The fixed income party is likely to continue in Europe – AXA IM’s Iggo
Chris Iggo, CIO Fixed Income at AXA Investment Managers, summaries the AXA IM Fixed Income forecasting: For Europe – the fixed income party is likely to continue
There are undoubtedly risks in being invested in fixed income markets. Government bond yields remain not far off their all-time lows reached in 2012. Corporate bonds yield less, relative to government bonds, than at any other time since mid-2007.
In the sub-investment grade part of the market which houses bonds with the highest credit risk, all in yields are below 4.0% in Europe and have just hit record lows in the US high yield market.
We are now approaching the situation where the growth rate of nominal GDP in many economies is moving higher than the prevailing level of yields on bonds. This is a situation that does not normally last for long. If the world economy is recovering and growth strengthens from its current pace, bonds do look very expensive.
Yet the demand for fixed income remains strong and returns in 2014 have been much better than most expected at the beginning of the year. At AXA Investment Managers, the fixed income team has just concluded its regular investment strategy review.
Its conclusion is that a benign macroeconomic environment, low inflation, a stronger global banking system, conservatively managed corporate balance sheets and central banks that remain biased towards easy monetary policies all mean that a significant rise in interest rates or credit spreads appears unlikely in the short term.
Indeed, the team remains biased towards corporate and high yield bonds and emerging market debt as credit spreads could continue to narrow further as we move into the second half of the year.
With valuations stretched and sentiment towards fixed income generally still positive, it is prudent to try to understand what could generate losses. What could come along to push bond yields higher and stimulate some kind of mean reversion in fixed income markets, which have been batting above their average for some time?
A key risk is clearly interest rates. In the UK, the Bank of England has expressed surprise that markets have not attached greater probability to interest rates going up before the end of 2014.
We think rates will go up in November in the UK. In the US the outlook is more mixed. The economy is moving slowly towards higher rates being justified but the Federal Reserve wants to be absolutely sure, meaning that rates remain on hold for the foreseeable future.
The question here is whether the Janet Yellen Fed leaves it too long and market yields rise quickly ahead of any official change in stance.
If markets start to price in a more rapid increase in interest rates because of strong economic data in the second half of the year, volatility will rise. Volatility has been very low in all markets and this has meant lower risk premiums.
In the fixed income world that means flatter yield curves and tighter credit spreads. Rising rates and volatility will lead to higher risk premiums in investment grade credit markets and high yield and push spreads wider and prices lower.
Emerging market debt could also suffer if US rates rise more quickly than is currently priced in. The US bond market is the biggest in the world and higher rates there mean greater competition for bond issuers elsewhere. Our expectation is that US and UK 10-year government bond yields move back towards 3.0% in the second half of the year.
Other risks that we identified would, if they materialised, result in a “risk-off” period in markets. Some geo-political risks become crystallised in energy prices with the situation in the Middle East and a potential deterioration in Ukraine being obvious. Global oil prices have already started to rise and we have seen many times in the past that this can impact on global economic conditions quickly.
We are also watching the Chinese economy closely and see recent weakness in domestic residential property prices and home sales as being a key risk to Chinese growth undershooting. Again, we have seen before how Chinese growth shocks can impact on global investor sentiment.
None of these risks are material yet. In the meantime the search for yield and regulatory driven reasons for owning bonds continues to drive demand. Our investment strategy review concluded with a preference for assets or markets with limited interest rate risks – such as high yield and euro investment grade credit – and for inflation linked bonds given that too little inflation has become priced in.
The areas we want to reduce exposure to are government bonds which are most at risk from increased interest rate risk, particularly in the US and the UK.
Finally, we welcome the recent policy initiatives by the ECB and the strong signal that policy rates should stay close to zero for a very long time.
This supports further good performance by southern European government bonds as well as European bank debt and more equity like products such as subordinated corporate debt issued by, for example, utility companies.
Spanish and Italian government bonds could soon be trading within 100bps of German debt. This is only two years since the ECB promised to save the Euro. It appears to have served fixed income investors very well. For Europe, at least, the fixed income party should continue.