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Fixed Income 2017 – Being selective

Abu Dhabi, 10 May 2017

At the beginning of the year we said in the ‘Global Investment Outlook 2017’ that this year would be better than 2016 for risk investing. As a result, we favoured equities over fixed income in our overall asset allocation. Within fixed income we preferred high yield bonds, which are more closely correlated to equities, over less risky investment grade bonds. US interest rates continue to be normalized by the Federal Reserve. This started at the end of 2015 and is slowly gathering momentum, with President Trump’s reflation policies that include tax cuts with spending. Inflation leads to naturally higher interest rates, and while there is no present danger of real US induced inflation, this continuous to be a headwind to US Treasury investing along with dollar-denominated investment grade bonds correlated to them.

Favouring equities over fixed income
2016 was a tumultuous year for investors. It started with the Chinese stock market crisis in January (triggered by the talk of higher US interest rates to come, that negatively impacted higher-yielding emerging markets). This was shortly followed by the UK’s national vote on Brexit in June that would take the country out of the European Union. Investors naturally spent most of last year fleeing to the safety of bonds, namely US Treasuries. We ended the year with Donald Trump becoming President-elect, which was the first trigger to reverse this course and invest in riskier assets like equities and high yield bonds. Despite all these events, in 2016 markets ended higher than where they started on a total return basis for most asset classes.

In 2016, fixed income led the charge, with high yield bonds returning a strong +14.47%* (*Bloomberg Barclays Global High Yield Bond Index). Investment grade bonds returned a very respectable +5.92%** (**Bloomberg US Corporate Bond Index). Both are in US dollar terms.

So what else did we say about fixed income at the start of the year? Investment grade bonds in developed markets, primarily the US, Europe and Japan, should underperform. The Asset Allocation Committee is currently ‘underweight’ governments and investment grade due to the interest rate thesis outlined above. We have talked about the ‘normalization’ in US rates already but the accommodation being supplied by the European Central bank (ECB) and the Bank of Japan (BOJ) in the form of unprecedented quantitative easing also has a time limit. Eventually normalization will occur there also.

In global high yield it is developed markets that we favour, over emerging markets. The world economy has come out of a very difficult period post the global financial crisis of 2008. As a result of this crisis, interest rates have been at or near zero for a very long time, with easy-money policies from the world’s central banks. As a result we have seen a disproportionate amount of that money flow into fixed income, compared with asset classes like equities. In our ‘Outlook 2017’ we highlighted that the big investing institutions around the world were overweight fixed income but still underweight in equities as an asset class. Post the Fed hikes, and Trump’s election, this is slowly reversing course, rather like a supertanker. Like all supertankers, it could be some time before you actually see it steaming off in the opposite direction.

USD denominated IG bonds* (green line) (+1.97% YTD) versus High yield** (white line) (+5.02% YTD)
(Source: Bloomberg)

Equities1

Equities2

Equities3

While the above charts show quite a marked turnaround in asset allocation of late, it doesn’t necessarily mean ‘the end’ for fixed income, which remains very much a mainstay of asset allocation for many investors.

Emerging markets (EM) remain important.

We have said that we favour the ‘commodity-consuming’ economies of the world over the ‘commodity-producing’ ones. Historically, EM has moved in tandem with a rise in commodity prices. The so-called commodity ‘super cycle’ in recent times was fueled by a resurgent Chinese economy, along with the global easy-money policies we talked about that made ‘commodity tangibles’ like gold, oil and others a must-have asset in a world of a depressed US dollar, and sapped confidence in paper assets brought on by the onset of the financial crisis.

All this has reversed with a rising dollar that restricts commodity prices that are priced in dollars. Commodity producers such as Brazil (soybeans, iron ore), Chile (the world’s biggest copper producer), Malaysia (palm oil) and the African nations have seen a repricing to the downside over the last several years.

In tandem with this, emerging countries that consume these commodities in a major way have seen raw material input prices fall, being of great benefit for these markets. China is not only the world’s largest emerging market, and world’s second largest economy, it consumes 70% of the world’s cement, 2/3rds of the world’s copper, and is the world’s biggest consumer of crude oil (behind the US).

India has been another theme we covered in the Outlook, which saw rice coming down in price, creating a more tempered environment for inflation, which had dogged the Indian economy in the past. Economic reforms put in place by Prime Minister, Nahrendran Modi, such as the liberalization of India’s energy sector, has created opportunities in capital markets. Mexico, at the rough end of Trump’s policies, is the major commodity-consuming economy of Central America, and set to benefit longer-term from the growing US economy next door (despite talk of the ‘wall’).

Indonesia and Turkey make up the themes in Asia and Eurasia. Indonesia is a net ‘commodity-consuming’ economy, with similar characteristics to India in terms of inflation and its growth outlook. Turkey remains a political story, but should have a good outlook for the longer-term. All these make for good opportunities in emerging market fixed income bonds.

In the Middle East markets, the extra spread being offered in MENA fixed income over EM fixed income continues to attract investors globally, particularly from Asian fund managers. We continue to believe MENA capital markets will be underpinned in the longer-term, after seeing a big correction to oil 18 months ago. It remains the outlier to our anti commodity-producing thesis.

Overall, we believe careful name selection is the key to returns in bonds. This continues to be a very important aspect of bond investment strategy, and far outweighs the trend-following practiced by many investors in both developed fixed income markets and emerging markets.

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