Bill Bovingdon and Chris Dickman give their views on what to expect from fixed income markets in 2017.
Last year was an amazing 12 months in investment markets, and in particular for bond markets, reflecting the enormous change in the political and policy landscape.
Australian 10-year government bonds started 2016 around 2.8 per cent and three-year bonds began the year around 2 per cent, and finished almost unchanged. But in between we have seen negative interest rates generate an historical low for bond rates before ultra-easy monetary policy gave way to a renewed enthusiasm for fiscal policy, and voter rejection of the establishment reflecting the adverse effects of globalisation.
The impact of these changes, in particular amazing events such as Brexit and Donald Trump winning the United States election, will continue to play out in 2017 and will have significant implications for bond markets.
Already the general shift in fiscal policy has had global repercussions, triggered by the US Federal Reserve lifting cash rates in December 2015 for the first time in nearly a decade.
The ramifications of this hike dominated the first half of 2016, with the strengthening US dollar setting off market turbulence that threatened the stability of major economies.
In China, capital outflows led authorities to intervene to arrest the sharp depreciation of the currency and precipitous fall in the share market. Meanwhile, the Bank of Japan, in something of a misstep, surprised markets by cutting cash rates and driving longer-dated bond yields into negative territory. The European Central Bank (ECB) responded by pushing European cash and bond rates further into negative territory.
Globally, business and consumer confidence were undermined, and growth lost the tentative momentum that had been building. Oil fell to US$28 a barrel, adding to the disinflationary pulse.
One result of this was the impact on real income, and the subsequent growth in popular unrest against the establishment and wholesale questioning of the political consensus about the ideal global economic model. Since the turn of the century, real income for all but the wealthiest in the developed world has been negative. Technological advances and globalisation have resulted in the middle class being ‘hollowed out’ over that time. As a result, business investment, largely attached to the fortunes of the middle class, remains anaemic.
An inadequate fiscal response has perpetuated this phenomenon and the gap between the haves and have nots, and the results have been, in the most part, unexpected.
Since the turn of the century, real income for all but the wealthiest in the developed world has been negative – as measured by the median real income level. On the other hand, the developed world’s most wealthiest have experienced income increases – as measured by the mean real income.
For instance, in June last year, Britain voted to leave the European Union, and in doing so take back sovereignty and work to arrest the growing income gaps. The consequent flight to quality, along with the Bank of England emergency cuts to cash rates and government bond purchases, pushed global bond yields to all-time lows. In addition, Trump, against almost all predictions, won the US presidential election, with significant ramifications for the future of US policy and growth.
However, the negativity of the first three quarters was completely unwound over the last quarter of 2016. The shortcomings of the efficacy of perpetually ultra-easy monetary policy had been realised. The ECB, followed by the Bank of Japan, recognised businesses and households need income and confidence. Although negative rates were retained, further cuts to cash rates were not made.
More importantly, longer-dated bond yields were allowed to rise somewhat to generate income and provide an environment where banks could lend to fuel an economic recovery.
Towards fiscal policy
Authorities began to recognise the need to move away from a reliance on monetary policy toward fiscal policy, including infrastructure spending.Emboldened by voter mandate, the Japanese government announced significant infrastructure spending. In the US, both presidential candidates lobbied for significant fiscal expansion. The ability to deliver these policies hinged on control of government. Trump was elected in November, and importantly a clean sweep was delivered to the Republican Party. Fiscal expansion is now less likely to be hostage to partisan obstruction.
Since the US election, the greenback has rallied strongly against all other major currencies, and bond rates have increased, factoring in fiscal expansion and expectations of a greater inflationary impact from protectionist policy. Confidence has lifted, and the Federal Reserve delivered the only rate hike of 2016 in December.
The strengthening US dollar has increased the rate of foreign exchange reserve depletion among many emerging economies, most notably China, driving Chinese sales of their US Treasury holdings, in turn pushing government bond yields higher.
Figure 1: Negative real income for all but the wealthiest
Figure 2: Australian government bond yields on the rise
Where to next?
Against this setting, the outlook for 2017 is looking somewhat brighter. However, although global policy settings are moving in a direction that supports economic and income growth, we believe markets may have priced in too much good news over the immediate horizon. The pace and extent of the recent rise in bond yields is consistent with a fiscal expansion reminiscent of the Reagan era and a healthy recovery in Europe. Bonds have been driven higher in yield by asset reallocation, significant central bank selling of foreign exchange reserve holdings of US Treasuries and other major bond holdings, and unwinding of underweight positions in growth assets, including the US dollar.
If the good news isn’t realised, global bond rates will likely fall, and the Federal Reserve will find it difficult to lift cash rates more than twice. Without broad real wage growth in developed economies, voter dissatisfaction with institutions will continue. In this scenario, predictions of a prolonged bear market in bonds will prove to be overly pessimistic.
Globally, market measures of inflation expectations have lifted. For this to be translated into reality for observed inflation, the US cannot grow in isolation. Other major economies must lift economic activity and inflation, otherwise the US dollar will strengthen excessively and longer-dated government yields will rise to the point where financial conditions tighten too much for the US economic recovery to be sustained.
European fortunes are pivotal to the performance of global bond markets and at Altius we are skeptical that Europe can meaningfully lift activity over the first half of 2017. While falling, European unemployment remains high, providing little upward momentum for wages and real incomes.
Important elections are on the horizon and protest votes in Europe typically mean greater political fragmentation. The political hurdle for European fiscal expansion is too high, so economic growth will have to be more organic and reflective of lagged benefits from the US recovery and therefore unlikely to be felt until the second half of 2017.
US unemployment is low, but inflation remains contained for the moment by a stubborn degree of underemployment. Real US median wages rose for the first time last year and business investment lifted accordingly, providing a potentially sustainable virtuous cycle for growth. Trump’s plan to cut tax rates for companies and households should show benefits late in the first half, boosting real wages at that time.
Higher rates for long-dated Australian bonds in part reflect, somewhat justifiably, the policy shift by international central banks to having steeper yield curves. Low domestic inflation and low growth, together with a stronger than expected Australian dollar should, however, dictate where the Reserve Bank of Australia sits on current interest rate settings and it may in fact have an easing bias for much of the year.
Accordingly, at Altius we find value in shorter-dated bonds that have largely been sold on the back of central bank foreign exchange reserve depletion. We also see a generally positive outlook for corporate bonds.
Active duration management will be necessary as the decade-long zero/negative cash rate environment has encouraged extreme financial market positioning. As this is unwound it will provide some appealing short-term opportunities. Overall, at Altius we anticipate adopting a generally defensive posture on duration in line with our confidence of a more meaningful lift in growth momentum in the second half of 2017.