The asymmetry in central bank policy
2017 was characterised not by central bank activity and the reduction of stimulus, but rather by the failure of inflation to respond to the acceleration in global growth (chart 1). Policy makers were again left questioning the models that served them well in previous cycles, such as the Phillips curve that shows the trade-off between inflation and employment.
Looking ahead, there is an increasing risk that central banks flex the interpretation of their mandates and signal an increased tolerance for ‘lowflation’. More than 25 years into inflation targeting, central banks have been very good at keeping inflation contained, but they have reached their limits in being able to push inflation higher.
This asymmetry of policy has kept central banks erring on the side of caution and keeping rates lower for longer, but this has encouraged financial imbalances to grow. The clearest sign of this is debt, which today stands at record levels of more than 260% of global GDP.1 Policy makers increasingly recognise this imbalance.
Chart 1: Inflation failed to respond to the acceleration in growth
Note: Simple average of real GDP and core CPI (both %YoY) of US, Eurozone and Japan. Source: Bloomberg, October 2017
In the US, the interest rate cycle will enter its third year. A new Federal Reserve chair is unlikely to change the Fed’s approach and we expect two hikes in 2018, slightly more than currently priced in by markets. Yet the balance of risks is still tilted towards a more cautious Fed.
While this has been the slowest tightening cycle on record, the past three cycles saw interest rates peak after only an average of 18 months. Nonetheless, buoyant economic data, lofty financial markets and a range-bound dollar should keep the Fed on a steady tightening path, for now.
In the Eurozone, the economy is experiencing its most broad-based expansion since the financial crisis. Banking sector wounds are healing while fiscal imbalances are a lingering concern, but unlikely to manifest until the next cycle. More pressing for policy makers is the lack of inflation.
The European Central Bank’s strict adherence to its inflation objective makes it the most unwavering of central banks to its mandate; however it also places it in a bind. Uncomfortable with ongoing QE and its cross-border ramifications, the ECB will struggle to justify any acceleration in the pace of policy normalisation given the Eurozone’s weak inflation trends.
In the UK, things may get worse before they get better. Housing data, normally a good leading indicator for the economy, is straining under the weight of Brexit uncertainty. A weak macro picture should keep the Bank of England on hold through the year.
In Japan, improving growth and an eroding output gap may encourage the Bank of Japan to raise its target for 10 year government yields late in 2018.
Outside of these markets, a key focus will be on the slowing Chinese economy, which will set the tone for the Asian region, commodities and broader risk sentiment. Faced with a significant debt overhang, recent spikes in CNY bond yields remind us of the fragility and imbalances in that economy, although Chinese policy makers have much dry powder to cushion any pullback.
For bond markets, sustained growth and a further rise in US rates should put upward cyclical pressure on yields globally. However, the structural supports for bond markets that have kept yields lower for longer remain in play: debt, demographics, low productivity growthy and political discontent.
Overall, we expect government yields to creep higher in 2018, but only a little more than what is already priced into markets. Our 12 months ahead base case for 10 year Treasury yields is to move from 2.35% to 2.5-2.75%.
Credit is expensive… investment grade best placed but choose wisely
Strong economic momentum and a benign interest rate backdrop supported credit markets in 2017. If these stable conditions persist, higher-yielding parts of the market should continue to outperform, supported by carry and spreads tightening beyond current levels. In fact, an upside risk for markets is the growing consensus of investor caution, particularly among asset managers.
The most pressing reality is that valuations are stretched, so it’s hard to be overly constructive (chart 2). Investment grade remains in the sweet spot and offers a sufficient cushion to withstand a downturn in the economy, but high yield and loans are especially vulnerable.
The tightness of spreads across both sides of the Atlantic, and in Asia, means that there are fewer regional opportunities to capitalise on than in previous years. Emerging market debt, however, offers decent return potential by being closer to investment grade quality and having a wider mix of risk characteristics and market drivers. Asset classes such as hybrids also offer opportunities, boasting yields comparable to traditional high yield markets but with the underlying credit risk of investment grade.
Late-cycle credit means be prepared for downturns
Nine years into this sustained rally in risky assets, investors should start positioning credit portfolios for late-cycle risks. With spreads tight, valuations should play the key role in allocation decisions.
Chart 2: Valuations are stretched but investment grade, hybrids and EM offer better value for their underlying credit risks
Source: Bloomberg, ICE BofA Merrill Lynch bond indices, option adjusted spreads, November 2017
Given the difficulties in perfectly timing markets and the higher transaction costs in credit, simply being nimble with asset allocation won’t be enough. Therefore, smarter diversification should be a key feature of late-cycle portfolios and investors should reduce the concentration risks that typically come from single-currency benchmark approaches.
For investors with a wide set of tools, late-cycle solutions can include dynamic portfolio hedging, which emphasises timely indicators of market stress, such as liquidity, momentum and investor positioning.
Another solution is using credit options to capitalise on low volatility - simultaneously selling upside potential while buying downside protection. Like asset allocation however, relying solely on these sophisticated approaches won’t completely mitigate the tail risk.
The final and most crucial solution is active credit selection. Low dispersion across credit markets means now is a good time to trade up in quality without giving up substantial yield. For instance, the spread between BBB and BB rated securities is close to all-time lows, so investors should question themselves each time they extend risk in pursuit of yield (chart 3).
Today’s environment provides a fruitful hunting ground to separate the winners from the losers, but late-cycle investing requires investors to be willing to sacrifice some returns. It is a price worth paying.
Chart 3: A good opportunity to trade-up in quality
Source: Bloomberg, ICE BofA Merril Lynch bond indices, based off option adjusted spreads, November 2017.
1Source: IMF Financial Stability Report, G20 debt-to-GDP ratio, October 2017
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