The same themes that drove fixed income returns in 2017 applied in the first week of the new year: a falling US dollar, surging Emerging Markets, buoyant Eurozone data and still, no sign of inflation. Will these trends continue in the new year? What should investors keep an eye on? Here are four questions for 2018.
ON THE RISE?
Will Europe outgrow the US? US credit markets outperformed their European counterparts last year, with US Investment Grade returning 6.4%, vs 2.4% in Europe, while US High Yield returned 7.5%, more than the 6.2% the asset class delivered in Europe. The story is the same over a 3-year period (11% vs 6.5% in the case of Investment Grade; and 20% vs 16% for High Yield). Will this trend reverse? Some investors speculate the economic cycle is more advanced in the US, whereas Europe’s momentum seems to be just starting. The Eurozone’s Composite Purchasing Managers’ Index (PMI) rose to a record of 58 in December, while it fell to 53 in the US, from 54.5 the previous month. As seen on the chart, the widening gap between the two regions is reflected on the exchange rate, with increasingly more US dollars needed to buy euros. After a decade full of recessions, sovereign debt crisis and political uncertainty, will 2018 finally be Europe’s year? Click here to read Legg Mason’s Annual Outlook and where some of our affiliates say investors could find value.
Growth Ryder cup: Will Europe's momentum outshine the US?
Source: Bloomberg as of 3 January 2018. PMI is Purchasing Managers’ Index (Composite used). USD is US dollar; RHS is Right Hand Side. Please see disclaimers for definitions.
Can Emerging Markets (EMs) keep their momentum? After delivering high single-digit or double-digit returns in 2017, some wonder if EMs will be able to keep their momentum, as some of last year’s rise was fuelled by the US dollar’s 7% slide. Some say the greenback’s softness may continue as president Trump’s proposed tax cuts are mostly priced in and may have a lesser economic impact than anticipated. Regardless of currency moves, EMs may also continue the growth, inflation-fighting and market-friendly political progress seen last year. Indonesia, for instance, has started 2018 strong: the country’s debt was recently upgraded by Fitch Ratings, driving down its 10-year yield to 6.2%, down from 6.5% in mid-December. India and China have also recently posted strong Manufacturing PMI data. Click here to read Brandywine Global’s “Around the Curve” blog: Can Emerging Markets hold steady?
ON THE SLIDE?
Is there any value left in High Yield? After delivering strong gains in all but three of the past ten years, and after a 500-basis point spread rally since early 2016, no wonder some investors worry the pace may not be sustained. The fundamentals, however, still support the asset class: albeit slowly, the US economy is growing and the planned deregulation and tax reform may lift corporate earnings. US defaults were also down last year, registering its lowest annual total since 2013. The US high-yield default rate is now 1.45%, well below a long-term average of about 3-3.5%. Some investors, such as Brandywine Global, believe that the asset class still offers value, especially among the highest rated issuers – those which are not part of a general trend of deteriorating covenant quality. As seen on the chart, investors have an increasing choice of higher quality US High Yield issuers, which now account for more of the asset class’ universe. Attractive High Yield opportunities may also be found in Emerging Markets. Click here to read Brandywine Global’s blog: Are there still opportunities in High Yield?
High Yield goes high: asset class’ quality improves as some investors favour top-rated companies
Source: Bloomberg as of 3 Jan. 2018. Ba is the highest High Yield rating, followed by B, then Caa and finally, Ca-D. Please find definitions in the disclaimer.
ECB: Beginning of the end? Although European Central Bank (ECB) president Mario Draghi has reiterated efforts to reassure the stability of the bank’s monetary stimulus, speculation is mounting that the programme may end sooner than expected. Over the weekend, ECB policy maker Benoit Coeure said that there could be a reasonable chance that the central bank’s extension of its stimulus in October could be the last, barring any substantial inflation disappointment. Markets don’t seem to believe that will be the case: the euro reached on Tuesday its highest level against the US dollar in 3 years and markets are now pricing in an interest rate hike early next year, the first since 2011. European sovereign debt has had a torrid start to the year. Some investors, such as Western Asset, believe that in some cases it may be fully priced – click here to read Western Asset Chief Investment Officer Ken Leech’s latest Market Commentary.
The Mid-Week Bond Update team wishes you a very happy 2018
Source for all data: Bloomberg and Barclays Capital as of 3 Jan. 2018, unless indicated.