2017 Fixed Income Outlook
FOR SOPHISTICATED INVESTORS ONLY
By James Alexander, Co-Head of Global Fixed Income and Head of Australian Fixed Income - 7 February 2017
A tale of two halves for bonds in 2016
Fixed income markets started with such promise in 2016, with Australian bonds returning nearly 5 per cent in the first half. Global bond yields then bottomed mid-year and rose sharply, returning negative 2 per cent in the second half. The Bloomberg AusBond Composite 0+ Yr Index returned 2.92% for the 2016 calendar year, with Credit the strongest performing sector for the second year running.
Global deflation fears, the unexpected outcome of the Brexit vote and easier monetary policy in Australia all helped bond prices rally strongly during the first half. US bond yields bottomed in July and began rising at a moderate pace, before market participants turned their attention to the evolving US presidential election campaign. The surprise win by Donald Trump drove bond yields higher, eventually undoing the initial strong performance from bonds.
2017 rates outlook
The selloff in global bond yields lost momentum towards the end of last year, as market participants began to take stock of the potential impact a Trump administration would have on the global economy. While Donald Trump the businessman is now officially Donald Trump, President of the United States, the initial euphoria in risk assets must give way to a more sober assessment of his policy platform. So far, markets appear willing to take a leap of faith that the Trump administration’s agenda would be largely implemented, and that the hoped for impact of its policies would be as positive as advertised. However, making substantial changes to such wide-ranging government policies, like trade and tax, do not always deliver the expected results and come with a high risk of unintended consequences.
While we wait for more policy detail from the Trump administration, business and consumer survey data in the US and Europe has been relatively strong, adding to speculation that inflation is likely to rise in the year ahead. Over the medium term this means that bond yields could resume their path higher on the back of President Trump’s agenda for lower taxes, increased infrastructure spending and a more protectionist US trade policy. With the US economy generating solid jobs growth, as evidenced by its low unemployment rate of 4.7 per cent, substantial fiscal stimulus at this stage in the economic cycle will be watched closely by the US Federal Reserve. We expect that the Federal Open Market Committee (FOMC) will react to any rise in inflation expectations in the usual manner, irrespective of the number of tweets coming out of the White House.
In the near term, however, our analysis of past bond market declines suggests that, given the pace and size of this move already, we appear to be overdue for a counter-trend rally. This is particularly true in Australia, where the economy has stepped back a gear, as evidenced by the disappointing third quarter GDP result, and the potential downturn in housing and construction. We would expect the Reserve Bank of Australia (RBA) will keep the cash rate at 1.5 per cent in 2017, but should continue to deliberate on the need for further easing to support the economy. With RBA policy anchoring the short end, we think that 3-year government yields will represent good value at 50-75 bps above the cash rate, equivalent to yields of 2% -2.25%.
Looking further out, the yield curve for 10-year Australian bond yields will likely remain in a 2.5% - 3% range in the first quarter 2017, before following global bonds to a new higher yield range later in the year. We believe that Australian bonds will outperform their global peers during this push higher, contracting to meet US 10-year yields, and being much tighter compared to European yields. The combination of relatively higher inflation in the US and Europe will lead the market to contemplate a more aggressive US FOMC, and German pressure on the European Central Bank to end its quantitative easing policies.
2017 sector outlook
Australian issuance will once again be dominated by Commonwealth Government bonds. As a result, our preference is to be underweight government bonds along most of the yield curve. The one exception is for very long maturity bonds greater than 20 years. There appears to be few alternatives in this space, and so these longer-dated bonds should remain in demand globally to match long-dated liabilities.
Semi-government bonds performed well over 2016 and we expect this to continue. Low levels of issuance expected in 2017 should see spreads remain relatively tight for most of the year, compared to government bonds. Within this sector, there is the potential for Australia’s sovereign rating to be downgraded, which would also see NSW and VIC lose their ‘AAA’ ratings. As such, we favour QLD and WA given their spreads already reflect their ‘AA’ ratings. However, we are likely to become more cautious on the semi-government sector later in the year, as we monitor the States’ asset sales programs. Once these programs are finished, the States are likely to become net borrowers again in order to fund new infrastructure programs, which would put pressure on semi-government bond spreads relative to government bonds.
The supranational, sovereign and agencies (SSA) sector should once again provide a yield pick-up over semi-government bonds in 2017. However, the issuers in this sector have a penchant for regular tap issues, which makes it difficult for their spreads to compress and hold at tighter levels. Accordingly, our preference is to trade in and out of this sector against the semi-government bond sector as the SSA sector spreads fluctuate.
In contrast, the outlook for the credit sector is mixed. Credit spreads have been responding positively to any signs of improvement in the business climate through tighter spreads. However US equity markets are also at historical highs and are expensive on a number of valuation measures, which elevates the risk of any retreat in equity prices dragging credit spreads wider. On top of this, credit fundamentals did not end 2016 in a healthy position due to continued growth in corporate leverage. As a result, we continue to be wary of longer duration credit and favour being defensive by holding shorter duration credit.
2017 credit outlook
After a weak start to 2016, credit finished up the year performing very strongly, leaving credit spreads at levels that are just above the lows of the 2008-9 financial crisis. US corporate fundamentals did not, however, fundamentally improve over the year, and so the growth in debt has continued to exceed the growth in profits. In such an environment, it would normally be hard to see credit perform. However, the unknown factor is the effect of President Trump’s policies and how these will be accepted by the market – if a risk-on mentality prevails and equities perform, credit spreads could, despite fundamentals, continue to tighten.
In the domestic non-financial sector, supply of corporate debt seems to place added tightening pressure on spreads, with Australian companies less inclined to use domestic bond markets as a funding source than their US or European counterparts. The troubled corporate names at the start of 2016, like Glencore, Anglo-American and BHP, are also now more settled, with spread volatility reducing during 2016, which provides further support to non-financial corporates.
Supply in the financial sectors, however, remains strong and the pressure for underperformance of these sectors is higher. A complicating factor, however, is President Trump’s desire for cutting regulation, after a period of markets adjusting to tightening regulatory requirements worldwide. For credit investors, regulation can be a positive if it improves bank strength but a negative if it weakens the claims. This possible change in direction could create increased uncertainty about the path of bank regulation even if, in the longer term, it leads to improved efficiency.
This material was prepared and issued by Nikko AM Limited ABN 99 003 376 252, AFSL 237563 (NAML). Nikko AM Limited is part of the Nikko AM Group. The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. Past performance is not an indicator of future performance. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.