From clear to cloudy skies
Over the last month all eyes have remained on the US, and investors are lapping up stories of ‘interest rate hikes’, and ‘economic growth’. Reports like the September fund manager survey by Merrill Lynch state that “there is not a cloud in the sky” and that players have now “shrugged off the last of their bear-market concerns”, and are consequently seeing their risk appetite increase. The damage to bond yields by the stark turn-around in sentiment, however, seemed to have come in one foul blow in August, so over the past month yields have remained fairly static in spite of the continued optimism.
Given that 65% of the fund managers surveyed by Merrill Lynch expect long-term interest rates to be higher in 12-months time, one would be forgiven in thinking that bond yields won’t remain static for much longer, however. Or will they?
When one digs a little deeper, it becomes quite clear that not everyone shares in the optimism, and clouds in the sky, there certainly are. Indeed, interestingly the Merrill Lynch survey shows that while 59% of equity fund managers think that long-term rates will be higher in 12-months time, only 35% of fixed income managers agree. Consequently, only 26% of fixed income managers think that global bonds are undervalued.
For Anthony Linehan, head of fixed interest at KBC Asset Management in Dublin, the economic outlook is still uncertain, and government bond yields will remain static – especially in the Euro-zone. “There is a logic to the European government bond curve at the moment so it is hard to argue that something should happen.” He argues that the economic outlook for Europe will keep them steady. ”While European government bonds will show some sympathy with Treasuries which are suffering from a more positive economic outlook in the US, some data shows parts of Europe to be in a recession. You cannot be overly enthused about Europe, and we’ve hit close to fair value there for European bonds.” Edith Siermann, head of fixed income at Robeco in Rotterdam agrees. “We’re neutral on European government bonds, and expect only sideways moves.”
But while both are of the opinion that a sell-off in the US could have a knock-on effect for European bonds, opinion differs as to how soon this may happen. Siermann is rather more optimistic for growth in the US, and is expecting a rise in interest rates to come in the next six months. A rise in interest rates in Europe would then follow, albeit likely to be a smaller rise at a later date. Linehan, however, believes it unlikely that the Fed would rise rates until the output gap is closed, which means that there is still value to be had from 10-year Treasuries. For Siermann, it is the 30-year.
Activest’s chief economist in Munich, Conrad Mattern disagrees entirely that an interest hike in the US is in the offing. “Yes, a rate hike by the Fed and the ECB have been priced in, but we see another rate cut early next year.” Franck Dixmier, head of fixed income asset management at AGF AM in Paris is also not discounting a further rate cut by the ECB. “If there is a surprise move in the euro versus the dollar then it could lead to the ECB cutting rates,” says Dixmier. Mattern’s argument for a rate cut, on the other hand, is that investors are wrong in thinking that just because Q3 growth rates are likely to show an economic improvement, that so will those of Q4. “We think that the global economy will show signs of improvement in the third quarter, but only as a result of fiscal stimulus. The fourth quarter will see growth rates below the third quarter, and disappointment will come next year, so central banks could cut rates then.” Mattern even argues that structurally the Euro-zone economy is better than the US. Activest, therefore, believes value in government bonds to remain until the middle of next year, and Mattern recommends a barbell strategy in both Treasuries and European government bonds.
In the corporate bond sector, lower-rated bonds have enjoyed a rally, and it is agreed that there is still value at the moment, even though yields are higher than at the beginning of the year. This value will increase if global economic outlook does improve, says Siermann. “If growth is gradual, then yield spreads could stay at these levels or even tighten further, but if economic growth is hampered, then we could be in for a harder time.”
AGF is also neutral to slightly positive on corporate bonds. “Technicals of the credit market are still supportive for spreads. The macro side is still neutral, we are finding, but on the micro side, profits have been quote good for telecoms and insurance names. We are neutral on the autos sector and would like to be positive on media but remain underweight on valuation concerns. So we’re slightly positive on corporate bonds, although our strategy is to reduce spread duration and reduce the beta of the portfolios.”