So far this year the higher-yielding, more economically-sensitive fixed income sectors have posted the strongest returns and the lower-yielding market segments generally delivered positive single-digit returns — arguably a respectable performance give the trend towards tighter monetary policy both in Europe and in the U.S.
As it is probably too early to call an end to the long phase of gradual global economic growth and abundant liquidity, we believe fundamentals and market technicals still present value-adding opportunities in fixed income given steep yield curves and the potential for tighter spreads.
That said, fixed income risk assets are climbing a wall of worry, and we believe that these risks will likely mount in the coming quarters while higher valuations and tighter spread levels reduce comfort margins. Here is a tour of the most prominent risks that keep us up at night.
Central bank policies
After extraordinary monetary stimulus over the past several years, major central banks appear set on tightening in an environment where inflation is still running below official targets. All of the G3 central banks have turned less accommodative in the recent past, increasing the risks of overtightening going forward.
- Of the G3 central banks, the Federal Reserve likely poses the greatest overtightening risk — one that may ultimately pull the next recession forward. The risks from the Fed stem from the reduction in U.S. labour overcapacity, a decline which has underscored the concern that the reduction will spill over into inflation pressures. Resolving the wide gap between the Fed’s median dot at the end of 2019, at 2.9%, and the market’s implied policy rate, at 1.66%, could prove painful. These risks could rise if potential replacements for Fed Chair Yellen and other FOMC voters carry more hawkish policy views.
- With European Central Bank asset purchases reaching self-imposed limits and a formal tapering decision possible by September of 2017, this shift could weaken some of the key supports that have bolstered European and global growth over the past several years.
- Chinese authorities may well choose to reduce the economic credit stimulus of approximately a quarter turn of GDP per year after they have held their 19th Congress in the fall of 2017 and the retiring members of their Politburo have been replaced.
While geopolitical risks can stem from a number of places, the Middle East and North Korea are two locations of particular concern in mid-2017.
- The ultimatum issued to Qatar is a symptom of a more fractious Gulf, with rising tensions between Saudi Arabia/GCC and other players including Qatar, Turkey, and Iran. This deepens the stakes and risks in a region already beset by weak oil prices. Near-term risks include escalation of regional political tensions, while longer term — unless oil prices recover — the region faces falling FX reserves, budget strains, and weakness in the banking sector.
- North Korea’s ongoing tests of its nuclear and missile capabilities pose a challenge to the Trump administration, and the risks remain that Chinese and other diplomatic efforts will fail to rein in the regime, triggering a military confrontation.
- Additional risks emanate from the Trump agenda in the U.S. and from the upcoming Italian elections in Europe. However, Trump bump expectations have subsided, while near-term risks in Europe have also faded somewhat due to the pick up in growth, consolidation of the political center in Germany and France, and the potential for reforms in France.
Exogenous event risks
These risks are hard to enumerate, let alone quantify, but they are no less real than those threats in plain sight. Here are two that bear watching.
- A global pandemic from diseases, such as Zika, Ebola, or a respiratory virus, such as SARS, remains a concern due to growing global populations and urbanisation, human encroachment into new environments, increasing frequency of heat waves and flooding, international travel, civil conflict zones, and poor medical coverage in frontier countries.
- As a whole, global cyberattacks, unplanned IT or communication outages, and data breaches constitute a growing threat to markets, which are vulnerable to attacks on e-services or on entities that provide critical physical or financial infrastructure. For example, the Wannacry attack in May 2017 crippled computers in 100 countries, including those used by the UK’s National Health Service.
Despite these walls of worry, however, we believe there are still multiple avenues to add alpha across the fixed income spectrum on a risk-adjusted basis. Below we share some of our sector views over the near term.
Investment Grade Corporate Debt: Modestly positive given fair spread levels, strong investor demand, and economic growth momentum. Still favour U.S. money center banks.
Global Leveraged Finance: Neutral on U.S. high yield given room for additional spread tightening but elevated macro tail risks. Prefer the CCC portion of the U.S. market (offset with higher cash balances), but are exploring opportunities across all quality buckets. Cautious on energy. Favourable on European high yield given the supportive technical backdrop and low default expectations.
Emerging Markets Debt: Positive. We view bouts of volatility as buying opportunities. In hard currency, we are maintaining a barbell position. In local rates, we look for rate cuts in several countries and are emphasising relative value in EMFX.
Municipal Bonds: Neutral. Strong technicals to start Q3 should begin to abate by quarter end; in addition, solid outperformance vs. U.S. Treasuries in Q2 leaves valuations less attractive compared to earlier this year.
Global Rates: Constructive based on attractive tactical opportunities throughout the developed rates markets as central bank policies progress on varied trajectories.
Agency MBS: Underweight in favour of high-quality spread sectors.
Structured Products: Positive on top-of-the-capital structure assets and the fundamentals of GSE credit risk mezzanine cashflows. Cautious on GSE spreads at current levels and negative on CMBS mezzanine tranches.
Arvind Rajan, Ph.D., is a Managing Director and Head of Global and Macro at PGIM Fixed Income, heading the FX, Global Bond, Emerging Markets Debt, Investment Strategy and Economic Research teams. PGIM Fixed Income is one of the largest fixed income managers in the world, with $US654 billion AUM