- For most of last year Bond funds were producing negative returns with an unholy combination of rising Government Bond yields and widening credit spreads. The year ended though with yields falling, and hence Bond prices rising, as fixed income markets jumped to the conclusion that there would be a sharp slowdown in global growth in 2019. UK Gilt funds finished on average flat for the year though less good news for fixed income investors was corporate credit spreads continuing to widen with the consequence that corporate bond funds fell by around 2.5% in 2018.
- The outlook for 2019 will, as always, depend on Central Bank policy. The Fed has signalled that interest rates are ‘close to neutral’ with maybe just one or two more hikes to a terminal Fed Fund rate of 3%. US long dated yields have taken a more bearish stance on growth, falling sharply in the last few weeks to below 2.8% at which level they are pricing in no rise in rates at all this year. In all likelihood the US 10-year Treasury yield of 3.25% we saw last year marks the peak for this cycle.
- The ECB has finally ended its QE asset purchase programme but with Eurozone growth disappointing and global growth in aggregate under pressure in 2019 it will be a struggle for the ECB to raise the discount rate in 2019. Even so, with 10-year German Bunds yielding a miniscule 0.25% the yield will probably drift upwards if global recession is avoided. As for Gilts, Brexit remains the loosest of cannons but 10-year yields at 1.25% don’t look great value whereas over 1.75% they would find buyers. This rather sums up bond markets these days, pretty tight trading ranges compared to previous decades so shallow moves up and down rather than more clearly defined bull or bear phases.
- It would be nice for portfolio construction to be in a position where you could buy long dated Government Bonds on half decent yields without having to worry too much about the downside. That way you get both a decent income and some very useful portfolio diversification against riskier assets like equities. We’re well away from this in the UK and Europe though US domestic investors are happily buying even relatively short dated paper at over 2.5%. Sadly for non-US buyers the cost of hedging the currency is ruinous due to the differential in short term interest rates between the US and everywhere else so we can’t take advantage.
- We have written a lot about ‘inverted yields curves’ as a harbinger of recession over the last few quarters. Sure enough, with the markets in such a tizzy about the slowdown in global growth the US curve inverted to an extent in December with the 2 year yield higher than the 5 year, though not yet the 10 year which is a more definitive indicator. If not yet actually inverted, the whole US curve from 3 months up to 10 years looks awfully like a pancake. Be wary of getting too carried away by the inverted curve obsession though, it is a reliable indicator of recession but not a timely one. On average recession follows up to two years after inversion and it says little about how stocks will behave in the interim period.
- Credit spreads are also pricing in significantly lower economic growth and corporate distress without at this point too much evidence. Investment grade spreads widened by around 50bps last year and High Yield by around 150bps. As a consequence they now offer better value when compared with Guvvies. An important caveat though is the deterioration in the quality of both investment grade and high yield credit as the cycle has matured. Significantly Increased leverage in the last two years coupled with less stringent covenants to protect the lenders have become an increasing feature of the US and UK corporate bond market and are uncomfortable echoes of 2008.
- For EM Debt to outperform Developed Market bonds there needs to be a reversal in dollar strength and a sense that the Fed is ending its rate raising cycle, both of which would likely occur together. Less tension between the US and China would also help enormously, as would less instability in Latin America and Turkey.
- As we have been saying for a couple of quarters now Cash is becoming King in the US with 3-month rates at 2.5% and presenting a strong ‘risk free’ alternative to equities and the riskier end of the Fixed Income market. No chance of that in the UK sadly or even more so Europe where 3 month rates are still negative.
Summary: Government Bonds rallied into year-end as markets factored in sharply slower global growth next year, indicating a peaking of US yields this cycle. Credit spreads have widened significantly so corporate bonds continue to underperform Government bonds.