Buying on dips has proved to be a winning strategy in fixed income over the years. Bond bear markets don’t last very long as investors soon get rewarded by higher carry. But the challenge is to see where the dips are coming and to buy the right dips. The ultimate cost of getting it wrong is default and losing your capital. In the US the market has re-priced because of the Fed reacting classically to the particular characteristics of this business cycle. There are now higher yields on the shelf in the US fixed income supermarket. In emerging markets the dips are quite specific but the overall asset class looks reasonably attractive after a poor year so far. In Europe, Italy is the main source of cheaper bonds. But beware, they have cheapened for a reason.
- The US economy grew at an annualised rate of 4.2% in Q2 with consumer spending growth itself at almost 4%. US asset markets have and continue to perform in line with this very benign macro backdrop. It remains my view that the most likely scenario for the US economy is that the Fed has to raise rates quite a bit more in order to get real interest rates to a level that does slow the economy. For sentiment on risk assets to be impacted, something needs to happen to change that expectation – either the Fed becomes publicly more hawkish or needs to raise rates more because inflation rises significantly above 3%. If neither of these things happen then staying in risk assets will be justified.
- US bonds have re-priced because of the strength of the economy and the Fed. Emerging market bonds are continuing to go through a re-pricing but this is being driven not necessarily by a broad deterioration in the business cycle for emerging economies, but by a combination of geo-political concerns (trade and China), inept macro-economic management (Turkey and Venezuela) and persistently chronic imbalances (Argentina and Turkey).
- In Europe we are not really getting any dips. The European business cycle has not been as robust as that in the US but the broad picture is one of economic expansion, low inflation and a central bank that has had to be more aggressive in fighting deflationary risks and, as a consequence, will be much delayed in exiting unconventional policy. Where is there scope for higher yields in Europe? It generally comes back to Italy which has been the part of the sovereign and credit market that has re-priced in response to market concerns over the economic programme of the new government.
- The challenge for long term investors is which dip to buy. Is buying Italy with a yield of 3.5% a good idea when the central bank is soon to stop buying government bonds and a new, relatively untested populist government is just about to try it on with fiscal policy? Patience is a virtue and over time better valuations for good credits will emerge. And if the US expansion continues with gradually higher inflation and rates, this re-pricing will only get more widespread.