Pockets of opportunity

Fixed Income

Pockets of opportunity

We continue to see opportunities, especially in high yield. Buy the dips, but selection is key.

It has been a volatile few months. As we look ahead to the next 12 months, we see three major themes shaping fixed-income returns. First, we expect the dollar to start to strengthen again against the euro. Recent dollar weakness looks overdone and key arguments do not hold, in our view, as explained in the next article.

Second, we expect the yield of both 10-year U.S. Treasuries and 10-year Bunds to increase. However, we do not anticipate a selloff in Treasuries. Rises in yields are likely to continue to be driven by strong and synchronized global economic growth, rather than a sharp uptick in inflation. Instead, we see inflation edging only slightly upwards. As a result, the U.S. yield curve is likely to flatten further, but not to invert. This is important, as historically, every U.S. recession since World War II has been proceeded by an inverted yield curve (a correlation which the new Fed president has recently tried to play down). Given solid growth momentum, we do not yet expect markets to start pricing in a U.S. recession during the next 12 months.

Against this backdrop in rates, we expect risk-on sentiment in markets to return, though higher volatility may persist. This should favor corporate credit over sovereigns. The bottom line is that from autumn 2018 onwards, markets may start to anticipate late-cycle economics. With central banks' cumulative balance sheets beginning to shrink in the second half of the year, fixed-income investing looks set to get trickier than it has been for much of the cycle. In general, we prefer shorter maturities in government bonds. However, there are still pockets of opportunity, even in fairly surprising places.

Among developed-market government bonds, we would single out Italy. Despite the surprising electoral strength of anti-establishment parties, we could actually see some tightening, once political uncertainty related to the new government formation calms down. This should result in positive absolute returns for Italian bonds; we favor the three- to seven-year range, due to carry and roll-down effects.

We remain positive on corporate credit in general. Risks from recent protectionist measures and geopolitical tensions need to be monitored closely, to be sure. However, we do not anticipate lasting consequences on risk sentiment. Instead, we consider recent events in both equity markets and certain corporate-bond segments as a bull-market correction rather than the beginning of a bear market for risky assets. To be sure, the likely phasing out of the ECB's corporate-bond purchase program could change the markets' dynamics. We would expect this to happen by the end of 2018. Keep in mind, however, that the ECB will continue to be a buyer through coupons and reinvestments of maturing bonds, probably for quite a while.

In high yield, we see a strong case for buying the dips. Credit fundamentals are mostly stable, on the back of rising corporate profits and low default rates. New-issue proceeds are predominantly used for refinancing, not bondholder-unfriendly activities. However, selection and active management remain key. Supply dynamics are fairly supportive. In the year to date, we have seen declines in new-issue volumes of 11% in the United States, to $43bn, and 17% in Europe to €10bn. This compares to outflows of $13.8bn in the United States and €4.4bn in Europe. Valuations have become more attractive both in Europe and in the United States, where we have a positive bias towards single Bs and a focus on issuers likely to benefit from rating upgrades or merger-and-acquisition activity.

Emerging-market bonds of both sovereign and corporate issuers also remain an attractive asset class. Stable commodity prices as well as stronger domestic and synchronized global economic growth are all supportive. Yield levels remain compelling. The asset class also benefits from a positive rating drift, with more issuers being upgraded than downgraded. One problem is that a lot of good news, notably on structural reforms in key markets during recent years, is already priced in. Potential headwinds could come from a sudden spike in rates and a significantly stronger dollar.

Emerging-market bond spreads

Emerging-market corporate-bond spreads remain fairly attractive. However, regional variations have narrowed.

High yield vs. government bonds

In recent months, option-adjusted spreads of high-yield bonds have stabilized in the United States and risen slightly in Europe

Currencies

The case for a dollar recovery

We believe that dollar weakness has gone far enough. Over the next 12 months, the greenback should recover.

There is no shortage of commonly held explanations for why the dollar has continued to weaken. Look more closely, however, and many of them fall apart. For example, many expect the widening U.S. twin deficits to put pressure on the dollar. However, current-account deficits have little predictive value for both the dollar and other currencies, at least in the short to medium term. Add deteriorating government finances, the other half of the twin-deficit thesis, and a more nuanced picture emerges. There appear to be significant time lags before combined fiscal and current-account deficits contribute to currency weakness; the dollar initially strengthened in the 1980s. Much also depends on the levels the twin deficits are at. For now, they remain fairly moderate.

We believe that dollar weakness against the euro has gone far enough. Make no mistake, by the way, that what we recently saw was dollar weakness rather than euro strength. After all, the trade-weighted euro barely moved. Over the next 12 months, we expect fundamentals to reassert themselves. These include swifter U.S. economic growth, thanks, amongst other things, to recent tax cuts and higher government spending. Interest-rate differentials also favor the dollar and look set to continue to do so for quite a while. On top of that, market positioning remains at extreme levels, and technical factors also look supportive. On a 12-month basis, we expect the dollar to trade at 1.15 against the euro.

What next for the euro-dollar exchange rate?

On a trade-weighted basis, the euro has been trading sideways. Extreme euro net-long positioning decreases the likelihood of further dollar weakness.