Focus on: global fixed income
For sovereign corporate debt investors, 2016 offered its fair share of surprises – not least an unexpected vote for Brexit, a rancorous US election and a world of central bank-fuelled negative yields. But could 2017 offer more of the same? Here, fund managers from Insight Investment and Newton give their views on the likely opportunities and challenges over the next 12 months.
What do you see as the biggest tailwinds for your asset class in 2017?
Ulrich Gerhard: We expect growth in the US and Europe to remain stable and positive next year. At the same time, we do not expect this growth to be strong enough to prompt a reversal in monetary policy. Although purchases of investment grade bonds by the European Central Bank (ECB), a key indirect tailwind this year, could fade in 2017, the monetary environment overall will likely remain supportive.
Adam Whiteley: We take a similar view and expect the fine balance between US and European growth to continue to create a particularly supportive environment for credit. Although tailwinds in Europe in 2016 – such as central bank corporate bond purchases – could fade away in 2017, conditions for global credit overall remains supportive.
Paul Brain: Since the financial crisis, the initiatives from the authorities have been supportive for government bonds. The moves to very low official rates and then quantitative easing (QE) have driven bond yields down and prices up. The fragility of the global economy, despite the monetary stimulus, means these supports are unlikely to be removed quickly. Government bond yields will continue to be artificially depressed as a result.
Do you think the trend of negative yields in sovereigns – and corporates – will continue? Are there any areas that look vulnerable to negative yields?
Paul Brain: In Europe and Japan, negative yields at the front end of the curve are an essential part of the authorities’ monetary stimulus plans. While growth remains hard to get, we believe these plans will stay in place. The move towards fiscal stimulus will take a long time both to implement and to make a significant change to the prospects for economic growth. Until there is clear evidence suchfiscal stimulus has succeeded, negative yields are likely to remain. The outlook for longer dated securities is more uncertain as inflation expectations will rise and fears of a reversal of the current loose monetary policy framework will raise volatility.
Ulrich Gerhard: In Europe, we believe the ECB will maintain its current negative interest rate policy for the foreseeable future. In the UK, the Bank of England (BoE) appears biased towards cutting its base rate further.
While this will likely be supportive of a negative yield environment, central banks have demonstrated increased concern regarding the effects of negative interest rate policies and flat yield curves. The BoE, for example, has ruled out a negative interest rate policy, while the BoJ has added flexibility to its annual purchases to target higher yields at longer maturities.
This indicates the universe of negative yielding securities may not increase and could in fact shrink. Furthermore, it’s not unprecedented for government bond yields to sharply increase absent a central bank catalyst – as demonstrated by the sell-off in German bunds in the second quarter of 2015.
How much of a factor is political risk? Which regions/countries would you view as presenting the most significant risks and why?
Paul Brain: Political risk is on the rise as politics moves away from the centre. The politics of populist parties create uncertainty and raises risks. Europe is probably the epicentre of these concerns just because of the number of different governments and the potential for change through numerous elections.
Ulrich Gerhard: We seepolitical event risk as a particularly important factor for high yield credit investors. Most recently, we saw this in the surprise outcome of the UK referendum and the resulting increase in political and economic uncertainty in the UK and Europe. Much is still to be determined as to the nature of the UK’s exit and the economic implications for Europe and the UK, making further episodes of volatility likely.
In 2017, Germany and France both go to the polls in an environment in which fringe separatist political movements are looking to consolidate their growing support. Announcements from organisations such as OPEC also have the potential to create volatility in risk assets, which is particularly relevant to high yield sectors such as energy, pipelines, basic materials and metals and mining.
High yield credit portfolios capable of applying a truly global approach are better equipped to deal with political risks than regionally constrained portfolios, given their greater diversification. The US market for example offers lower exposure to Brexit-related political risks, while the European market is less exposed to the energy and metals and mining sectors.
Furthermore, a short duration approach to high yield, without the constraints of a benchmark, can leave an investor less vulnerable to credit risks. Diligent credit analysis can provide cash flow visibility across shorter time periods, allowing for greater certainty of repayment. During volatile market conditions, whether they are driven by political or macroeconomic factors, this can help investors pinpoint compelling value opportunities.
Adam Whiteley: We agree global credit portfolios are better equipped to deal with political risk than regionally constrained portfolios, partly because of the opportunity they offer to diversify. For example, global credit indices only allocate around 5% to sterling credit and so were less volatile on an excess return basis versus sterling credit markets in the aftermath of the Brexit referendum result.
Global developed credit portfolios can seek to minimise the volatility induced by regional politics as their universe incorporates credit markets denominated in currencies such as the US dollar, euro, sterling, Japanese yen, Australian dollar and the Canadian dollar. The ability to manage risk actively can further open up relative value opportunities between regions, allowing investors to potentially benefit from the volatility created by political event risks.
What areas of hidden or unrecognised value do you expect to focus on in the coming year?
Adam Whiteley: We expect the ability to allocate across different regional markets to prove a compelling source of outperformance for credit investors. From a more bottom-up perspective, we believe that credits that are de-leveraging, possibly following activity such as M&A could offer opportunities to managers able to conduct thorough bottom-up credit analysis.
Likewise, we expect managers with the ability to allocate off-benchmark exposure to add value. We believe areas such as asset-backed securities will continue to offer excellent additional fundamental value. Fundamentals in emerging market debt are also improving and the differential in growth between emerging and developed markets is increasing even as external imbalances recover and countries such as Argentina, Indonesia and Brazil implement important reforms.
Paul Brain: The rise in inflation expectations, for the first time in many years, has brought the area of government inflation-linked securities back into focus. Global growth is still challenged and when markets over-anticipate interest rate increases there will be opportunities to invest. Elsewhere, we expect government bond markets across the globe to grow at different speeds and so diversifying into markets where rates could be cut (for example Asia) could give the global investor an important opportunity for outperformance. Finally, currencies will continue to diverge with those that have a loose fiscal and tight monetary policy stance, likely to outperform.
For Professional Clients and, in Switzerland, for Qualified Investors only. In Germany, this is for marketing purposes only. Any views and opinions are those of the investment manager, unless otherwise noted and is not investment advice. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and its subsidiaries. Issued in the UK and Europe excluding Switzerland by BNY Mellon Investment Management EMEA Limited, BNY Mellon Centre, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No. 1118580. Authorised and regulated by the Financial Conduct Authority. Issued in Switzerland by BNY Mellon Investments Switzerland GmbH, Talacker 29, CH-8001 Zürich, Switzerland. Authorised and regulated by the FINMA.