2019 proved to be an extraordinary year for global bonds in terms of performance and issuance, as central banks embarked on a new phase of supportive monetary policies. In October, the US Federal Reserve made its third interest rate cut of 2019 – 75bps in total for the year. The Fed stated how this was in line with previous episodes of “insurance cuts” but also signalled a pause unless the economic outlook changed materially – the US consumer has remained upbeat throughout 2019 and GDP growth is expected to reach 2.3% for the whole year. On the other side of the Atlantic, Christine Lagarde took over as President of the European Central Bank (ECB) on the 1st of November, pledging to continue the Bank’s bond purchasing programme and urging governments to boost public investment for Europe’s fragile economy. Despite deteriorating economic indicators – especially in German exports and manufacturing sector – average growth in the Eurozone during the first three quarters of 2019 was exactly the same as in 2018.
Geopolitical risks that dominated the markets for much of 2019 started to abate by the end of Q4 and, with record returns in global bonds and equities, investor sentiment around the world improved. In December, fears of an immediate global recession faded following the temporary trade truce between the US and China as well as the Brexit withdrawal agreement’s approval in Parliament after Boris Johnson’s general election victory in the UK. Better than expected confidence and joblessness data for Q4 also contributed to the more positive outlook for the extended late cycle.
Taking advantage of the ups and downs
The Q4 story for fixed income was and continues to be more of the same. Bond valuations have been boosted more by technical factors than fundamentals for some time now given the unconventional monetary policy of the past decade, and investors have started to accept that this lower for longer environment might well be the new norm.
Positioning became trickier as the large inflows into the fixed income asset class were met by a historically high level of bond issuance, while short-term volatility – fuelled by geopolitical and trade war headlines – created trading opportunities for investors. We continued to selectively pick pockets of value in the investment grade space in Q4 as spreads further tightened and outperformed government bonds. Government bond yields rose in most of the developed markets during Q4, generating negative total returns.
We favoured European credit, as the US performed well but has been losing momentum and is entering an election year with all the uncertainty that generally comes with it. Although credit spreads in Europe are becoming stretched, they are not at their tightest in historical terms and with the ECB still buying bonds we believe there is more value to extract. In terms of duration, we have been cutting in Europe and adding to our US exposures with the view that the Fed has more scope than the ECB to deliver interest rate cuts in the future if warranted. In the UK, we are more neutral and have been adjusting duration closer to benchmark. Brexit remains the key driver here and the UK economy still faces uncertainty as the new government contends with the European Commission over details of its withdrawal agreement.
As active investors, we remain focused on staying clear of problematic names affected by the trade war as well as the “zombie companies” that will face difficulties in servicing their debts.
Stretching into 2020
The market has tended to shrug off geopolitical risks and eventually bounce back until the next event comes along. For example, the recent tension between the US and Iran had the potential to derail the markets but both governments quickly de-escalated the situation without leaving major dents on risk assets. We are constantly monitoring these risk events and, in our view, the trade war and rise of populism are two global trends that have the potential to derail the current recovery.
Looking ahead, although we do not believe a recession will materialise in 2020, a slowdown in any major economy around the world could lead to a black swan event that could profoundly change the markets; for example, in the US or China. Europe would come less as a surprise since investors have adjusted to the lower trend growth for some time now. We believe one of the major risks for fixed income this year is a rate reversal. As the new Lagarde-led ECB has announced a review of its policy objectives, while increasingly pointing to the detrimental side effects of negative rates and the pressing need for fiscal stimulus, rates can soon be exposed to upward pressures. This would translate into higher yield curves, making it increasingly difficult to replicate return levels delivered in 2019. In the US, we view this risk as more balanced due to the Fed wait-and-see approach and we view the bar for future hikes to be much higher than for additional cuts.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate. Currency fluctuations can also affect performance.
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CLI1556 Expiry on 31/12/2020