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Swings and roundabouts

  • By Jason Stockwell

Nick Wall, co-manager of the Merian Strategic Absolute Return Bond Fund, Merian Global Investors, assesses the outlook for fixed interest markets in 2019

Central banks in developed markets around the globe have changed tack and turned to tightening after a long period of easing and this will have implications for fixed income investors in 2019. Major central bank balance sheets are now expected to fall 4% by the end of 2020. The era of easy money is near an end.

We expect the Fed will continue to raise interest rates well into 2019

This will be problematic for global liquidity, but also for dollar funding given the large role that the US Federal Reserve (Fed) plays in the normalisation of the global economy. Three quarters of international credit is dollar denominated, and this year’s dollar strength highlighted fragilities.

A diverse range of developing economies is seeing their domestic financial cycles follow the US, regardless of the domestic economic conditions. Some are struggling to pay back their dollardenominated debt as their currencies weaken.

We expect the Fed will continue to raise interest rates well into 2019. For the past two years, US policymakers have sought to stop the world’s largest economy from overheating. Despite their action, tighter monetary policy has remained elusive with financial conditions in the US actually easing. US economic growth remains strong, interest rates are too accommodative and leverage has slowly started to build up again in the system. It’s for this reason that we think the market should be prepared for the prospect of the Fed fund rates potentially climbing above 3%.

What about China?

Meanwhile, China’s economy is slowing and its current account is moving into negative territory, reflecting a big change in global capital flows. For years, China’s current account surplus heavily contributed to funding US Treasuries and formed part of what former Fed chair Ben Bernanke called the ‘global savings glut’. This situation has reversed and we think China will soon become a capital importer.

US monetary policy is one driver of yields. The other is something called the term premium, or the extra return (or yield) that investors demand for holding a longer-term bond rather than a series of shortdated instruments. While the term premium has historically always been positive, it’s been in negative territory for the best part of two years, pushed lower by quantitative easing in Europe and Japan. In 2019, we think it should start to normalise once again.

Investors can expect more volatility as the termpremium continues to normalise. In 2018, any upticks in the term premium precipitated a bout of volatility in other asset classes, most notably in the US equity market which sold off heavily in October.

Reasons to be optimistic

US-China relations may be thawing now that the Democrats have won control of the House of Representatives. President Trump may be unable to implement further fiscal stimulus. Brexit may be coming to a close, though the ending seems unpredictable for now. Meanwhile, the Italians are softening their rhetoric towards Brussels.

While it’s been a tough year for emerging markets, there were idiosyncratic stories that began to offer significant value for the first time since mid-2017. We saw Argentina as an especially attractive proposition given the under-pricing of its reform story.

We see opportunity in US Treasuries, especially at the front-end of the curve, while the European periphery and local emerging markets look attractive as central banks seek to tighten policy as gradually as possible. We would avoid UK, core European and Japanese duration risk given rich valuations. We are also conscious that as QE goes into reverse many of the ‘search for yield’ investment strategies may unwind, so prefer short positions in US credit where spreads look too tight.

US-China relations may be thawing now that the Democrats have won control of the House of Representatives

About Nick Wall

Nick joined the company as a fixed income portfolio manager in July 2016. Prior to joining the business, Nick worked as a fund manager in the global macro team at Invesco Asset Management, from 2007. He is a CFA charterholder and has an economics degree from the University of York.

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