Theme 1: Bond yields – Lower for longer
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Our premise was that overcapacity in manufacturing, low commodity prices and low wage growth would lead to low inflation in much of the world, keeping monetary policy accommodative and causing bond yields to fall further. Markets joined us in this view, and probably even took it a little too far in the month of February. At one point, they believed the Federal Reserve (Fed) would no longer hike interest rates at all in 2016, and inflation breakeven rates suggested that US inflation would remain below the Fed’s target for the next 10 years.
By comparison, we still expect to see two rate hikes in the US this year and do not believe that inflation can remain this low for much longer.
Where do we stand now? Inflation may start to bounce back if commodity prices start to stabilise, as we expect.
Core inflation (excluding food and petrol prices) has also ticked up somewhat in the US. It is fair to assume, though, that overcapacity in emerging markets (China in particular) will continue to put a cap on inflation and that the larger than expected stimulus package by the European Central Bank (ECB) and an enhanced bond buying will continue capping any significant upside in global safe haven bond yields. On 10 March 2016, the ECB overwhelmed the markets by extending its bond buying programme to 80bn euros per month until March 2017 and including corporate bonds on its buying list. This is likely to put further downward pressure on the European bond yields.
As a result, the theme remains in place and the search for yield should continue. In addition, the inclusion of non-financial Investment grade corporate credit in the ECB’S recently expanded QE programme should boost investment grade credit further. Equity strategies that create shareholder value through dividend pay-outs or share buybacks should also reap benefits. However, as we think that inflation expectations are now too low, we shift out of conventional US Treasuries and UK gilts into inflation linked bonds. Moreover, as a result of the tentative improvement in some emerging market fundamentals (a possible stabilisation of oil prices and the USD), we add selectively to our exposure to emerging market (EM) debt and recently upgraded our view on the local currency EM debt.
Theme 2: Globalisation versus Localisation
After decades of global and regional integration, this could mark a turning point or at least a pause in globalisation. However, global connectivity in the virtual world continues to gain momentum. Intel Corporation believes that the current 15 billion connected devices will grow to over 200 billion by 2020. Many technology companies reported Q4 2015 earnings ahead of expectations and continued to speak positively about connectivity and the growth in the Internet of Things (IoT). Beyond the technology sector, companies in other industries have also focused on embedding connecting devices into their end products, such as appliances and switches, automobiles, wearables including watches, and industrial machinery. Indeed, large market participants have expressed excitement about growth potential in these market segments for years to come.
We believe that companies focused on networking hardware, software, processing and routing will continue to experience a secular tailwind for revenues related to interconnectivity. While traditional globalisation seems to be stalling, virtual globalisation powers ahead and we believe it will outgrow the broader economy on a multi-year basis.
Theme 3: China in transition
As we suggested in our 2016 outlook, China has been struggling to balance the longer term transition of its economy (from investments and exports to consumption) with the shorter-term management of its current economic slowdown. Markets equally struggle to reconcile these two different horizons, and continue to look for more clarity on China’s short-term policy.
Some clarity on FX policy was recently provided by the Chinese officials, who explained CNY would now be managed against a basket of currencies and have been at pains to stress that the currency would not be devalued to gain competitiveness. A stable currency seems a prerequisite and a good first step to temper capital outflows and allow for further cuts in interest rates or bank reserve requirements. Indeed, it seems likely that monetary support will be combined with fiscal stimulus and continued reform, as suggested recently by the Chinese central bank governor. We continue to believe that China has the monetary and fiscal means to ease the cyclical slowdown, and that genuine longer term concerns over leverage are unlikely to block the near term need for monetary accommodation. As a result, market sentiment should find some support and should rebound in H2 2016, when we believe data will stabilise. We believe CNY will weaken slightly (to USD/CNY 6.9 by the year end) and maintain a small overweight on China due to attractive valuations, with a preference for Hong Kong listed H-shares over A-shares, which are listed in mainland China.
Theme 4: End of the ‘BRICS’- But select opportunities in EM remain
Emerging Markets (EM) remain a mixed bag and we continue to believe that it is important to distinguish between them, avoiding generalisations such as the ‘BRICS’. However, the outlook is getting somewhat more supportive for the asset class in general. In fact, EM demonstrated a resilient performance across a myriad of asset classes in recent weeks, despite a broader ‘risk-off’ sentiment in January, triggered by volatility on European financials and expectations of lower US growth.
Instead, the market’s re-pricing of a slower and more gradual US hiking cycle and a weaker USD, supported EM through lower external debt servicing costs. A bigger than expected stimulus package by the ECB and lower Japanese rates have provided further support to EM local rates and renewed inflows from foreign investors looking for yield. Meanwhile, a rebound in oil and commodity prices, along with improved communication by the PBOC’s Governor, regarding China’s efforts to proceed with its FX reforms, allowed EM assets to perform well compared to the developed markets (DM).
The main risks for EM, namely commodities, China’s growth fears and US rates, are likely to remain an overhang in the short-term and a potential source of continued volatility, however we believe that they are not as intimidating as they looked in the recent months. Our base-case scenario is for steady but low global growth, the Chinese economy finding its bottom towards the second-half of the year, USD losing steam against the majors, whilst arguing that the bulk of EM FX weakness is behind us.
While hard currency debt can typically better withstand any short-term uncertainty, we also incorporate select local currency bonds which may benefit from the above mentioned drivers. EM equities have demonstrated higher sensitivity to global growth concerns, however, may remain somewhat more volatile, despite their recent outperformance versus DM. Valuations are cheap and are nearing an inflection point which could provide a catalyst for further upside when clarity about Chinese and global growth improves.