Author: NN Investment Partners
Bond yields may rise in 2018 as central banks dial back their easing policies. The changing landscape creates challenges and opportunities for fixed income and equity investors.
In the coming 12 months, government bond yields in the US and the Eurozone are more likely to go up than down. Monetary policy will be reaching its maximum easing point. The Fed will start shrinking its balance sheet at a faster pace and will raise interest rates at least two and probably three times. The European Central Bank will reduce its monthly bond purchases by half starting in January. Combined with strong macroeconomic data and a bottoming of inflation, this may shift the outlook towards higher yields. Fixed income investors may find best opportunities in assets that are more oriented towards growth or shorter duration. For equities, the playing field will tilt in favour of cyclical sectors.
Government bond yield normalisation may be volatile
After years of solid returns, the environment for the fixed income investor has become quite challenging. How fast will central banks normalize monetary policy, and how will this weigh on fixed income asset classes? Where are the opportunities? The increase of government bond yields will be gradual, but the path is likely to be a volatile one, depending on the market’s reactions to economic data and to central bank actions and statements. Economic data may either heighten or ease concerns about the monetary policy path.
The fact that the US and the Eurozone are at different points in the economic cycle is affecting the shape of the respective yield curves, as expressed in the difference between 2- and 10-year bond yields. The German yield curve has steepened over the past year, while the US curve has flattened. As the Fed has already increased interest rates a number of times, the US 2-year yield has been steadily increasing, while the German 2-year yield is still very low. The longer end of the German curve correlates more strongly with global conditions than the front end.
With the Fed likely to continue hiking – we now expect a rate increase this month, three in 2018 and two in 2019 – and the ECB keeping rates on hold next year, we could see further flattening of the US curve and perhaps some steepening of the German curve.
How vulnerable are fixed income spread markets?
For spread products like investment grade and high yield credits, the general economic environment is positive. It should translate into low default expectations, which would justify a lower level of required spread compensation. Still, spread product valuations are quite high, and it is hard to see spreads tightening much again next year. Money has been flowing into spread classes for almost a decade amid a widespread investor search for yield. If bond yields rise, some of the spread tightening could be undone as investors move to a search for return.
The combination of tight spreads, a long period of sustained investor flows and some signs of market liquidity constraints could signal some vulnerability for spread products. However, history has shown that a sustained and significant widening of spreads seems to require a rise in default expectations. That is why spreads widen substantially only during recession periods. We do not rule out temporary volatility in spreads, but given our constructive growth outlook for 2018, we don’t expect a large sustained spread widening.
Where are the opportunities in 2018 in fixed income?
We expect continued positive global growth, moderate inflation and a gradual monetary policy normalization. This means that fixed income assets that are more oriented towards growth and/or shorter duration could outperform the fixed income universe on a total return basis. Examples are high yield, emerging market debt, convertible bonds, and less liquid strategies with floating coupons, such as senior bank loans, emerging market loans and export credit agency loans. For the near term, we maintain a tactical preference for investment grade over high yield and emerging market debt.
Where are the risks?
We expect inflation to be contained next year. However, a surprise in the form of accelerating inflation could lead to a more aggressive central bank reaction, which could become a headwind for all fixed income and spread markets, particularly emerging market debt. We expect growth to hold up well in 2018. If the growth environment deteriorates materially, long and safe duration assets in the portfolio can offer the fixed income investor protection. By remaining flexible, investors can respond to changing macro and market conditions.
Bond yield outlook favours financial stock
The likely increase in bond yields in the coming year could have a significant impact for the performance of different equity market sectors. Some sectors, such as financials, are positively correlated with bond yields, while utilities and other “bond proxies” are negatively correlated. The graph below shows how closely the relative performance of financials versus utilities tracks the trend in 5-year German and US bond yields.
Macro outlook should benefit cyclicals
The continued strength in the macroeconomic picture for 2018 portends a generally better outlook for cyclical equity sectors than for defensive sectors. While cyclicals no longer trade at a discount relative to defensive stocks, earnings estimates indicate that they will be the primary drivers of next year’s profit growth, with biggest contributions from financials, technology and energy.
The energy sector is profitable at current prices and the dividends look secure. The demand/supply balance is supported by the broad economic recovery and by likely supply constraints, especially since last week’s agreement among oil-producing nations to extend their production limits until the end of 2018. The materials sector, where the chemical industry plays an important role, also benefits from higher oil prices.
Our preferred sectors for 2018 are financials, industrials, technology, energy and materials. We are cautious on utilities, telecom and consumer staples, whose earnings will probably grow at a modest, low-single digit pace. We think these sectors can perform well only during periods of increased risk aversion or weakening macro data. Next year will surely include such periods, calling for flexibility in our allocation, but for the year as a whole, a cyclical bias seems justified.