By Iain Stealey
Fastest out of the blocks in 2014 (and against almost everyone’s expectations) has been fixed income. Year-to-date an index of global governments bonds has returned 2.25%, while global corporates or US high yield has outpaced even that, returning around 2.70%.
Consensus coming into the year was for a continuation to the outperformance of equities over bonds, witnessed during 2013, as improving economies and a US Federal Reserve starting to “taper” should push core government bond yields higher. Instead those same government bonds have rallied hard, with US Treasury 10-year yields falling 40bps, while equities are flat to up marginally.
Many reasons have been thrown around as to why the market has confounded expectations. Continual concerns regarding emerging markets, starting with Turkey in January and moving onto a possible military event in the Crimea between Russia and the Ukraine over the last week. Issues within the Chinese shadow banking system, combined with the largest daily depreciation in the Chinese renminbi since the peg to the USD was removed. And finally the polar vortex which has gripped the US, effecting two thirds of the population and dumping 56 inches of snow (the height of an average 11 year old child) in New York City during February, disrupting the strength of the recovery and possibly impacting economic data.
These have all influenced markets to some extent, yet the consensus positioning coming into the year of being overweight stocks versus bonds also needs to be highlighted. As the reality of falling yields did not match people’s perception of how this year would start, the profits made from being long equities and short bonds during 2013 looked all too compelling to unwind and lock in.
However two months does not make a year, so following this great start for fixed income how will the remaining 10 months play out? A dose of realism needs to be taken as these returns, unfortunately, are not sustainable (2.25% annualised would be north of 13% for the year, implying over 1% fall in average government yields from here – only realistic if your base case is a depression.) That said this is not a time to sell your fixed income, this year has again highlighted the diversification benefits it brings to a balanced portfolio and opportunities within bonds remain abundant.
With a slow global economic recovery, low default rates and central banks continuing to remain accommodative, credit continues to look appealing, especially when measured as a spread against government bonds. And within the torment of the emerging world opportunities are arising as active central banks and compelling valuations will entice in investors. However, expect volatility across markets to stay, so how to access these opportunities remains the big question. An unconstrained fixed income style which can shift between the sectors will set you up nicely for the remainder of the 2014 market marathon.
Iain Stealey is a fixed income portfolio manager at JP Morgan Asset Management
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