Salman Ahmed, Chief Investment Strategist at Lombard Odier Investment Managers outlines the three biggest challenges facing bond investors for 2017 and their implications for portfolio management.
THE THREE MAJOR CHALLENGES FOR THE BOND MARKET
1. Generally low/negative interest rates: The sharp rise in bond yields led by the United States has spread globally. However, we believe that divergent economic policies in the US relative to the rest of the world will limit the potential spillover to non-US markets. On this point, the effective use of yield curve control in Japan can be a model to follow. We believe a similar policy could also be implemented by the ECB next year, as asset shortages will still be an issue, although the rise in yields following the US election has eased pressure on the European central bank towards a long-term extension of quantitative easing.
2. Increased market risk: the risks associated with the extension of the duration implemented by investors in recent years have been highlighted by the dynamics of the US bond market; the increase in volatility implies that the risks associated with this issue will still be in play, especially if there is more uncertainty about monetary policy in the wake of policy changes.
3. Fragmented liquidityIn the immediate aftermath of Trump's victory, some anecdotal evidence suggests that liquidity conditions in several segments of many bond markets, particularly emerging markets, have come under severe pressure. In general, the structural weakness brought about by the low liquidity environment, created by regulatory tightening and central bank interventions, has been increasingly in the spotlight in recent weeks.
IMPLICATIONS FOR MARKETS – WE REMAIN CAUTIOUS ON DURATION
In the US, the steepening of the bond market curve and the strengthening of the equity market that began after the election, together with a significant rotation between sectors, the outperformance of small caps and the strengthening of the dollar, are logical and consistent with previous trends historical, especially with the policy shift in the early 80s when Ronald Reagan introduced a strong fiscal stimulus.
The sustainability of the current market moves will depend on the exact shape/size/scope of Trump's tax plan, but also from the Fed's reaction. However, we believe that global bond yields have already bottomed out this cycle. Considering this environment and the expected potential changes in monetary policy outside the United States – including the possibility that a yield curve control also applies in Europe – we believe that the arguments have strengthened in favor of a shift towards credit risk versus of duration.
On the equity front, i US stocks appear to be in a better position than their European counterparts, on the one hand due to the possibility that populist votes could prevail in the elections scheduled for the next 12-18 months to the detriment of the European Union, which with the current political structure would not be able to deal with a shock of this type on the other because the United States has a better policy mix at the macro level.
Looking at the emerging markets, the changed scenario has a negative impact on fixed income in local currency, given the pressure deriving from the strengthening of the dollar and from the trend in US bond yields. However, considering the continued improvement of fundamentals in emerging markets, in terms of growth, external profiles and strong idiosyncratic histories, such as the case of India (which recently demonetised the larger denomination banknotes in order to give a round of the shadow economy and foster digitalization), the improvement in ratings will need to be reviewed when Trump's policies become more visible.
Said this, the implications for the emerging market equity outlook are much more nuanced and hinge on other aspects of Trump's potential policy agenda, notably trade and immigration, where our expectations are relatively benign, despite the rhetoric that has characterized his campaign. On this front, we believe that in a scenario of stagnant trade, where no new trade agreements are signed, domestic demand in emerging markets and economic growth will gain importance both from an economic policy perspective and in terms of market dynamics.
