Why there is still value in fixed income
Sentiment toward the global economy is beginning to shift. So far this year, the focus has been largely on recession fears and central bank easing, which has been good for long‑duration assets such as high‑quality government bonds, investment‑grade (IG) corporate bonds, and BB rated high yield bonds. Fears over a recession are beginning to diminish, however, and while central banks are likely to continue easing, there is a limit to how much further they can go. So central bank easing could soon give way to a quiet period in which rates remain on hold.
We’re just at the beginning of this period of change. There is understandably still a lot of caution out there, but recent positive developments in U.S.‑China trade talks have boosted confidence. While many international organizations continue to cut economic forecasts, our economics team recently upgraded its forecasts for European and U.S. growth next year. This is predicated on easier financial conditions, which have eased materially over the past year – an indication that the investment environment is likely to change.
One of the most likely manifestations of this could be a steepening of the yield curve as future inflation expectations rise. This will probably mean that long‑duration bonds, such as high‑quality sovereigns, will begin to perform less well. Investment‑grade companies in stable countries, which have been widely owned while investor sentiment has remained cautious, may also begin to fare worse than other asset classes as optimism returns.
What will perform instead? Most likely, the assets that investors have been avoiding for the past year or so. These include single B and CCC rated high yield bonds, which have underperformed the BB space this year and could start to outperform higher‑quality credit investments as people may begin to venture into riskier asset classes.
For emerging market bonds, the absence of short-term price pressures should continue to be supportive as central banks will be encouraged to keep monetary policy accommodative. Local debt of emerging market countries, in particular, stands to benefit in this environment. This includes countries like Indonesia as local inflation is expected to remain well behaved.
Although inflation is currently muted in most countries, unemployment is also low and business investment has been weak, so inflation may start to rise again over the medium term. If it does, Treasury inflation protected securities may do well. The U.S. dollar would be expected to decline in this environment, but that is a more difficult call.
The main risk to growth is probably U.S.‑China trade talks deteriorating once again. However, as things stand, it seems like both sides want to at least maintain a truce through 2020. If that holds, growth is likely to recover—and a rotation in outperforming assets can be expected.
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