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Normalisation: A Turning Point?

Friday, August 04, 2017

Tim Haywood, investment director for fixed income, says that with policy normalisation from central bankers in both Europe and North America driving bond yields aggressively upwards, June may be remembered as a turning point for fixed income markets.

“Perhaps the most upbeat at present is ECB President Mario Draghi, whose reference to “reflationary forces at play” resulted in a near vertical jump in European bond yields and the euro. While a weak consumer sector is likely to steady the Bank of England’s hand, recent communication appears to be preparing the market for a possible rate hike and ongoing currency weakness has driven inflation to a four-year high – even when we consider this week’s surprise reduction in CPI from 2.9% to 2.6%. Conversely, recent weakness in economic data does not appear to have lessened the Federal Reserve’s desire to reduce its balance sheet alongside further policy normalisation, while improvements in the labour market enabled the Canadian Central Bank to lift interest rates in early July.

As is to be expected, government bonds in the developed world performed poorly in this environment, with the UK and Canadian markets the worst performers in local currency terms. Rising government bond yields are also weighing heavily on corporate bond performance, with many markets reliant on income accruals to deliver investors a positive return. Speculative assets including emerging market debt have fared better and we have benefited from this, despite mixed performance within the equity market and ongoing commodity weakness.”

Tim explains where he sees the best opportunities looking forward: “Global economic activity continues to advance steadily with deflationary forces being replaced by reflationary ones according to ECB President Mario Draghi and while this may not be the case in the US, where inflation appears to have flat-lined, the Fed is expected to begin reducing its US$4.5 trillion balance sheet later this year, alongside further policy normalisation.

Consequently, we are inclined to maintain a short bias in the developed world, but remain willing and able to move ‘long’ should the economic outlook or trading conditions change. The UK remains our favourite developed market short and we have profited from rising yields since the Brexit referendum and subsequent central bank stimulus drove Gilt yields to historically low levels in 2016.

We continue to see value in the emerging world where real yields are attractive and demand from institutional investors is likely to remain strong. Mexico is our favourite market and we expect bond yields and interest rates to stabilise and fall now that policy tightening appears to have finished. This market remains beholden to US foreign policy and therefore requires close attention.

Corporate credit has the potential to suffer under the pressure of rising government bond yields and interest rates, but this does not mean the market is devoid of opportunities. Looking forward, we expect fundamental credit research to play an even more important role in issuer selection as tight spreads force investors to focus more closely on company-specific fundamentals.”

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.
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