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Impact Investing

IPE special report May 2018

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Stuck between two floors

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It’s extremely quiet in the bond markets at the moment, making it hard for managers to maintain their customary avid focus on their beloved markets.
The late summer months are often void of excitement for those left studying their screens while colleagues bask on the beach. But this year is worse than most. “Volatility has sunk to a five-year low,” says Christel Rendu du Lint, fixed income fund manager at Pictet Asset Management in Geneva. “Markets are hardly moving: the 10-year Bund has been trading in a 10 basis point range of 4.20-4.30% for the whole of July.”
Markets are expecting the US Federal Reserve to raise rates soon, not least because of the looming US presidential election. It is virtually certain that Fed chairman Alan Greenspan will be anxious to avoid making any policy statements or actions before, during or soon after the election process; he will not want to be accused of political bias. That rates will be raised is not in doubt; that some of the rise is imminent is accepted too. So why the anxiety and wariness?
“Waiting for news is like being stuck in a lift, suspended between two floors,” agrees Andreas Schuster of CapitalInvest. “One camp argues that growth will increase and with it inflation; the other says that the worst, in terms of yield rises, is behind us and that bond markets aren’t that bad just now.
“The US is still a big focus for us all, and we’re not about to see any decoupling between markets in the US and over here. Our view is pretty much consensus, that growth is decelerating somewhat but is probably sailing along quite comfortably at 3%. Greenspan is behind the curve. But he’s sort of painted himself into that corner really, and he’ll be very anxious not to kill the recovery. We think he will stick to his script and hike a few times before then.”
Schuster continues: “While the bond bears do have some plausibility, EU growth is hardly a ‘problem’ for bonds. Yes, inflation is above 2%, but if growth is not accelerating then we think there is not too much to worry about. Economic growth in Germany is key – and we are still not seeing domestic demand taking over from the recovery we have already witnessed in the export sector. It is the same pattern repeated over the last seven to eight years where the spark from growing external demand fails to ignite the consumer. And if Germany or France or Italy aren’t going well then no matter how healthy the peripherals are, the EU as a whole will not be dragged into faster growth.”
Rendu de Lint believes there are several reasons why bond markets have been apparently directionless for so many months, despite a powerful global recovery. First, the steepness of yield curves makes it expensive to implement bearish positions due to the high cost of carry. Secondly, there are plausible macro-economic reasons to be wary of the sustainability of the US recovery. She highlights the weakness of domestic demand in the euro zone and the relatively low levels of job creation in the US.
But she thinks the most important factor is the highly unusual dichotomy between the growth cycle and the Fed’s tightening cycle. “In the last three cyclical rebounds, the Fed tightened on average seven months after the ISM manufacturing survey reached its trough, but this time waited twice as long. By now the Fed would have generally hiked rates by 125 basis points (bps) whereas it has only raised them by 25bps We believe this is where the bond market’s unease comes from. How can it reconcile the fact that the growth cycle might already have hit its peak whilst the Fed has hardly started raising rates.”
Rendu de Lint argues that these qualms have forced investors into a pragmatic Fed- and data-watching approach with all bond market action concentrated around times of central bank comments and data releases. Although there can be wild price swings, it’s not long before the market freezes up. “Couple that with the market still trying to make up its mind between the relapse or sustainable growth scenarios and it is understandable that we have been moving inside a range for so long without establishing any sort of trend.”
But investors cannot afford to sit on their hands. Schuster and his team think investing in credit is still a good thing to do, even if spreads have already narrowed so much over the past year. “Spreads have not moved for a while now, so if you can pick up 60bps in investment-grade paper and just stick with it, that makes a material difference to your total returns when your index is ‘only’ yielding just over 4%. There’s not much issuance as company balance sheets are quite strong just now and there is not significant investment spending and we are certainly not in the middle of an M&A spree, so paper is in demand and investors have cash.”

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