Weekly Bond Update: Stay the course
- 2016 sees bonds outperform, particularly EM bonds
- Fed normalisation a key factor for high-yield bonds
- ECB QE expected to continue for some time
- EM bonds will profit from a general continuation of the status quo
By Simon Fasdal
This year will doubtlessly be remembered for the stellar performance seen in bonds – particularly emerging market bonds, which have posted a 16% year-to-date gain.
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Source: Saxo Bank
But can we expect this trend to continue, or should we anticipate a "mind the gap"-type experience a few of months down the road? In the following, we discuss the pros and cons of various strategies and factors, and what investors should consider over the next couple of months.
Source: Saxo Bank
Watching the Federal Reserve
The Fed is the single most important actor in terms of its ability to remove appetite from EM bonds as an asset class.
Allthough markets have started to consider the (worrisome) possibility of a September interest rate hike, the overall sentiment is that the US hiking cycle will still take a step-by-step approach.
We realise that sentiment regarding the US economy is positive overall, but it is doubtful whether inflation will rise much from its present low levels, especially given that commodities have depreciated since July due to lower oil prices.
Since its recovery to $50/barrel, oil has slid back and is now hovering just below $40/b. At this price or lower, oil and commodities will start to drag global inflation down again, which is a major concern for central banks trying to avoid deflation.
Another major concern with oil sliding lower again is the turmoil we could witness in energy-sector related corporates. This was a major factor in the unease we saw in equities in January and February; if oil does not "normalise" to levels above $60/b, major, oil-dependent regions like Russia and the Gulf states will need to restructure their economies in order to face the new reality.
In that case, EM bonds from these areas should be handled with care. Having said that, other EM countries will see major benefits from lower oil – India and China being just two of the larger examples.
All in all, a low oil price removes upward pressure on global core yields, which paves the way for a continued fertile environment for riskier bond classes, high-yield corporates, and emerging market bonds.
This is simply because the added yield per risk unit in these markets is attractive from a relative perspective.
The European Central Bank and EM bonds
The ECB is another central bank that will, at some point, start to taper its quantitative easing programme. As has become clear, however, it is obvious that the ECB is concerned about the aftermath of the Brexit vote, the political pressure on the euro area, Europe's still-ailing banks, and continued low inflation.
ECB head Mario Draghi and company will play it safe and remain accomodative side for a long time. The risk of a new round of Eurozone-related fallouts, potentially disturbing the economic area's structure (we have had a few), is in the ECB's view a much larger concern than stimulus-derived "bubble building" in a few asset classes.
We could see the bank's efforts directed more and more towards a graduation of helicopter money as the real economy impact of buying government bonds alone is both small and harmful for European banks.
When the ECB crossed the thin line of buying corporate debt, it also opened the door for potentially buying other assets – like equities, for example – should the need arise.
Our overall conclusion on what the ECB is doing and is expected to continue doing for many months is that QE is one of the best methods of sending cashflows into assets outside the Eurozone. This is why EM bonds have been one of the preferred asset classes for investors.
The appeal of the status quo
All in all, there is a high probability that EM and other higher-yielding bonds will enjoy a fertile environment for quite a while, or at least for as long as the global economy stays in its present rut of low oil prices, stubborn growth, and continual central bank stimulus.
The most important thing is that risk factors stick to their present levels. Essentially: oil must not fall too low, central banks mustn't grow too hawkish, growth and inflation mustn't spike upwards, and market volatility must remain within a certain range.
Given all this, we could easily see further performance in the riskier bond classes.
— Edited by Michael McKenna
Simon Fasdal is head of fixed income strategy at Saxo Bank