With quantitative easing (QE) set to relaunch in the eurozone, ultra-low or negative rates look likely to extend into the foreseeable future. In this environment, we believe a selective approach and dynamic management are the keys to worthwhile returns in fixed income.
Insightful security selection can play a crucial role by helping to avoid losses through defaults and can enhance gains by identifying mispriced bond issues. Dynamic management can add value by responding quickly to price movements across markets. In euro-area markets where both yields and spreads are likely to be anchored at low levels, dynamic management might appear to have lost its edge. But we believe news flow will still drive price movements and provide opportunities for nimble investors. In fact, euro-area markets trading at such high valuations may be more susceptible to short-term over- or under-shooting.
More Central Bank Easing
On 1 November Christine Lagarde is set to take over as president of the European Central Bank (ECB) with an eight-year term. Her mission: to continue the policies of Mario Draghi to preserve the euro, “whatever it takes”. This is no simple task, as reviving QE faces both practical difficulties and growing criticism. Nonetheless, it seems that the political mission will drive policy. Consequently, we expect that euro-area rates will continue at ultra-low or negative levels for the foreseeable future. Volatility is also set to stay at relatively low levels, given buying support from the ECB.
It looks likely that the US Federal Reserve (Fed) will have already cut rates by the time that the ECB restarts QE. So pressure will build on other countries not to lose out in a race to weaken their currency and sharpen their competitiveness.
Benefits of Longer Duration
So what should investors do? In this environment, we believe longer-duration euro-area bonds will likely offer solid return potential. In this part of the yield curve, we believe the upside from higher yield and potentially stronger returns far outweighs the downside risk of capital losses from rising-rate expectations. Longer-duration government bonds with relatively high underlying risks that enjoy ECB backing have the highest prospective returns—notably, Italian treasuries (BTPs).
Holding select European credits also looks attractive, as the gravitational pull of ECB buying will likely both keep yields low and spreads tight. Although the supply versus demand balance in euro-area credit markets remains relatively favourable, it is the business fundamentals behind European corporate issuers that are crucial for long-term investors, we believe. Consequently, we think a cautious approach to security selection is sensible now, with a focus on higher quality issuers that can navigate the current low-growth environment.
Euro-area bonds could be even more attractive to US investors, considering the potential additional yield pickup from hedging back into USD. And strategically, eurozone bonds can present a useful offset to equity risk assets which are more sensitive to the growth slowdown in Europe and to potential continued trade tensions. European high-yield credit currently offers higher income than the dividend yield of the DAX and Euro Stoxx 50, with potentially much lower volatility and drawdowns in an environment in which corporate earnings could have peaked.
What About Inflation-Linked Bonds?
Conversely, the case for inflation-linked euro-area bonds looks weak right now. As core European inflation has not moved above 2% since 2003 and currently sits at 1%, the prospect of the ECB hitting its inflation objective in the coming years seems somewhat remote. Whilst inflation-linked securities in Europe and the UK are not appealing, the case for US Treasury Inflation-Protected Securities is more compelling, we believe.
Core US inflation is higher than the levels markets are pricing in and could stay that way. The market for capable labour in the US is still tight, and import tariffs are likely to have an inflationary impact for US consumers. Oil prices may stay firm too, while the Saudi Aramco initial public offering is in progress. That’s because the Saudi’s are unlikely to loosen supply while they are auctioning a stake in the largest oil company in the world. So there is a reasonable case that US inflation could exceed expectations.
Dynamic Management Is Essential
In a world of ultra-low or negative rates, skilled security selection and the ability to change positioning dynamically will be vital sources of value-add, in our view.
