(Part two of two.) I recently discussed some thoughts on Fixed Income Opportunities ahead of next Central Banks’ meetings with my colleagues Mike Temple, Director of Credit Research, US and Mauro Ratto, Head of Emerging Markets. We think we are closer to a turning point for financial markets. Financial markets are questioning the ability of Central Banks (CBs) to boost output and inflation, while CBs have started to hint that they cannot deliver stimulus forever. Markets are wondering if the marginal benefits of current monetary policy stances truly surpass the marginal costs – as CBs continue to assert. The weakening of investors’ trust may be powerful enough to open the door to noisy volatility.
We may see more frequent episodes of market turmoil. Even if these do not reach extreme levels, we may see spikes in volatility and increases in positive correlation between bonds and equities as markets perceive some discomfort by CBs with the current policies stances.
Get Ready for Further Volatility Spikes and Rise in Correlations
Sources: Bloomberg, Pioneer Investments, Data as of September, 2016. The “Correlation of Everything to Everything Else” is calculated as the average magnitude of the 3 months rolling cross-asset correlations, calculated on daily return/change basis, between (1) S&P500, (2) Bonds Yields (average of USD government bonds 2 years and 10 years), (3) Yield Curve (USD government bonds 10 years-2 years), (4) Credit Spreads (Moody’s BAA – USD government bond 10 years), 5 Dollar Index (DXY) & (6) Commodities (GSCI Spot).
Central Banks are not fully synchronized and economic cycles are at different stages, in both developed and developing markets, leading to relative value opportunities among yield curves and currencies.
The steepening of yield curves that recently started is expected to continue as markets anticipate more expansionary fiscal policies, which could support a pick-up in inflation. Given little expectation that inflation will rise, we could easily see some repricing in the event of even small positive surprises and this could benefit inflation-linked bonds. We are now in the very unusual situation in which core CPI in the US is above the 10-year Treasury yield, which reveals that there is very little value left in Treasuries. Floating rate notes, including bank loans, could, therefore, be more appealing in an environment of raising rates. With a stronger cycle in the US, we believe that the US dollar will remain supported, even if we do not see any strong appreciation from the current prices.
Sources: Bloomberg, Pioneer Investments, Data as of September, 2016.
Emerging Markets (EMs) have been among the biggest beneficiaries of the financial repression; EM bonds enjoyed strong inflows and spreads have tightened materially. But we observe a continued improvement of fundamentals in EM economies as the restructuring process continues apace, especially in Asia. We expect EMs to be resilient, in both the equity markets and the fixed income space, as the “carry” versus Treasuries may protect investors in case of a market correction. We prefer short duration bonds that could be more resilient if the Fed hikes rates.
In conclusion, in the current market environment, we believe it’s time to invest in unconstrained solutions, diversifying investment approaches that include a broader range of instruments that allow for flexibility and adaptability in a world where financial markets love for CB may start to wane.