The tide that lifted all boats is ebbing and the withdrawal of crisis-era liquidity support is changing the dynamics of the fixed income market. Quality and security selection will be a key driver for fixed income returns in 2019.
As the Federal Reserve’s tightening cycle comes to a pause in 2019, it should anchor 10-year Treasury yields at around 3 per cent, and provide some relief to emerging market debt as well. Meanwhile we advocate a defensive stance on corporate credit where cooling growth and high levels of debt would act to push spreads wider.
Lower liquidity means rising risk
2018 will not be remembered kindly by investors, with volatility a common thread across all markets. Central banks began to pull back from crisis-era monetary policy, challenging what had become fixed income market conventions of low volatility, limited drawdowns and low yields.
As the Fed shrinks its balance sheet, the European Central Bank prepares to end asset purchases, and the Bank of Japan gradually steps back from the market, yields are adjusting higher and risk premium is coming back to the fore. Lower central bank liquidity naturally leads to higher volatility, creating an environment that will reward careful security selection in 2019. Such a narrative tends to benefit companies with strong balance sheets committed to a sustainable capital structure. When it comes to selecting high-quality securities, European investment grade debt offers better opportunities that US credit over the next 12 months. Valuations are becoming stretched in the US and it makes sense to take profits and put them to work in overlooked markets.
Periods of significant equity market turbulence, like the one seen at the end of 2018, have typically been foreshadowed by a widening of credit spreads. However, corporate credit was resilient to the volatility in equity markets, outperforming on a beta-adjusted basis. This was to be expected to some extent given the relative underperformance of the asset class in 2018, low supply and cautious investor positioning.
Investors should not get complacent as it is yet to be seen whether the moves in equities this year hint at something more sinister to come in 2019. As the capital market narrative develops next year, we would argue for a defensive stance on global credit, as cooling global growth and elevated corporate debt will eventually act to push spreads wider.
A climate of reduced liquidity that focuses investors on high-quality securities should offer up opportunities for attractive returns and income. Securities at the lower quality end of the spectrum, on the other hand, such as leveraged loans and high yield credit, are likely to fare worse, with growing evidence that the end of the credit cycle is nigh. Companies have taken advantage of the buoyant environment to ramp up supply and ease or remove covenants, to the detriment of investors. Similarly, high yield names in the BBB segment may be subject to ratings downgrades next year as earnings soften.
A pausing Fed may lift Treasuries
Treasuries had a tough 2018, but we expect 2019 to bring the market some relief.
Our view is for the Fed to pause rate hikes in the middle of the year, as tighter financial conditions and effects of trade tariffs begin to weigh on the real economy. Calling a halt to rate rises after two 2019 hikes in March and June will anchor 10-year Treasury yields at around the 3 per cent mark.
While inflation is the central risk to this outlook, we don’t expect prices to rise meaningfully. Wages may be firming against a backdrop of stronger-than-expected US growth, but unit labour costs are stable. Productivity is rising in tandem with wages, helping to ease the inflationary pressure. As a result, our base case is that inflation stabilises, barring any shocks from higher commodities prices.
Chart 1: Inflation steady as she goes
Source: Fidelity International, October 2018
The Fed has grown more confident, but it has little incentive to be overly hawkish. A December hike is fully priced in, and risky assets are showing signs of ‘yield fatigue’, particularly in the reaction of equity markets to the rise in US Treasury yields, which turned a traditionally negative correlation positive. As Treasury valuations fell, so did equities, indicating a broad level of fear in the market over the potential effects of tighter monetary policy on all asset prices.
As with previous episodes of such turbulence, we view it as a temporary phenomenon, and see correlations reverting to their negative long-term norm. With yields unlikely to rise further from here over the next year, we see value being created in the US Treasury market, particularly at the longer end of the curve.
Emerging from the storm
Higher US yields and a stronger dollar proved a challenging combination for emerging market debt. However, a rebound is on the cards.
US liquidity withdrawal, slowing growth momentum and higher inflation will still be themes that the asset class will have to contend with next year, but much of the bad news is already priced into the market, creating pockets of value for investors. At 6.8 per cent, the yield on the JP Morgan EMBIGD index is the highest since the global financial crisis, and now better compensates investors for the risks that still lie ahead. Within EM hard currency debt, we still prefer corporates to sovereigns, as they remain a better allocation on a risk-adjusted basis.
Currency devaluations have already done much to rebalance economies of countries such as Argentina and Turkey. Furthermore, an extra boost could come in the second half of next year from a more cautious Fed. As such, there are significant opportunities in the form of undervalued EM currencies. After a traumatic year and sizeable repricing, our top picks are now the Argentine Peso and Malaysian Ringgit.
China’s inclusion in the Bloomberg Barclays Global Aggregate Index, a key bond benchmark, in April, will reignite capital inflows in 2019. These should support Asian investment grade bonds where we see three additional tailwinds. Corporate fundamentals in the region are improving, companies are deleveraging, strengthening their balance sheets. At a technical level, we’re seeing a resurgence in domestic demand that will provide additional support to the market.
On the macro side, we see Chinese authorities responding strongly to the slowdown in economic growth with looser fiscal and monetary policy, supporting risky assets. We also expect policymakers to prioritise support for infrastructure projects in the near-term to help cushion the pace of the country’s slowdown.
Elsewhere, we are watching for sovereign debt opportunities in some of the smaller, fast growing, pro-reform frontier countries such as Ivory Coast, Argentina, Ecuador, Ukraine and Albania. Middle East sovereign bonds, such as Saudi Arabia and UAE should benefit from elevated oil prices and index inclusion next year. And, in local rates, the debt of countries such as South Africa, Peru and Mexico, offer high real yields, credible central banks and steep curves.
While there is no doubt that EM debt will still face possible headwinds, from a strengthening dollar, escalating trade tensions, and continued bouts of market volatility, the rapid rise in risk premia in 2018 has created attractive entry points to add risk in 2019. Again, as with Europe and the US, the narrative for the sector is centred around picking out areas of value in a potentially volatile environment.
In conclusion, the outlook is for an unsettled global market environment; one that is prone to periods of volatility as debt investors adjust to dwindling liquidity and tighter monetary conditions. Against such an uncertain backdrop, we see opportunities to differentiate high-quality corporate names from less attractive, lower-quality peers, a soft ceiling on US Treasury yields as well as favourable valuations in emerging market debt securities.
The tide may be ebbing, but not all boats will hit the floor.