Happy Holidays

It has not been a great year for investors. Bonds and equities have delivered negative returns. Optimism on global growth turned to concerns about the end of the business cycle by year-end. The long awaited increase in bond yields did not last long and was limited to US Treasury yields only briefly rising above 3%. If anyone doubted that the world was in a long-term low interest rate, debt plagued, deflationary-risked environment, then 2018 should have further eaten away at those doubts. Some European official is reported to have remarked recently that trillions of euros have been spent buying bonds for a 4/10th increase in core inflation – hardly the most rip-roaringly successful public policy experience. As always, the US showed the way with fiscal policy taking over from where the Fed’s quantitative easing left off. The cost of US economic leadership has been a bloated central bank balance sheet and a surge in government borrowing. I guess most Americans – where unemployment is at a generational low – would say was a price worth paying. There is little sign of another other developed economy following the US example. So after years of expansion the world remains awash with debt with growth slowing and inflation having failed to erode the real value of our liabilities. Fixed income markets are re-pricing to take into account these concerns. This is painful right now and could get worse. On the upside, bonds are becoming more attractive. We look forward to not everything having a negative return in 2019.

Bad and better news

This is my final note for the year as I am taking a family holiday and will not be back until January. I can’t tell you how much I am looking forward to it especially how hectic the last few weeks have been. The markets have certainly kept us all busy with volatility picking up across asset classes and with investors continuing to be challenged by numerous economic, policy and political risks. We have worried all year about trade tensions, about the Italian political and budgetary situation, about a potential Chinese hard landing and, dare I say it, about Brexit. Against that backdrop the bond team at AXA Investment Managers and myself have been reviewing the market and how we should position our fixed income portfolios going into 2019. I thought it would be useful to share the conclusions of our discussions. There is good news and bad. The bad news is that we see sentiment in the global outlook getting worse, making it a difficult environment for risky assets. The good news is that this has already been evident for some time and both equity and credit market volatility has picked up accordingly. The other goods news is that we are closer to the end of the interest rate cycle in the US and that if credit spreads continue to widen at the same pace as they have in recent months, there will be some attractive buying opportunities in fixed income in the first half of 2019. At this stage, more fixed income sectors are expected to deliver positive total returns in 2019 than has been the case this year.

Bunds, who knew?

I would be willing to purchase a fruity beverage for anyone that can claim to have forecast that German bunds would be the best performing asset class in the mainstream fixed income markets this year. The 10-year Bund started off in January with a yield of 0.385%. It looks to be closing the year somewhere around 0.28%. An index of German government bonds has delivered a total return of 1.85% this year (as of December 11th) compared to -1.39% for an index of US Treasuries. So reminder number one form 2018 is that yield does not always equal return, especially in relatively short investment periods. The contrast is an index of European high yield bonds which began the year with a yield-to-worst of 2.8% and has had a total return of -2.9%. Even US high yield, with a starting yield-to-worst of 5.8% has had a negative return. While yield is important in determining the amount of carry a bond portfolio will deliver, the total return is impacted by what drives interest rates and credit spreads and it is there that the second half of the year has been important in that there has been a major shift in expectations. As always, at the market level, the drivers of rates and credit spreads are generally macro developments.

Road map (or WAZE plan) - Our road map for fixed income markets in this cycle was that interest rates would rise in response to a globally synchronised economic expansion. At some point this would begin to bite on growth and raise questions about the valuation and future performance of credit assets. Spreads would widen in response to slower economic growth and then, as the cycle rolled over, rates would peak and start to price in an easing of monetary policy. Once that happened, typically well into the slowdown or even recessionary phase of the next cycle, credit spreads would reach a cheap level and start to rally. So where are we in that road map? It has not quite worked out in a text book fashion. For a while it looked as though a globally synchronised expansion would lead to generally higher bond yields and interest rates (recall Bund yields hit 0.80% last February), by mid-year it was clear that Europe and China were slowing down. So the road map was confined to the US where rates did continue to increase and now we are in the phase of credit spread widening amid fears of economic slowdown. As the US goes, most other developed markets follow, hence higher US rates did widen credit spreads in emerging markets and now have been contagious to Europe and elsewhere. It may have happened more quickly than I anticipated but the market has done what was expected. What is hard for European investors is that the credit widening has happened without the increase in rates, so there is little buffer when credit does weaken.

Peak rates?

Our discussions last week were very much focussed on whether the market had actually moved too far in anticipating the peak in the US interest rate cycle and the risks of a much slower rate of economic growth next year. For what it is worth, our economics team are forecasting a slowdown in world growth from 3.8% to 3.6% in 2019 with the US slowing from 2.9% to 2.3%. Arguably this means that the US economy will continue to grow at or above trend for most of next year. Therefore there will not be much scope for any re-emergence of spare capacity and with there still being some chance of higher wage growth underpinning core inflation close to the Fed’s target (it was 2.2% in November). Hence most economists continue to forecast further rate hikes in the US next year. However, the market has taken signals from the modest inversion at the short end of the yield curve (5-year yields falling below 2-year yields) and Powell’s suggestion that we are close to neutral as meaning that the Fed is almost done and that recession risks are building. Thus not rate hikes beyond the 0.25% expected next week are priced into the OIS curve. Longer term bond yields have fallen in response with the 10-year Treasury yield at 2.9% compared to a high of 3.25% in early November. That has been quite a rally. In recent sessions the market has come off the highs so yields have not fallen below the bottom of the range that has contained the market for most of the year, but the sentiment has clearly shifted. Our expectation is that this more bearish growth sentiment will persist in the short term but it will be important what the Fed says next week and beyond. Each FOMC meeting now will become more interesting and the outcome of the interest rate decision much more depending on the current run of data. My own view is that we can’t write the US economy off just yet. Above trend growth, a super tight labour market, inflation at or above target and a generally loose set of economic policies suggests the outlook is still very much balanced. I see higher US rates in 2019 although we have moved on from the “quarter every quarter” mode of the Fed.

Continental gloom

The mood was much more bearish on Europe. As I was writing this note the headlines from the ECB press conference were coming over the wires. There does not seem to be much new from Draghi other than a few more operational details on how the end of quantitative easing will be handled. More and more economists are suggesting that the ECB will not raise rates at all next year. This begs the question as to when will conditions be right for an interest rate hike. The US will slow, China will slow, and emerging markets have slowed. There is very little chance of Europe seeing a surge in domestic demand even though employment growth is solid and real incomes are being boosted by tax cuts, wage increases and the decline in oil prices. Of course, things may change and we may be being too pessimistic on the Euro Area economy, but even if that is the case, it is hard to see rates going up much. Meanwhile, credit spreads are widening on the fears of slowdown, on what a deterioration in Italy might mean for parts of the corporate sector and on the longer term concerns about another debt crisis should there be a downward shift in growth. A significant policy shift on the fiscal side would appear to be needed if growth expectations in Europe are to be lifted. We have no strong view on what happens to core Bund yields next year other than they are likely to remain low. Meanwhile the view is that credit spreads can continue to go higher. The greater concern is that the Euro Area is hit with an existential crisis again. Fiscal slippage in a period of slowing growth with concerns about the lack of structural reform at the member state and community level pose the risk of wider sovereign spreads. It is worth noting that a senior official at the International Monetary Fund this week warned that not enough had been done on the policy front to confront another financial crisis. These are words that particularly ring true for Europe.

Plan for value

If the United States, where growth was boosted by tax cuts this year, is not able to sustain the global expansion in the next couple of years, then markets are justified in pricing in a more difficult investment climate. Not that 2018 wasn’t difficult enough. Bond and other investors have to contemplate the scenario in which the Fed has completed its rate hiking cycle for now before the ECB and the BoJ have even started. They also have to contemplate that nagging message that the US yield curve is telling us and even if it only means a recession in 12-18 months, markets will anticipate that. So in credit markets I am looking at levels that we reached back in late 2015 as a kind of marker on how bad things might get. US investment grade spreads are at 150 bps at the moment. They surged to 220bps in early 2016 but didn’t stay there very long, so a level of 180bps in the next quarter or so would indicate to me that the market was cheap to the economic fundamentals. Beyond that level, assuming that the US economy is still motoring along at around a 2.5% pace, I could envisage investors adding to risk. For US high yield the upside is greater but 2015 saw very specific conditions in the US energy sector that are not evident today. Still another 150bps on spreads is possible if sentiment continues to worsen. Again, this would be a clear buying opportunity. In the sterling credit market, there is a Brexit premium, but today’s spread levels are getting close to the early 2016 high. The overall yield (3%) is not that attractive but relative to a gilt portfolio, sterling credit is looking more attractive. In Europe, investors will remain plagued by low yields and if rates are going nowhere, the buying opportunity in credit will be when yields are no higher than 2%.

Framework for investing

We use a combination of macro, valuation, sentiment and technical factors to help us assess what we think about different parts of the market and to establish some return and risk expectations. It’s not a science but it helps decision making. The macro environment may be shifting to slower growth but alongside that we see less pressure on global interest rates. Not that there is a strong argument for lower rates – I mean outside the US they can’t really get much lower and the Fed is not going to be easing. So neutral to long duration in US fixed income is the stance of choice. Valuations are more important for credit markets as they are getting cheaper and, given the deterioration in sentiment, are likely to get even cheaper still. Technical factors, which in the past have been very supportive for bond markets, are more negative nowadays largely because of the slow end to the era of quantitative easing. So all in all we see negative trends in credit and more stable signs from the rates market. For completeness, nothing much appears to be going on with inflation but the decline in oil prices has already pushed US break-even inflation rates to the lower end of their recent range. Another 20-30bps decline in inflationary expectations might open up the possibility for a positive allocation to inflation again. In the UK it is the other way around. Break-evens have surged in response to a weaker pound and the threat of a no-deal Brexit pushing up import prices. As the US decline in inflationary expectations looks overdone, the spike in the UK market seems difficult to justify.

Won’t get fooled again

Finally, we like emerging market debt. It has been hammered this year but it is very unusual to see two consecutive years of negative returns from hard currency sovereign emerging market debt. Of course there are political risks in emerging markets and the uncertain path of the Chinese economy in the near term is a factor. But from a valuation point of view the asset class is attractive and with Argentina and Turkey unlikely to repeat the poor performance of 2018, we see positive returns ahead. The problem is that most investors don’t appear to share that view as there continues to be outflows from the asset class. That may mean it gets cheaper still. The sweet spot for emerging markets would be marked by a peak in US rates, a weaker dollar, stable to higher oil prices and a resumption of confidence in the Chinese economy.

China on my mind

One thing that has become clear when we look at the world at the end of 2018 is that China should take as much time in anyone’s analysis of the world economy as the US and Europe. China is as important an export market to Germany as the US and the UK these days. The slowdown in Chinese import demand has hit European exports. The trade-rift with the US has impacted on both economies. China is no longer a current account surplus country so it will be less of a capital exporter, which may in time have implications for US yields. The Chinese bond market is likely to get more and more interest from western investors as liberalization of the capital account continues slowly. While Chinese government bonds are not that attractive from an outright yield point of view (3.3% for 10-year), they yield more than all developed market government bonds. It is likely that they would provide some diversification for global investors too.

Auld lang syne

So that’s the year up. A year in which President Trump continued to tweet, delivered on his tax cut promise, delivered on his threat to change the trading relationships of the United States but lost control of the House of Representatives. Like it or not we will have to keep on having to deal with his unpredictable style of governing. It was a year in which the UK political system imploded. At the moment no-one really knows what either of the major political parties stand for nor what the future holds for the UK in a world where it seems, more than ever, that working together to deal with the challenges of our time is more critical than ever. The divisions within the UK will take a long time to heal and more political unrest is likely. It was a year which seemed to be marked by angst and frustration, continuing to fuel populism even if populism’s direct political reach is limited. I was struck by comments I heard in Shanghai recently that people were getting angry about various things including inequality. We will see how this shows up in European Parliamentary elections in the spring of next year. It was a year in which planet earth warned us again to take climate change seriously, which we are starting to but where more is clearly needed. It was a year in which capital preservation turned out to be the key investment strategy and, in that respect, bonds did what they are supposed to do – at least relative to May equity markets. Not a great year for investors. Finally it was a year of utter frustration at being a supporter of either Manchester United or Sheffield Wednesday (my dad’s team). The highlight of the year was obviously the performance of the young England team in Russia (and congratulations again to France for being worthy world champions). My disappointment on the football front were more than compensated for by seeing New Order and Johnny Marr on consecutive nights during a very wet weekend in early November – thank goodness for the enduring amazingness of Manchester music. Looking forward to 2019!

Have a great holiday season and a very happy, peaceful and prosperous New Year.

Chris

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