Fixed income – thoughts on positioning in Q2

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What is perhaps most surprising about increased market volatility since the start of the year (see Exhibit 1 below) is that some find it surprising at all. The global economy is, after all, in the later stages of the economic cycle, and it should be expected that investors will increasingly focus on downside risks to the outlook as a decade of central bank support begins to fade away.

Exhibit 1: Market volatility has increased markedly since the start of 2018 (graph shows percentage of days within the previous 90 days when the S&P 500 index had significant up or down moves)

Source: Bloomberg, BNP Paribas Asset Management as of 14/04/18

Those were the days…..

The halcyon days of 2017 which saw globally synchronised growth, reduced political uncertainty, and suppressed volatility have now passed. Global growth divergences are beginning to appear and increased political uncertainty as well as the uncharted territory of central bank balance sheet normalisation now weigh heavily on global equity and fixed income markets.

Risk premia are on the rise

The conclusion the fixed income team has reached as we enter the second quarter of 2018 is that risk premia will be reintroduced into credit spread-sensitive markets.

In the immediate future, the tailwinds of strong global growth should continue, but further out into the second half of 2018, those positive tailwinds should slacken off.

We forecast that US and EU company earnings will meet and likely exceed market expectations for now, but only for the next quarter. Due in part to base effects for revenue and earnings growth, we expect a slower pace of positive evolution later in 2018.

Rotate into more defensive fixed income sectors….

The positive tailwind of foreign buyers supporting US fixed income markets has all but disappeared as the relative attractiveness due to hedging costs now favours other markets.

Over the coming weeks and months, we will be focusing on preparing the portfolio for the second half of the year by rotating into asset classes which are more defensive and less sensitive to rising yields.

…in spread markets

We favour higher-quality sectors and names. With the meaningful repricing in front-end rates and credit, there are also potentially interesting opportunities in floating-rate and other short-duration products, including investment-grade corporate securities, CLOs and ABS.

The challenge of course is to ensure adequate market liquidity given our expectations for volatility to remain elevated compared to last year.

…in sovereign debt markets

In our view, some opportunities remain in European ‘peripherals’, though we remain attuned to political risks, particularly in Italy. US inflation breakevens also still provide value as investors are still underpricing the inflation risk premium.

As for the US Treasury yield curve, the path of least resistance is for further flattening in the near term, but as the cycle continues to age, we will consider the possibility of scaling into steepeners.

Emerging market debt

We entered 2018 with a strong conviction that local currency debt would continue to do very well, primarily driven by EM currency appreciation.

Conversely, we believed that EM hard currency debt would not be in a position to deliver the stellar returns of 2017 as spreads were relatively tight and policy uncertainties originating in the US would continue to weigh on the asset class. Performance through March  validated our views. Given the spread widening in hard currrency debt since February, we are seeing some short-term tactical opportunities in spreads again.

This window of opportunity will not last for long, however. Longer term, local currency debt should continue to offer more value, though with volatility as we have seen recently. 2018 should remain a year of relatively high volatility with low correlation across sub-segments of EM fixed income (FX, rates, sovereigns and corporates). The era of the tide lifting all boats is way behind us. Geopolitical uncertainties, including tensions between the US and Russia and the Syria crisis, as well as lingering concerns of an escalation in trade tensions, will continue to impact the asset class.

However, we think these uncertainties are unlikely to derail the broader story: the overall macro background of solid growth combined with a gradual reduction of fiscal and balance of payments imbalances should continue to support EM currencies.

Given that the EM outlook is increasingly desynchronised with some central banks still easing policy and others embarking on a tightening cycle, local currency will remain a land of idiosyncratic opportunities rather than a “ buy the index” space.

We keep a relatively negative bias towards low-yielding markets that should remain heavily correlated with US Treasuries, but continue to see many opportunities in countries with high real rates that are likely to ease monetary policy in the future.

 

This article is an extract from “As good as it gets?” our fixed income quarterly outlook for the second quarter of 2018. To obtain a full version, please send an email to am.investmentwriters@bnpparibas.com

Dominick DeAlto

Chief Investment Officer, Fixed Income

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