Volatility has dominated markets for much of 2018, with the VIX, or so-called fear index, spiking in February following a subdued 2017.
But despite the concern, we believe there will be plenty of opportunities for active bond investors in 2018, especially in the high yield and emerging markets space. February’s market shock came on the back of growing concerns that interest rates could rise at a quicker pace than previously anticipated, after stronger-than-expected US wage growth came through.
Equity markets retreated, with the MSCI World down -1.28% in the first three months of the year, while the 100% ICE BofA ML Global High Yield Hedged USD fell by -0.60% over the same period. Regardless of this instability, global economic growth remains strong and broad-based, with the US, the Eurozone and emerging markets all enjoying decent momentum.
In addition, inflation is widely expected to rise, but this is expected to be gradual, and the ongoing lack of price pressure could support higher profits and encourage companies to expand globally. Overall we expect the global economy to grow by 3.9% this year, slightly ahead of 2017’s 3.7%.
This combination of strong growth and slowly rising inflation can be supportive for financial markets and we believe that value opportunities will emerge as the global cycle further matures over the coming years.
High yield – value makes a comeback
Right now we are positive on high yield credit, spreads have widened and, in addition, higher interest rates have pushed yields up, bringing some further value back into the sector.
Investment grade spreads are stable, providing additional returns for high yield investors and in Europe this spread is much higher than it was for a large part of 2017.
Presently yields are looking more attractive, with the US Core High Yield Index yield-to-worst (YTW) – the lowest possible yield available for a bond without it defaulting – at 6.35% versus 5.84%6 in December. In Europe there is smaller gap, with the YTW coming in at some 2.94%5, compared with 2.49% in December.
We believe as long as equity market volatility remains contained and default rates – as forecast – remain low, high yield should deliver this year and potentially provide some of the strongest returns in the fixed income universe. In the current environment, where interest rates look set to rise, our preference remains for short duration high yield assets.
There’s still opportunity in emerging markets
Year-to-date performance for emerging market debt performance has been negative. Total return bond indices are showing declines of up to almost -5% and we believe there are two fundamental factors at play – higher US interest rates and a stronger dollar1.
The rise in external debt in emerging markets has increased the vulnerability to a higher dollar and higher US interest rates. This is not a new thing in emerging markets. Countries that have high levels of hard currency, external debt are particularly vulnerable.
If investor sentiment is also turning negative, this can have a powerful impact on flows. Our own analysis suggests that about half of the (negative) total return from emerging market debt since the beginning of the year has resulted from the rise in treasury yields. The rest comes from rising risk premiums on emerging market assets as seen by the increase in spreads.
We believe that strong arguments remain for holding onto emerging market positions. The first is that the asset class has got cheaper. Spreads are now slightly above their long-term average with all-in yields much higher than at the start of the year. For example a portfolio of short duration emerging market bonds can now yield between 4.5% and 5.0% compared to around 3.5% at the end of last year1.
We also believe that the fundamental story still has some legs. Growth is doing well in emerging economies and many of the bigger economies do still have some policy flexibility to offset market weakness or any signs of growth slowing down.
Medium term, however, I strongly believe in a role for emerging markets in a global fixed income portfolio. It provides additional yield relative to other hard currency assets, diversification if local currency exposure is sought and the ability to take advantage of macro-economic factors that differ from developed markets.
Moreover, structurally China will become a very important component of global fixed income once its bonds are included in some of the key global indices.