The breadth and diversity of the fixed income asset class will continue to attract investors in 2013. Ongoing concerns about uncertainty and volatility in financial markets will see many investors retain a preference for lower-volatility assets. For those willing to take on a little more risk in search of higher real yields, emerging market bonds are attractive, particularly as currency appreciation could enhance returns. While the idea of a bond bubble has become a subject of debate due to the strength of the flows into fixed income, I see little scope for a reversal in the fundamental attractions of the asset class given the likelihood of a low-growth environment in which central banks are committed to easy monetary policy. Nevertheless, on the basis of the medium-term interest rate outlook, we believe a shorter duration stance is appropriate.
In terms of economic growth outlook, the imminent threat posed by the US fiscal cliff is a concern. If you go back to the debt ceiling issue which last came to a head in August 2011, the uncertainty which that created caused a visible slowdown in US economic activity. We are starting to see some poorer US data and the danger is that these are due to the uncertainty created by delayed investment and spending. I do believe that the US Congress will ultimately muddle through by agreeing a temporary solution.
Looking beyond this potential fiscal drag, we see US GDP growth in 2013 being somewhere between 3 and 3.5%, which is some way above where we saw it only six months ago. A large part of this is predicated on signs of a stronger recovery in the US housing market. House prices are picking up, there is relatively low housing stock in some areas and turnover is also rising. At the same time, employment is beginning to improve and the US consumer is starting to spend a bit more. This is all positive for economic growth at a measured pace. In China, industrial production growth is bottoming out and conditions for a recovery are gathering steam; this will have a positive impact on Asian markets.
In the Euro-zone, the outlook is less encouraging. Purchasing managers’ indices (PMI) are coming down, signalling that economic performance is deteriorating and will likely translate into a broader-based fall in GDP. This is bad for employment prospects and will cause a drag on economic performance especially in the peripheral economies, such as Spain and Italy.
Overall, the fundamental problems for economies remain, particularly the amount of debt within the system. In developed markets, gross government debt as a percentage of GDP is still increasing, as are government deficits as a percentage of GDP Over time, as debt is slowly reduced, we will start to see an economic recovery get under way but a long period of deleveraging in the US and particularly in the Euro-zone is in store. This means we can expect more of the same in 2013; a low-growth environment that commits central banks to quantitative easing policies - similar to the situation in the middle part of 2012.
We are only part way through the QE journey. At this stage, there are some signs of the strategy having the desired effects. In the US, unemployment is starting to come down, and there is a school of thought that QE is the most viable, least damaging solution available. I would expect QE to be pursued throughout 2013 on effectively a global basis, led by the US Fed, the ECB, the Bank of England and the Bank of Japan. Indeed, monetary policy will remain stimulative for a sustained period, and we are unlikely to see interest rate hikes in the US until 2015. Quantitative easing does continues to pose a significant tail risk given the massive expansion we are seeing in central bank balance sheets, and inflation could become more problematic as we head into 2014.
The idea of a bond bubble in fixed income markets is beginning to concern some investors, given the inflows we have seen in fixed income markets. In my view, to fundamentally reverse the strong trend in bond markets, you have to assume that we are entering a high-growth environment where interest rates are going up, and in which the fundamentals of fixed income investing become challenged. The probability of this is remote; I do not anticipate the kind of higher growth environment in 2013 that would force interest rates higher globally.
Many investors remain concerned about volatility and uncertainty, which will continue to draw them to towards fixed income as an asset class. And, within fixed income there is a great deal of diversity.
In developed markets, high-quality government bonds do indeed appear overvalued versus our fair value models. This could, in fact, remain the case for some time however, given heightened uncertainty and a reduced supply of high quality assets - much of which is being bought up by QE programmes. If and when economic recovery becomes more established, the gap between current government bond yields and measures of fair value are likely to close. As such, investors need to mindful of the duration of their assets; a preference for shorter-duration assets may help to guard against this risk.
In investment grade credit, credit fundamentals remain positive overall and balance sheets are largely robust. Spreads are still attractive but do offer more limited scope for compression compared with the experience of the last three years. There is also a danger that some companies will take advantage of cheap financing and start to re-leverage their balance sheets for M&A, share buy-backs and dividend purposes. That could cause some credit ratings to drift downwards, so a fundamental research-driven approach to credit selection is vital.
We continue to see some value in high-yield markets, but we think investors should focus on the high quality end of the market. Investors should also be realistic about prospects for 2013; the exceptional returns of recent years will not be repeated. We can expect high yield bonds to offer attractive positive carry rather than strong capital appreciation prospects, and we’re likely to see returns in the high single digits rather than the double digits.
Emerging market debt has been a positive asset class in the past year and one that remains attractive given the prospect of capital flowing to higher-yielding currencies. There is a strong correlation between emerging market PMIs and emerging market foreign exchange. If we see a gradual global recovery taking shape, we should expect to see a pick-up in emerging market foreign exchange returns. The next leg of this rally though will not necessarily be in hard currency bonds; it is likely be in corporate bonds and local currency issues.
Lastly, investors should be wary of latent inflation risk as 2014 approaches. This makes inflation protected strategies attractive but the caveat is these bonds typically perform better in a higher growth environment and the longer duration structure of many developed market issues introduces undesirable interest rate risk. A better inflation-hedging strategy may be to increase exposure to emerging market inflation-linked bonds, which are supported by higher economic growth rates; these bonds would be well placed to perform well if the global economy strengthens.
Given the diversity of opportunities within fixed income, a strategic approach to investing in the asset class will remain popular with investors as we enter 2013. Those bond funds with the flexibility to allocate across bond categories and tactically tilt their firepower to the most attractive areas are well positioned to provide an attractive risk-adjusted return to investors in an environment with so many economic uncertainties.
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