Q3 Outlook: Global policy panic to boost bonds
Senior Fixed Income Strategist
Summary: European government bonds have rallied powerfully since the end of 2018, with periphery issuers, such as Greece, benefiting the most.
European government bonds have rallied powerfully since the end of 2018, with periphery issuers, such as Greece, benefiting the most. European sovereign debt valuations are likely to be well supported throughout the summer, and a further rally could be ahead if the unfolding economic slowdown triggers a new loosening of monetary policy.
Central banks are rushing again to ease economic conditions. It is now clear that an economic downturn is inevitable, but will loose monetary policies succeed in saving the world again this time? We believe that central banks’ policies may not be enough this time around, but in the meantime, investors have plenty of time to decide where to invest. The fixed-income market provides a great opportunity to investors to ride the rally that comes with loosening of monetary policies, while taking less exposure to volatility than in the equity market as recession kicks in. It is important to consider risk wisely and choose quality over higher returns.
European sovereigns: The rally will last through the summer with help from a dovish ECB, but an economic recovery is unlikely
We believe that European sovereign debt valuations will continue to be supported throughout the summer, and they may tighten a little further as monetary policies remain extremely dovish. European Central Bank president Mario Draghi’s last speech made clear that the ECB is ready to increase monetary stimulus if the economy does not improve. At this point, not only inflation is disappointing, but the data show weakness in the biggest EU economy, Germany, as economic sentiment plummeted in June, while uncertainty over US foreign policy is weighing on economic forecasts.
European sovereigns have rallied powerfully since the end of 2018. Periphery sovereigns benefited the most, with Greek 10-year yields falling 2 points, to 2.5% from 4.6%, since November last year. The drop in Greek sovereign yields was followed by Portuguese sovereign yields falling 1.4 points, to 0.55%, since November last year, while Italian and Spanish 10-year sovereign yields fell one point.
We believe that once sovereign prices stabilise, the bonds will hold their value throughout the summer, and another rally could be right around the corner if more dovish statements come out of central banks. Spanish and Portuguese sovereigns are now trading below 1%, but, given the countries’ significant economic improvements in the past few years, we can expect them to be less vulnerable to external factors than other sovereigns, such as Italy. In the case of Italian sovereigns, we believe that the rally is overdone, and that BTPs should price lower because the country’s weak economic data and populist policies are clearly going to go against the EU indications and further destabilise the economy. While the value of Italian BTPs can continue to be supported throughout the summer, we believe that volatility will increase as autumn approaches and the 2020 budget talks begin. Overall, we are positive on European sovereigns, except for Italy, as we believe that a sell-off of Italian bonds may materialise in autumn this year as national budget talks get started.
US Treasuries: Fed policies and trade war to keep yields low for longer
We believe the market is too dovish in pricing three US interest rate cuts this year, starting in July. The Federal Reserve just finished hiking rates four times last December, reaching a “comfortable” level at the moment. Unless there are clear signs of distress or economic downturn, the Fed will not rush to cut interest rates, because then it would be unable to use the interest-rate tool when it most needs it. We expect, however, that the Fed will deliver one interest rate cut as the economy is clearly heading towards a downturn, and the Fed will also need to mitigate the effects of an escalation of trade war if it persists.
If the Fed does not deliver, it would be a huge disappointment to the market and could lead to a correction that might cause the US yield curve to invert suddenly as rate-cut projections change on the short end of the yield curve, pushing it upwards, while the longer part of the curve would be slower to widen as fears of an escalation of trade war would keep attracting safe-haven seekers.
Corporate debt: yields are falling but risks remains high
European and US corporate bonds have been rallying since the beginning of the year, reaching levels previously seen at the end of 2016, at a time when economic conditions were robust and well before the Fed and the ECB started to talk about raising interest rates. Now the economic backdrop is weaker amid slowing growth and escalation of trade war, so it is hard to justify low yields on corporate bonds. The real issue is that prices continue to rise, pushed up only by indications that central banks are ready to stimulate the economy further. Although there has been an obvious deterioration in the quality of corporate debt, investors’ buying frenzy is pushing companies to seize the opportunity and issue more debt, thereby increasing overall leverage and putting more pressure on an already tired economy ready to tilt towards recession.
In Europe, bond sales in the primary market have fared particularly well this year, with 2019 bond issuance up 9% from 2016 and 3% from 2017, according to Bloomberg data. If the market keeps trading at current levels, or if it rallies further, we expect to see more issuance taking place, especially in high yield, as companies take advantage of low interest rates to refinance existing debt, while investors are pushed towards higher-yielding credits as yields get squeezed.
Similarly, it is clear that the rally in US corporate bonds has been driven merely by the market’s expectations that the Fed will cut rates, while ignoring underlying economic conditions. So, the biggest risk that corporate bondholders face now is that the Fed does not deliver, which would cause a sell-off, especially among lower-rated credits.
Therefore, we believe that investors should remain cautious and look at investment-grade corporates and carefully select higher-rated junk issuances.
Although in the short term the positive market trend caused by loose monetary policies supports corporate bonds prices, both in the US and Europe, we believe that the long-term effects of such a trend will have serious consequences for the market and that, once a recession starts, many investors will find themselves trapped in lower-rated securities and suffer severe losses. Although in the short term, junk bonds may present an opportunity, in the long term, we prefer better-quality names.
UK bond market: Still at the mercy of Brexit
Since the resignation of British prime minister Theresa May last month, we have seen 10-year gilt yields inevitably fall below 1%, exactly as was seen in 2016 after the Brexit referendum. The message that the bond market is sending is clear: things are going to get worse before they get any better. This has serious implications for investors with sterling as a base currency as it means that they need to pay up for good-quality assets, but if they venture into the junk space, yields are so high that they may be irresistible. The average yield offered by sterling high-yield issuances is around 6% across maturities, while the average yield offered by investment-grade sterling bonds is only around 2%. The biggest problem with high-yield corporate names, however, is that it is still unclear how Brexit will affect their operations, and a large majority of them do not have any Brexit plan in place. With a trade war also looming on the horizon, it is obvious why investors are steering away from lower-rated bonds. Unfortunately, we do not believe that the situation will change until there are clearer indications of where Brexit is going. So, also in this case, investors should be cautious and prefer higher-grade names over junk.
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