Freeze in volatility unlikely, says BNY Mellon’s Brain says
Although supported by global growth momentum and greater policy clarity, the prospect of emerging market volatility remains very real, according to Paul Brain, manager of the Newton Global Dynamic Bond Fund.
After months of anticipation and anxiety, the somewhat muted response of investors to the US Federal Reserve’s (Fed’s) announced reduction of quantitative easing (QE) in December demonstrated market participants’ agreement with the central bank’s positive view of the economic recovery. Consequently, investors were considerably better prepared for a tapering of QE than in May. Indeed, strong forward-looking indicators imply US growth remains on course, while the robustness of the US housing market (despite higher mortgage rates) is supportive of consumer confidence, as the rise in output gains traction.
Government bond yields should thus continue to edge higher but, with yield curves already steep and central banks reiterating their ‘lower-for-longer’ bias amid subdued inflationary pressures, a further sharp jump in borrowing costs would seem unlikely. As such, issues of short-to-intermediate maturity remain attractive. Limited long-duration exposure remains advisable amid rising yields but in the absence of considerable acceleration in economic output, significant underweight duration positions are no longer justified, given the extreme historical steepness of yield curves and the sharp price declines already witnessed through the early stages of a global economic recovery.
While investment-grade credit remains somewhat correlated to movement in underlying sovereign bond yields, we believe improving developed-world economic data should be positive for corporate bond spreads, particularly if company profits remain supported.
With short-term rates on hold, high-yield credit remains attractive, given a more positive growth backdrop, limited refinancing needs and low projected default rates. Meanwhile, continued global growth momentum and greater clarity over Fed tapering and the prospects for rates rises should help to support shorter-dated hard-currency issuance from developing markets.
Yet in the context of continued capital outflows, much-needed structural reforms and challenging domestic politics (including imminent elections) for many prominent emerging market issuers, the prospect of volatility remains. In such an environment, we maintain the currencies of many developing economies have limited potential for sustained appreciation over the coming months (especially as many emerging-market authorities are keen to boost exports via a weaker currency).
However, signs of improving trade balances and the recent extended ‘sell-off’ versus the US dollar, may present selective short-term opportunities. Meanwhile, the continuing US economic recovery points towards the appropriateness of a high dollar weighting, at the expense of the other major currencies (the yen and the euro). Indeed, the Bank of Japan’s aggressive QE programme and the continued deterioration of Japan’s current account suggest the Japanese yen is particularly vulnerable to further weakness.