Fixed Income Outlook: Bonds Remain Expensive

Fulcrum fixed income strategist Andrew Bevan reflects on the drivers of the bond market in 2017 and where returns will come from in the remainder of the year

External Writer 2 August, 2017 | 11:12AM
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Morningstar's "Perspectives" series features investment insights from third-party contributors. 

Ten-year government bond yields finished the first half of the year lower in the US, but higher in Canada and Europe. Markets were surprised by the poor US economic data in the first quarter and loss of confidence in the new administration to deliver fiscal stimulus, while political turbulence in Europe anticipated by many failed to materialise.

Core inflation rates fell, encouraging the view that central banks would keep low rates on hold, lending support to riskier assets such as equities. Despite the Federal Reserve hiking interest rates, the dollar’s trade-weighted index fell by nearly 10%.

Looking ahead to the rest of 2017, we expect robust global growth to assuage concerns about low inflation and anticipate some increase in global yields in anticipation of less accommodative central bank policy.

Key Global Macro Themes and Risks

We identify the following key global macro themes in the formulation of strategy for the remainder of 2017:

Robust Global Growth – the major advanced economies are growing at above-trend, with close-to-full employment in the US, the UK, Germany and Japan. Emerging economies are growing at trend. We identify China as the main risk to the economic outlook, though growth has stabilised at around 7%.

Gradual Upturn in Inflation – inflation is still running below the major central banks’ targets but tightening spare capacity should gradually add to global inflationary pressures. The main risk factors to higher inflation expectations include the Fed tightening too fast and/or renewed China-related worries associated with fresh declines in commodity prices.

Monetary Policy Synchronisation – the Fed is likely to tighten by at least in line with the forwards, followed by Canada and perhaps the UK. Elsewhere, with the notable exception of the Bank of Japan, other major central banks have signaled a shift away from policy accommodation. In EM, we see a shift toward tightening in Asia, and Central Eastern Europe Middle East & Africa (CEEMEA), and only limited scope for further rate cuts in Latin America.

Cyber-Attacks – recent events have shown that both the corporate and government sectors are increasingly subject to the risk of malware attack, with cyber-crime becoming a much more prominent source of potential shock to economic activity.

Geopolitical Risks – sources of uncertainty range from the stability of the US administration, to tensions in the Arabian Peninsula between Qatar and its neighbours, and ongoing situations in Syria and North Korea.

Bonds Remain Expensive

We believe global bond valuations remain expensive. In our view, the outlook for higher real yields and breakeven inflation is risky. Momentum is now again slowly turning negative.

Global growth looks robust, a growing number of countries are approaching full employment, and inflation is likely to edge higher. The sell-off in global bond markets towards the end of June revealed the sensitivity to any hint of central banks reducing policy accommodation and points to some rebuilding of term premiums.

We view the environment as generally still supportive of risk assets but see increasing risk of a setback in credit markets. We continue to view China and geo-political factors as the main risks to our views.


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