After a year of shock results and unexpected outcomes, two signs of change have materialised on the fixed income horizon for 2017.
First, recent economic data has highlighted a gradual increase in prices, particularly in the US where rising housing and fuel costs contributed to the fourth consecutive monthly gain in inflation in November. However, if we look past the volatile food and energy components, service sector inflation has been creeping upwards for over twelve months. This is most evident in the medical sector, where care services cannot be outsourced abroad.
Furthermore, if Donald Trump’s pre-election promises prove to be more than campaign noise, plans to limit the competitiveness of internationally produced goods within the US also has the potential to drive prices higher. Across the water, the UK is vulnerable to an inflationary shock on the back of currency weakness, although the domestic economy has proven surprisingly resilient post the Brexit referendum.
Oil prices have a strong influence on inflation and inflationary forecasts, but with the price of Brent crude appreciating from a low of USD 27.88 in 2016 to USD 57.38 per barrel in the opening days of 2017, it is difficult to see prices rise materially from here – even with recent cuts to production by OPEC members. However, this steep appreciation is likely to have a smaller impact on inflationary data as the base effect begins to ware off.
Our view is that none of these factors, singularly or as a collective, signal that we are facing a persistent and elevated inflationary state: the risk is more nuanced. Supply is being trimmed rather than demand not being met – with OPEC supply cuts providing the perfect example – while sluggish global trade figures further reinforce this view. Wage growth also remains modest, with minimum wages being raised by politicians, not workers at picket lines.
All this suggests an imminent ‘pulse’ in price data, where we expect to see multiple occurrences of low-level increases combine, contributing to a modest uptick rather than a persistent long-term inflationary environment. So how best to profit? With inflation-linked securities offering unattractive real yields with high sensitivity to interest rates, going short nominal debt is the more attractive option
A second change on the horizon is increased scrutiny of ultra-accommodative monetary policies and the pressure mounting on governments to come up with alternative strategies. In the US, the reasons for delaying normalisation are becoming weaker and scarcer, as are the number of opponents to such a shift in direction. While the Federal Reserve’s decision to increase rates in December was considered a sure thing, it is plausible that we will see more than the two hikes that the market has currently priced in for 2017.
In Europe, the ECB’s ‘tapering by another name’ (same amount, spread over a longer period), hints at stresses within the governing council and briefly led government bond yields higher, although the market seems to have faith in President Mario Draghi’s “whatever it takes” 2012 promise.
Absent central bank buying, we believe core bond yields have the potential to appreciate some 50 basis points at the long end of the curve to reflect a rise in inflation, positive growth dynamics and a material change in official supply / demand dynamics.
For Japan, post-US election uncertainty could increase the value of the yen still further, which would be bad for both Japanese exports and inflation and makes the prospect of helicopter money being ‘dropped’ on Japanese consumers a more real concern.
The pace of the year-end sell-off prompted the trimming of short strategies in the developed world, with the emerging markets now looking a more attractive home for assets. Continuing to offer good value with falling growth and inflation likely to trigger more rate cuts across 2017, markets such as Brazil are proving beneficiaries. Mexico, currently cheap by any measure, is another one to watch as US policy developments unfold.
In currency markets, volatility remains elevated, and investors cannot overlook the risk that a strong US dollar poses. But with developed bond markets facing the headwinds of interest rate rises rather than cuts, less quantitative easing, increased issuance and an inflation pulse, particularly in weak currency countries, the challenges of emerging bond markets seem well countered by their positive fundamentals.
Tim Haywood is investment director for absolute return strategies at GAM