David Roberts

What to expect from bonds in 2019

David Roberts

Writing this in early December, unless we see a turnaround into year-end, it looks like being a tough 2018 for equity investors and there has been little safe haven in bonds. As we move toward the end of another year, we look back at recent events and also attempt to forecast what will happen in 2019.

Despite the recent rally, US bonds are about half a per cent higher in yield and 3% lower in capital value than in January. Most markets have posted negative returns, with high yield and investment grade credit the latest to move into negative territory.

Thankfully, our Strategic Funds have had a “light beta” stance since launch earlier this year. Bond managers typically like to be long either lower-risk government markets or higher volatility credit but our rather unusual view was that both risk and risk-free were too expensive. Of course, given that each was propelled upward by a decade of Quantitative Easing (QE), perhaps it is no surprise they fall together?

Looking forward to 2019, the macroeconomic outlook is actually quite constructive despite recent market turbulence. Growth and inflation data from the World Bank and International Monetary Fund suggest the global economy is likely to perform around trend, which means over 4% nominal growth for developed markets. Add in a little productivity and decent G7 equity performance should see nominal bottom line growth in the 6-8% range. Under such circumstances, you do have to wonder why central banks continue to favour easy monetary policy. Well, actually central bankers have long told us the period of easy money is coming to an end but until recently markets didn’t really believe them.


US yields have risen, a little

US Yield Rises - David Roberts GFI Outlook

Source: Bloomberg, as at 07.12.18. Chart shows US ten-year Treasury yield in %.

Interest rates in the US market are back at levels many have never seen during their careers – you need to be over 30 to remember US 10-year yields above 3%. That is truly scary and no less worrying is that people had forgotten the impact of higher discount rates on earnings, so we see little surprise the FAANG (Facebook, Amazon, Apple, Netflix and Google) growth darlings have all of a sudden gone out of favour.

Of course, the direction of, and return on, equities depends as much on value and sentiment as it does fundamentals. I may have an opinion on those, but it is that of an amateur and I am much more comfortable relating my rudimentary economic knowledge to the more parochial world of bonds.

Just to be clear, those IMF forecasts already factor in negative first order effects from nascent trade wars and for bond investors the results make pretty depressing reading.

US bonds have performed worst among the G7 in recent years – although this year, Italy has been the standout. According to Merrill Lynch, investors in US Treasuries have lost 4.2% of their capital as at 19 November. Those owning German, Japanese or UK bonds have fared much better but danger still lurks for the complacent investor in those markets.

For several years now, those blindly buying bonds may have made a small nominal return: chances are however, that when adjusted for inflation, that return became negative. If we consider those buying German bonds – ten- year currently yield around 0.35% – a holder would make 3.5% over a decade, which is hardly great. Of course, German inflation is currently around 2%, slightly above the European Central Bank (ECB) target. Repeat that for a decade and prices will have risen around 25%: put another way, in real terms, the German investor has lost more than 20%.


Now investors own bonds for a variety of reasons, purportedly as a store of value, a safe haven, or to hedge liabilities. When you lock in a negative real return though, it is difficult to claim they fulfil any of those objectives. For me, it is difficult to blindly buy sovereign bonds today. As we move inexorably toward 2019, there are as always a series of challenges to what is at the core, a benign economic outlook. Some of those could make certain parts of the bond market attractive.

So, what could possibly go wrong? I have no crystal ball but there are a few fairly obvious stumbling blocks for the global economy:

  1. Tariffs and Trade

    Both the IMF and World Bank have already adjusted their forecasts, deducting roughly 0.2% from global GDP for each $250 billion worth of unilateral tariffs (Source: IMF Economic Outlook, October 2018). So, much of this is already in the price and explains why companies from Anheuser-Busch to Apple are seeing earnings downgrades. There is the chance we will see an escalation of tensions, especially between China and the US, and second order effects could also be underestimated. Not great, but we have to look at the 0.2% in context of a global economy likely to grow around 6% in nominal terms once we add developing to developed world data.

  2. China slowdown

    This, of course, is covered to an extent by the above. As is often the case in financial markets, analysts are prone to double count: be careful that those telling you tariffs are a disaster don’t also add in a China effect. I am not materially worried if China grows around 5.5% rather than 6%. Given the Government’s ability to manage the economy, that feels about as bad as it gets.

  3. Monetary tightening 1: Federal Reserve to do more

    Until very recently, it was clear the Fed still believed rates were below neutral and was unprepared to take too much of a risk with an already hot economy. Recent rates rallies have “priced out” more than a couple of further rate rises. With markets looking fragile, we would expect a little dovish rhetoric from Fed governors but it may be difficult for them to fight the data. Their two favourite data series seem to be Core PCE and Average earnings. Although the lower oil price may soon start to impact on the former, restrictive trade will push it higher. Average earnings rose at a 3.1% annualised pace in October, the fastest in a decade. Don’t bet on the Fed stopping anytime soon.

  4. Monetary tightening 2: the ECB is in play

    By the middle of next year, we will have a new ECB president, we should have an end to QE and a material chance of higher interest rates. Core Europe is overheating and if the euro weakens as the Fed raises rates more than expected, we may see growth and inflation spike to the upside. Three years ago, the market didn’t see any chance of US bonds yielding more than 3%; similarly, next to no one today thinks Bunds will yield more than 1% by the end of 2019. That is just half the rate of prevailing German inflation. Of course, everyone loves the Germanic safe haven but we will lose our beloved Angela Merkel soon and may just be surprised at the economic stance of the incoming chancellor. Safe havens are safe until they are not.

  5. Italy and Brexit

    You pays your money, you makes your choice. Frankly I have no idea how these play out short term. Value in Italian bonds is OK, less so in the UK. Fundamentals in neither country favour bond investors – for example, it is very difficult to see how UK inflation can fall below 1.5% in the short term under any Brexit scenario. I cannot take a position on a coin toss.

  6. Gold, gulf states and gushing oil

Cheap energy seems back on the agenda. The advent of cheaper renewables, together with lower capex oil production, should limit our need to focus on Brent or WTI (West Texas Intermediate), as well as reducing oil price volatility. The latter stages of 2018 perhaps hinted that was the case: yes, volatility came back but compared with the selloff in 2015 and rally in 2017, reaction away from producing sectors was more muted. At a macro level, the impact of changing oil prices is pretty balanced and it really is a story for equity sector specialists – and of course a few emerging markets high-yield bonds.

The rise and fall of a barrel of Brent

Brent Barrel Prices - David Roberts GFI Outlook

Source: Bloomberg, as at 07.12.18. Chart shows European Crude Dated Brent Spot price in $.

What has been strange is the failure of Gold to find traction. While the US Dollar has risen a little, suggesting some safe-haven buying, gold has remained resolutely in negative territory for the year. I come back to where I started – although a pretty torrid year for many, core US equity markets are still in positive territory and long-term bull trends remain in place for most developed markets.

And can we make money in this environment for bond investors? Alpha versus beta….again

I believe the answer is yes. So far, the dispersion of return among bond funds in 2018 has been extreme and I’m sure that is all about how managers have played alpha and beta separation.

Basically, from 2008 to 2016, investors seldom had to think. Central bankers gave us a pile of money and simply asked us to spend it – not in any meaningful, real-world way that would lead to growth and inflation or course, rather we were all told to go and buy financial assets, make ourselves rich and allow the trickle-down effect to move the real economy.

And we wondered why growth, inflation and efficiencies were hard to find?

Two years ago, the US had had enough and rates started to move higher. No one really believed it – indeed, the greatest amount of internet trolling I’ve ever had was when I said US 10-year yields would move back above 3%, a return to the old normal.

Opportunities do exist to exploit what remain generically low yields. This is my beta point – although we may make some capital gain from the US bond market in 2019, it is extremely unlikely core Europe, the UK or the rest of the G7 can offer anything approaching a positive real rate of return.

It is very old fashioned I know, but buying cheap stuff and selling expensive stuff is often the best long-term strategy. To that extent, we like:

  • US Bonds generally: we are compensated for inflation, they have repriced lower.
  • US inflation securities: paradoxically US inflation is undervalued.
  • Floating rate notes: shorter maturity bonds provide some protection against rising rates.
  • High yield: OK, so the selloff is only just starting but five points of capital loss year-to-date are tempting us. It helps coming from an underweight position.
  • Short-dated securities: everyone is talking about “curve flatteners” but that looks so last year. Long bonds globally are too expensive and a crowded trade. Those who bought in recent months are already wondering why.
  • New Zealand: who doesn’t? Kiwi bonds have lagged the recent rally – too many people in work. Core price data though looks soft.

High yield: back to five-year lows…if we forget about the energy crisis

High Yield Fiver Year Lows - David Roberts GFI Outlook

Source: Bloomberg, as at 30.11.18. Chart shows US high yield market price (the Markit iBoxx USD Liquid High Yield Index) in $.

We don’t like:

  • UK, Japanese and European bonds: why lend to someone and receive a negative real return? We don’t need to.
  • Canada: Buying their bonds on lower yields than US Treasuries makes no sense.
  • Low-rated, highly levered credit: Avoid anything beginning with a C.
  • Subordinated financials: Yes, they are beaten up but too systemic for us (for now) and that’s before the leverage cycle really rolls over.
  • Emerging markets: leave it to the equity folks – they get paid for high growth, bond holders don’t.
  • Loans: the current equivalent of sub-prime?
  • Illiquids: investors are jittery and have a right to take money back. Illiquid bonds hold up well until someone tries to sell one.


So, lots of alpha for active managers to target. What about the beta?

Now, it’s at this stage that the interests of clients and asset managers often diverge. I love volatility, I hate trending markets. The former is a challenge, the latter dull. However, let’s be honest: clients want low volatility, high positive returns and those are best generated from dull, trending markets. Honest point, number two – we’ve had nearly 10 years of a bull market for almost all risk assets. QE and associated central bank measures have reduced volatility and meant all people had to do to top league table was take lots of risk. That period seems to have ended.

However, it does mean the core beta returns for bonds is likely to be low. The good news though is that risk assets such as high yield and investment grade have recently moved aggressively lower just as sovereign debt has rallied. Indeed, in certain parts of the market we can now see decent, long-term value.

And now the difficult bit – returns for 2019

Global rates markets

I continue to believe central banks will further tighten monetary policy next year. Folk are suggesting they are running scared given equity market corrections but as I type, despite all the noise, major US markets are (just) in positive territory for the year. We have seen a correction from highs but in no one’s book is that a crisis. I listed a pile of stuff that could go wrong above but against the following base case scenario– inflation at or modestly above target, low unemployment, ECB ending QE, US slows but no recession, and no trade war disaster – I’d estimate these returns from bonds:

 

10 year now

10 year at end 2019

Total return from “beta”

US Treasuries

2.9%

3.1% (having been close to 3.5% mid-year on strong wage data). The Fed is well through its cycle, rounding errors now.

+2% (small capital loss, but 2.9% income)

German Bunds

0.3%

0.8% (having been close to zero early in 2019 on Italy, German and UK politics). Still well below inflation.

-2% (capital loss and no compensating income)

UK Gilts

1.3%

2.0% (Brexit done and either way they are a sell – inflation, growth or Jeremy Corbyn as PM)

-2% (in reality, who knows – small potential upside, material downside)

 

Credit markets

 

10 year now

10 year at end 2019

Total return from “beta”

Investment grade (US proxy)

4%

4% (Little change to yield, rising sovereign debt offsets tighter spreads)

+4% (all income – downside danger as market is “long” and trying to sell risk)

High yield (Global index)

7%

6.5% (tricky, could be 5.5%, could be 9% but less crowded part of risk given rise of loan market)

+8% (some way from the start of the default cycle, but risk backdrop prevents capital gains)

EM (hard currency sovereign)

5%

5.5% (no disaster as US rates don’t go too much higher, but risk- adjusted looks poor)

+3% (belief that US won’t raise rates and $ will fall has held prices up. That may change, a little)

 

I said a year ago there was danger in buying bonds and despite increased equity volatility, most bond investors are down year to date. I believe the same patterns will repeat in 2019 although of course, the beta is marginally less expensive.

Optically there are some fairly simple trades: as you can see, I like the better “value” of US Treasuries and the better technicals of high yield. We are perhaps all too worried about Mr Trump, Italy or Brexit to see them. Sometimes there is no substitute for stepping back and trying to see the bigger picture – who knows, perhaps the holiday season will see us all gain new perspective.

For a comprehensive list of common financial words and terms, see our glossary here.

 

Key Risks 

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing. 

Tuesday, December 11, 2018, 2:24 PM