By Stephen Cohen
From great rotation to disinflation, the momentous bond bull market defied expectations again in 2014. With many yields now at record lows, what will take the spotlight in 2015?
‘Hunger Games’: the search for yield
Low global yields are now a fact of life, presenting a huge challenge as investors’ income needs continue to grow. This is causing many institutional investors to rethink their fixed income allocations and consider unconstrained strategies and less traditional areas of the market.
If the downward pressure on global yields from the disinflation in Japan, China and Europe wasn’t enough, sub-$50 oil is a game changer. If energy and commodity prices remain at these levels, the impact on fixed income as an asset class is profound.
For yield seekers, emerging markets will be a key area of opportunities and risks, as divergence is likely to be the norm. Greater idiosyncratic opportunities at the sovereign and corporate level will be a key theme for the year as reform and governance take centre stage. FX remains the shock absorber for EM macro and balance sheets, and a key driver for asset allocation. Energy importing versus energy-exporting country differentiation will continue with much of Asia the main beneficiaries in the former. In the latter, the sell-off in energy exporters is now creating valuation opportunities in parts of EM where balance sheets remain strong.
Fed and BoE at the ‘Edge of Tomorrow’
Pressures on the Fed to raise rates will mount. The US economy is showing signs of sustainable growth with an improving labour market. Falling unemployment should bring with it wage increases – the missing ingredient of the recovery so far. Expect the Fed to raise rates mid-2015 and the yield curve to flatten further, with global disinflation limiting the rise in long-end yields.
Arguments for being long the USD are strong: the US remains the fastest-growing region and energy independence is in sight. Long USD is, however, the world’s number one consensus. Expect volatility and bumps along the road.
The BoE had long been in pole position as the first central bank to raise rates. However, a drop in inflation and a cooling housing market has given the Bank pause despite a strong growth picture. Political risk will rise as we head towards the May general election. We expect gilt yields to move higher, but this move will be limited by the global growth picture. GBP can strengthen, but weak structural issues and politics are key risks to sterling.
ECB and BoJ join ‘The Imitation Game’
Alongside sovereign QE from the ECB, greater political risk in the eurozone is rearing its head again. For peripheral eurozone bond markets, this means greater volatility – even if the overall path for Italian and Spanish spreads to Germany gradually tighten. Better value is to be had in the laggards: Portugal and Slovenia.
In Japan, the second round of the bazooka now sees the BoJ buying 90% of gross JGB issuance. Such duration extension will keep long-end JGBs firmly anchored and the long-end of the yield curve flattening as the JPY continues to weaken.
Credit: shaken but ‘Unbroken’
Share buybacks and M&A continue to rise, and in the US the releveraging cycle has begun. For credit investors, this means an environment where events or accounting readjustments drive greater idiosyncratic volatility.
Our positive view on European financial credit panned out in 2014, driven by the deleveraging of the banking system. Such positivity has further to run but may slow in 2015. In Europe, the later cycle and ECB policy have driven investment grade yields to very low levels, but solid balance sheets and lack of alternatives should keep prices supported.
High yield seems set up for a better year. Cooling retail flows and sharply-wider spreads have improved valuations. Expect balance sheet expansion at both the ECB and BoJ to keep the world flush with central bank liquidity and prolong the credit cycle with sub 2% default rates. However, recent events have reminded investors that HY is not a one-way bet. Investors can expect greater dispersion across both sectors and ratings going forward.
Volatility and illiquidity: ‘The Force Awakens’
The combination of diverging monetary policy and (dis)inflationary shocks has re-awakened investors to the potential for a return of volatility. The Fed’s withdrawal of liquidity may be offset to some degree by the ECB and the BoJ, but not all liquidity is created equal. Liquidity will find its way from some places to others, having significant impact on EM and adding to cross-market volatility. Did the Q4 2014 volatility spike provide a trailer for 2015’s release? We think so.
Stephen Cohen is chief investment strategist, International Fixed Income at BlackRock and iShares EMEA
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