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As the prolonged era of extraordinary monetary policy winds down, our fixed income fund managers consider what investors should look out for in 2018.
Mark Twain famously quipped: “The reports of my death are greatly exaggerated.” It is a line that could be applied to the long-running bond bull market which, despite countless predictions of its demise in recent years, has kept on going.
Of course, this has largely been fuelled by the aggressive and unprecedented monetary policy easing by major central banks in the post-financial crisis era, which has supported bond prices. As this era slowly but decidedly, draws to an end, the outlook for fixed income seems more fragile than it has been in decades.
With the US economy continuing to strengthen, the Federal Reserve raised rates three times in 2017, and even the Bank of England (BoE) increased its benchmark rate in November; the first such move in a decade. And while the European Central Bank (ECB) and Bank of Japan (BoJ) may not yet about to embark on their own hiking cycles, they too are moving closer to the exit door.
In 2018, much will hinge on investors’ response to progressively tighter monetary policy. According to Charlie Diebel, head of rates at Aviva Investors, inflation will be a key theme as central bank bond buying is scaled back. “The Fed will continue to hike, especially if the US tax plans push growth further along,” he says. “The ECB will buy fewer bonds and is expected to stop purchases altogether by the third quarter, while the BoJ might alter its yield-curve control targeting, where it has bought bonds in order to keep ten-year yields at zero.
“Markets will have to absorb net positive supply for the first time in years,” he adds. “Although global inflation has been subdued, if it were to surprise on the upside it could knock demand for bonds. The unwinding of loose central bank policies could become more disorderly than expected.”
Geoffroy Lenoir, head of euro sovereign rates at Aviva Investors, expects yields to rise, especially for longer-dated bonds, as investors “face the reality of reduced bond buying from the ECB” and as stronger economic growth raises inflationary pressure.
“While political risk is likely to fade somewhat in 2018 from the elevated levels seen in 2017, it is likely to remain a key determinant of spreads between German bunds and ‘peripheral’ markets,” he adds. “The positive economic outlook for Europe should support further European integration, despite elections or fragile coalitions in some member states that could slow the process and temporarily stoke yields higher.”
Despite the backdrop of Brexit negotiations, Edward Hutchings, senior UK sovereign debt portfolio manager at Aviva Investors, believes 2018 is unlikely to see a drastic change in market conditions.
“Yields are stretched to rich levels, but at the same time are supported by the benign economic growth outlook,” he says.“This, coupled with weak wage inflation, means the BoE will be cautious in increasing rates further. With the uncertainty surrounding Brexit negotiations and inflation likely to recede from current levels, a sizeable rise in yields is unlikely in the near future. This may well change, however, as we navigate through 2018; especially so if we see changes in either the domestic political backdrop or positive developments on Brexit.”
Meanwhile, Liam Spillane, head of emerging market debt at Aviva Investors, believes the asset class will continue to draw investors in 2018.
“We expect that client demand is likely to remain high,” he says. "The broad and synchronised improvement in fundamentals in emerging markets over the course of 2017, along with a broadly supportive macro picture and some attractive valuations, should offer a significant buffer against any notable increase in volatility in 2018. However, this will be a concentrated political and electoral year across our markets and selectivity will be critical.”
Challenges for credit
Colin Purdie, global head of investment grade and liability-driven credit at Aviva Investors, believes that although total returns are likely to remain positive, 2018 will be a more challenging year.
“Investors will become more selective and this will mean that 2018 may be a year of greater credit differentiation, especially as we head into the second half of the year,” he says. “As government yield curves ‘normalise’, it will not be a one-way march tighter in spreads, as in 2017. Certain credit sectors, primarily those that have been heavily bought by the ECB such as utilities, could come under pressure. On the other hand, European financial sector debt should continue to perform well.”
The market will also keep a close eye on US tax reforms, which could lead to a contraction in bond issuance. “The impact of US tax reforms will need to be monitored closely, as markets may be underestimating the significance of the changes,” says Purdie. “We could see a big drop in supply as companies buy back debt and shift financing away from the bond markets. This could prove supportive from a technical standpoint.”
The return of volatility
Apart from a few noteworthy episodes in recent years, volatility has been noticeable by its absence in the fixed income markets. Josh Lohmeier, head of North American credit at Aviva Investors, cautions this could change in 2018.
“Foreign and retail fund flows will need to be watched closely in the coming months,” he says. “They were a significant tailwind for US credit in 2017 and, while they should remain positive in 2018, the size of net inflows could reduce. This is one reason we expect returns in 2018 to be more modest than last year, and why there could be potential for more volatility than we have seen in recent years.”
James Vokins, senior portfolio manager, multi-strategy fixed income at Aviva Investors, also believes volatility will be more evident in the European credit markets.
“The combination of the ECB unwinding asset purchases and a continuation of strong corporate bond supply will cause an increase in credit spread volatility,” he says. “Merger and acquisition activity will likely pick up as the economic backdrop evolves, and we will begin to see valuations better reflect the fundamental differences between companies and sectors. This is a contrast to recent years, where indiscriminate bond buying has made company valuations trade tightly together.”
Vokins is more positive on the outlook for UK credit, however, noting that much of the outstanding debt in the sterling credit market is issued by non-UK companies. “Attractive valuations and the increasingly global diversity of the sterling credit universe will increase interest from overseas investors in 2018, which should offset UK political concerns,” he says. “Having said that, some sectors are clearly more exposed to the political uncertainty than others; we are particularly cautious on bonds issued by UK-focused companies in the more cyclical retail and banking sectors.”
Aviva Investors’ head of global high-yield, Kevin Mathews, thinks periodic bouts of volatility could create buying opportunities, although market conditions are likely to be more challenging overall. “Total returns on high-yield debt should be positive in 2018, as defaults stay low and fundamental factors remain sound,” he says. “However, yields are likely to tick higher following the exceptionally strong returns seen in 2017. While short-term rates will rise with central bank tightening, longer-term rates should remain steady.”
Only time will tell what lies ahead for fixed income markets, but what looks certain is that the tide of easy money investors have become accustomed to is turning back the other way.
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