Q1 Outlook: Bonds shine in baby bear market
Fixed Income Strategist
Summary: The biggest driver in the bond markets in 2019 will be a slowdown in the global economy combined with high political and economic uncertainty, which will lead many investors to flee to safety and to favour sovereign debt that has already undergone tightening, such as US Treasuries.
2019 will be a year of profound changes, so we believe that investors should take urgent measures to preserve capital and prepare for a downturn. They should look at the bond market as a way to diversify their equity portfolios and use bonds as a buffer against market volatility.
Positioning is crucial.
In sovereigns, we prefer safe haven assets, such as 10-year Treasuries and 10-year bunds. In the US, we also like short-term Treasuries with maturities up to two years, which could be a sensible place to park money while the economic cycle ends and the economy heads towards recession, providing an opportunity to reinvest proceeds at a later stage once better prospects emerge. In the US corporate world, we like short maturities up to three years, with a preference for high-quality investment-grade corporates offering at least 150 basis points over Treasuries, so that real yield would not be eroded in the unlikely event that inflation continues to rise.
We also believe that opportunities still exist in the high-yield corporate world, but investors should be careful not to jump into a liquidity trap and should select names carefully.
In both high-yield and investment-grade names, we prefer the defensive sectors, while we dislike capital-intensive sectors that we believe will undergo radical changes as liquidity dries up. Finally, EMs will continue to be volatile, but opportunities can still be found selectively. We believe that China can offer good opportunities, especially after the repricing of these assets in 2018, as the government stays focused on supporting the economy and implementing reforms that will ultimately further develop, and create security within, the Chinese financial market.
Like last year, the performance of sovereign debt all around the world will remain dependent on political headlines and central banks’ monetary policies. But unlike 2018, the biggest driver will be a slowdown in the global economy. This means that political and economic uncertainty will remain high in 2019, causing many investors to flee to safety and prefer sovereigns that have already undergone a tightening process, such as US Treasuries. In the US, the year is getting started with an inverted yield curve in the short part of the curve, while the long part of the curve is undergoing a slow and painful flattening.
This has left investors wondering about the distance to recession, which looks closer and closer. The main driver for US Treasury performance this year will be the US’ economic performance. We expect the Federal Reserve to refrain from raising rates in 2019 due to concerns over the economy, while Treasury issuance will remain high amid the Fed’s balance sheet normalisation. Domestic and foreign demand will continue to be high due to weak global growth, and most of the demand will concentrate on the longer part of the yield curve, in the 10-year and 30-year maturities.
This will lead the yield curve to flatten further, with 10-year Treasuries trading well below 3% for at least the first quarter. We might see the 10-year Treasury softening from the current level if the US reaches a trade deal with China, but we still expect it to trade around 3% as concerns over the economy will intensify.
Positioning depends on the particular needs of the investor. If the investor is looking to flee to safety as volatility increases to create a cushion against bleeding equities, the 10-year Treasury would serve this purpose. Otherwise, if investors are looking to park money while the economic cycle ends and a recession begins, short-term maturities up to two years are the most feasible, especially in light of lower inflation expectations.
Things look very different in Europe, where not only is the European Central Bank facing growth problems again, but political risk in Italy, France and Germany remains very high. The market expects the ECB to raise interest rates after the summer for the first time since 2011, but we believe this will prove impossible as the economic slowdown becomes a major challenge for the euro area as well.
Because the ECB has played all its monetary policy cards in the past few years, and it has not yet started tightening, we can expect exchange-rate policy to be the only instrument available to the ECB – i.e. keeping the euro low to stimulate the economy.
Looking more specifically at various rates in the European Union, we remain negative on Italian BTPS and French OATS, while we continue to be positive on German bunds given their safe haven status. Although the clash between the new Italian government and the EU seems to be resolved, we believe there are still many reasons to fear that the situation will destabilise again as the two deputy prime ministers, Matteo Salvini and Luigi Di Maio, fight to implement their political policies within the deficit boundaries agreed with the EU.
Italian newspapers are forecasting new elections as soon as spring 2019, before the European Parliament elections. As if that wasn’t bad news enough the Northern League, whose rhetoric has been the most euro-unfriendly so far, seems to be leading in the polls.
We believe that 2019 is all about bonds. The bottom in the equity market has not yet been reached, and that should push investors into safer assets. In a baby bear market where uncertainty becomes the norm, the only way to sleep at night is to choose quality, and bonds can provide that and give interesting returns, especially when cherry-picking across several sectors and durations. However, it is important that investors realise that the credit spread widening that began in 2018 will likely continue in 2019, because of the large refinancing burden that corporates face now that interest rates have increased.
In the past few years, many corporates that were unable to access bank lending have been serviced by collateralised loan obligations; now that interest rates are higher and volatility has increased in the equity market, however, these vehicles are clearly destined for repricing. This means that firms that have relied on that sort of financing will suddenly be locked out of the market and corporate defaults will spike, causing more volatility in an already very fragile situation.
Nonetheless, we believe that US credits will outperform Treasuries as upside for further tightening in Treasuries from current levels is very unlikely. Furthermore, although credit spreads are certain to widen, if an investor chooses solid names offering a good pick-up over the US Treasury curve and stays invested in short maturities up to three years, we believe that these instruments will provide a nice buffer in a diversified portfolio. Even if inflation increases, we believe that returns of corporate bonds with a good pick-up over Treasuries will not be eroded and will serve as a buffer as the equity market remains volatile.
The widening of credit spreads will depend mostly on investors’ risk perception and the economic cycle. Whille high-yield credit spreads tend to widen faster than investment-grade credit spreads when the market sentiment is risk-off, IG credit spreads tend to widen faster in the final stage of the economic cycle preceding a recession. The key question at this point is how long we have until recession arrives. Given this, we believe it is important to stay short duration and be invested in maturities up to three years maximum; such bonds would be less sensitive to market volatility, and investors can wait for the bond to mature in case credit spreads widen severely.
In the corporate credit space, we dislike capital-intensive sectors such as real estate, automobiles, manufacturing and the transportation sector, including railways and airlines. We remain positive towards defensive sectors, such as healthcare – one of the few sectors that performed well in 2018 – and industrials excepting natural resources companies.
For financials, things are getting more and more complicated as the US yield curve continues to flatten, pointing towards an inversion. But we still believe there are good opportunities in this space, especially when looking at senior unsecured bonds with short-term maturities. It is important, however, to select betterrated and liquid names and avoid smaller banks amid the risk of a global slowdown.
Emerging markets remain the most discussed opportunity and threat. Last year brought a significant repricing of these assets, and the average yield of EM bonds is currently near a nine-year high. Therefore, investors are now starting to look at this space with interest, thinking that if central banks become more accommodative amid a global slowdown, maybe some of the most resilient EM bonds will recover as well. We believe this may be true. But, like everything else in this market, it is important to select risk in order to avoid bad surprises.
We see Latin America as one of the areas exposed to the biggest risk. Not only is Argentina still struggling with a currency crisis, but this year has brought new presidents to Mexico and Brazil, which could be a gamechanger for the region. Although the obstacles between Mexico and the US seem to have been overcome, one should not forget that Andres Manuel Lopez Obrador (known as ‘AMLO’), who took office in December 2018, is a left-leaning populist who favours social reforms over economic ones.
Already in November, when he cancelled the construction of a new international airport in Mexico City, he showed that he does not care about the economic consequences of his actions, and this should alarm investors. One of the most controversial points in AMLO’s campaign concerns the energy reforms he wants to implement: AMLO sees Mexico as an an energy-independent country, and he pledged to end oil exports and stop gasoline imports from the US. Not only would this have devastating effects on Mexico’s state-controlled petroleum giant, Pemex, but it could even intensify unwanted confrontation with US president Donald Trump.
Similarly, even though Jair Bolsonaro in Brazil was welcomed as a market-friendly new leader, we believe he will not live up to market expectations. International investors expect Bolsonaro to implement structural changes, particularly pension reforms, to keep the country from borrowing money to pay public-sector employees and retirees. However, it is easy for the market to forget that Bolsonaro was not elected on the strength of his economic agenda, but rather due to disdain for the corruption within his rival Workers’ Party. It would not be surprising if Bolsonaro gave priority to other reforms before touching the hot potato of pension reform, and that could mean significant delays in the much-awaited economic reform.
In Africa too, risks remain high from an economic point of view, especially concerning the elevated issuance of debt in hard currencies by these countries in the past few years. Another destabiliser could be the general elections in South Africa in May and presidential elections in Nigeria in February. These are the region’s two biggest economies, and they will be instrumental in shaping the political and economic patterns in sub-Saharan Africa. This region will be the most vulnerable to an economic slowdown, so risk allocation should be extremely selective.
We remain positive on China. Although trade-war worries are still running high and the economy is slowing down, the Chinese government is focused on implementing the necessary supportive reforms. During the Central Economic Work Conference held on December 19-21, China’s representative talked about “countercyclical adjustment”, with the government ready to intervene with tax cuts and prudent monetary policies. As a consequence, we have seen the People’s Bank of China cutting the reserve requirement ratio by 1% at the beginning of the year.
Not only is the central bank extremely supportive now, but the country is concentrating on improving property policies, advancing manufacturing and implementing reforms of state-owned enterprises, which will be instrumental in boosting fair competition with privatively owned businesses.