixed income sector. According to Lee the most encouraging employment and wage growth news is currently coming from the US, which added 192,000 jobs in March alone after an economic dip now largely attributed to a sustained spell of unusually bad weather in North America earlier in the year.1
“The US was the only place where we have seen any wage growth in 2014, though even that is quite hard to see. There has been some upward momentum in terms of wage growth but it is still at a fairly low level. Nevertheless we feel the US labour market is starting to heal and the Fed is driving the country towards full employment levels,” she says.
US Treasury bond prices did rally after the March US employment figures eased concerns that the Federal Reserve might raise interest rates sooner than expected.2 But, despite this positive news, some investment managers remain wary.
US investment manager Standish analyses a wide range of economic factors and agrees wage and employment data can provide important indicators of likely changes in fixed income markets. But it also views the latest available data with some caution. Standish chief economist and global macro strategist Thomas Higgins is particularly concerned by a recent policy shift by the Fed away from its previous quantitative intervention towards a more qualitative approach to guidance on the labour market, inflation expectations, and financial developments. He feels this new approach has the potential to increase both uncertainty and volatility, with potential consequences for fixed income markets.
The move was initially prompted by the fact the Fed has made significant progress on meeting its maximum employment goal with the economy adding more than 8.2 million jobs since January 2010, persuading it to abandon its quantitative 6.5% threshold on the unemployment rate at its March policy meeting in favour of more qualitative guidance.
But, Higgins is not convinced the change will benefit the market. Explaining his reservations he says: “Looking ahead, we worry that the lack of explicit objectives - driven by the move away from quantitative forward guidance on the labour market - will create greater uncertainty about the future path of interest rates and thus add to Treasury market volatility.”
Higgins believes fixed income sectors with large retail investor bases - such as emerging market debt and high yield bonds - are more vulnerable to this volatility given the risk of bond fund outflows. But he adds that stable to improving corporate fundamentals will continue to be supportive of investment grade bonds and the high yield sector, while valuations in the emerging market space have become more attractive. Ultimately, Higgins feels increased Treasury market volatility could present opportunities for investors. Historically, higher Treasury yields have been accompanied by tighter credit spreads.
Beyond the important US market, the employment and wage growth picture is mixed; although there is at least some good news. British employment levels set a new record in the three months to November 2013, reaching 30.1 million,3 and registered further good news in April 2014 as its weekly earnings finally edged above inflation after nearly six years of falling living standards. According to figures from the Office for National Statistics weekly wages, including bonuses, rose by 1.7% in February, up from 1.4% in January, while inflation, as measured by the Consumer Prices Index (CPI), fell to 1.6%.4
But the picture is less positive elsewhere.
According to Lee growth in both Continental Europe and Japan remains sluggish, raising few positive indicators to encourage fixed income investors. “Eurozone labour market signals are very mixed,” she says, adding: “Real wage growth is still weak, though there are some signs of a pick-up in Germany, with certain skill shortages reported - a sign the market is moving back to normal. In contrast, in the economies of southern Europe unemployment is still rising. Part of the problem is labour markets became uncompetitive when interest rates were too low.”
In Japan, despite the best efforts of prime minister Shinzo Abe, the labour market picture also remains gloomy. In addition to this, Lee adds that reform holds potential risks of its own. “Japanese labour market reforms have been very slow and the country is locked in a form of quantitative easing in which the Bank of Japan is buying the net supply of Japanese government bonds. This process has to be managed carefully because Japan risks replacing deflation with hyperinflation if the country gets the balance wrong,” she concludes.
Taking into account the overall global employment and inflationary picture, Higgins believes some of the best value in bonds currently resides in developing economies, though he stresses investors should place their capital carefully.
“We believe emerging markets are one of the most attractive sectors of the fixed income markets at the present time. The sector was the most beaten up by the sell-off last year when talk of the Fed tapering its quantitative easing program first arose. Emerging market dollar debt has tightened since then, but emerging market local debt is still relatively cheap.
“You have to be selective though. There are countries with structural issues like Turkey - which still has internal and external imbalances and some geopolitical risk. But there are also other countries like Colombia, which have sound macroeconomic fundamentals and are therefore much more attractive,” he concludes.
What to watch out for
- The potential impact of the US Fed’s move towards a more qualitative approach to guidance on the labour market, inflation expectations, and financial developments. Fed meetings to take place in 29/30 July, 16/17 September, 28-29 October, 16-17 December
- Further good news from the UK on jobs and growth throughout 2014
1. US labour market emerges from winter blues. FT. 04.04.14
2. Treasury Bonds Rally on U.S. Jobs Data. The Wall Street Journal. 04.04.14
3. Working it. The Economist. 25.01.14
4. ONS: After six years, wages finally overtake inflation. BBC Business News. 16.04.14