AXA IM's Chris Iggo: Outlook for fixed income markets in 2018
AXA IM's Chris Iggo: Outlook for fixed income markets in 2018
Chris Iggo, CIO of Fixed Income at AXA Investment Managers (AXA IM), comments on the year ahead for fixed income markets.
(For a more in-depth view on any of the below convictions please contact the media relations team to arrange an interview.)
“Bond markets enter 2018 with yields low and spreads tight. However, there is very little consensus that bonds will get significantly cheaper anytime soon. The global economic outlook is positive but the lack of inflation remains the key factor that is preventing any increase in global interest rate expectations.”
“Despite five increases in the Fed Funds rate, markets continue to price in fewer rate hikes going forward than the Fed’s own median forecasts. This poses one risk to rates markets if economic data point to higher inflation on the back of further increases in resource utilisation, especially in the United States.”
"However, it is hard to see any policy induced rise in rate expectations in the Euro Area or in Japan. Ongoing, albeit reducing, quantitative easing will continue to be a major influence on global bond yields.”
"Return expectations will be governed by the starting level of yields. As well as the risk of higher rates, increased volatility is also a threat to returns from bond indices. Any sign of a deterioration in credit quality could push spreads wider. However, the recent US tax cuts, broad based global growth and ongoing strong demand for yielding assets should keep spreads in check in the early part of the year.”
"We retain a cautious stance in active strategies, keeping duration relatively underweight and being selective in credit allocation. Our credit teams remain positive on fundamentals but wary of valuations. However, finding attractive yields without taking on greater levels of liquidity or credit risk is a challenge. Higher full year returns will require some correction in prices before adding risk levels in active portfolios.”
Bonds expensive, but no obvious catalyst for lower prices
Rates – “As expected, the Fed raised the Fed Funds rate to 1.25% - 1.50% in December. In its statement the Fed described the stance of monetary policy as accommodative and we do not see Jay Powell’s chairmanship of the Fed changing the overall message. That implies 3-4 interest rate increases in 2018. However, so far the curve has flattened and long rates have remain in well-defined ranges. We do expect to see some drift higher in yields but market positioning remains firmly against any bond market rout. QE in Europe and Japan is also supportive of government yields remaining low. No rate changes are anticipated in Europe or Japan. The UK could see a further hike if inflation remains sticky.”
Inflation – “Any change in the dynamic of rates markets will have to be driven by some shift in inflationary expectations. Numerous factors could explain why inflation has remained so low but another year of synchronised growth should shift the odds towards some increase in inflation rates.”
European spreads – “On the whole the ECB’s policy stance will provide support for European peripherals. The key risk is around the Italian election on March 4th. The prospect of an indecisive result with little appetite for fiscal reform is likely to mean spread volatility for Italian bonds in the early weeks of the year. The tights in spreads in December will not be seen again for some time.”
Investment grade credit – “The economic and corporate backdrop suggests there could be further modest spread tightening in some credit markets in early 2018. Tax reform in the US should be particularly supportive for US credit where there is better prospects for income return. In Europe, returns are likely to be lower but fundamentals and technicals remain positive for the asset class.”
High yield credit – “High yield is also supported by macro-fundamentals and the benign market view on rates. While tax reform may have mixed implications for US high yield borrowers, the demand for yields should keep the market well supported. We see positive excess returns for US and European high yield.”
Structured credit – “Most structured credit assets richened further in the final quarter of 2017 but demand for floating rate, good quality assets remains strong. If rates and credit volatility remains low, we see senior securitised products remaining attractive relative to fixed income.”
Emerging markets – “We remain positive on emerging markets as many economies enter 2018 on a stronger footing than they entered 2017. A generally stable dollar and rising commodity prices are key supports. However, domestic policy settings are also positive in many emerging economies. It remains a key overweight in our fixed income allocation.”
Macro themes - The expansion is long, can it continue to run?
“Cycles don’t just die – It is well understood that the current US expansion is one of the longest on record. However, at the global level the expansion since 2009 has seen numerous interruptions. As such, only now are we seeing positive growth across both developed and emerging economies. Output gaps are coming down but few economies have reached full employment. The US is clearly ahead in this respect with the current unemployment rate below the estimated non-inflation accelerating rate. The year ahead could eventually see wage inflation respond to the tightness of the labour market in the US but signs of this elsewhere are few and far between.
“Where is normal? - In that context, a central question is what level of US interest rates would constitute a neutral policy. Academic estimates of the real neutral rate together with surveys of long-term inflation expectations point to a neutral nominal policy rate in the 2.00% - 2.50% range. That could be achieved within the next few quarters. If this analysis is correct, then US Treasuries are at long-term fair value today and we will continue to see the yield curve flatten as the Fed follows through on its policy decisions. The risk to Treasuries comes from this being wrong – that strong growth, boosted by tax cuts, raises both the long-run real neutral rate and inflation expectations. The problem is that these factors are unobservable in the short term so we need to rely on how the economic data prints.
“Cyclical strength – In that respect the near term view of the cycle is to the upside. Cyclical data like purchasing manager surveys are strong. The US will see a boost to after tax corporate and personal incomes. The wealth effect has been strong globally and companies appear to be more willing to ramp up capital spending. Investors currently do not see interest rates rising that much which should be supportive of credit markets. However, a world in which monetary policy becomes tight at a 2.5% Fed Funds rate is not a very bullish one for risky assets. From a Euro perspective, the Fed could be seeing the peak of its rate cycle before the European Central Bank has even started normalising.
“Optimism – The alternative is that the global economy has healed more than generally thought and that the expansion can continue for longer. That would suggest higher interest rates over the cycle but in the short-term would be supportive for equities and high yield. With the US ISM index ending the year at 59.7 the data is certainly pointing to the upside risks.
“Politics – Markets navigated political risks last year. This year sees a less crowded agenda but typically Italy will be a concern in the European arena. Obviously, the US’s foreign policy stance will be a constant source of uncertainty but, as in 2017, little that was tweeted about had an impact on markets (except the positive effect from the eventual agreement on US tax reform).”
Tuulike Tuulas +44 20 7003 2233 - Tuulike.Tuulas@axa-im.com
Jayne Adair +44 20 7003 2232 - Jayne.Adair@axa-im.com
Jess Allum +44 207 003 2206 – Jessica.Allum@axa-im.com
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