AXA IM: Here Comes the Summer – View from the Bond Market

Jul 8, 2019

• Stop It
• Gilts to the moon
• Spend it
• New era in Europe?
• Politics demands stimulus
• Attack the savings glut
• Meanwhile, emerging market yields stand out

Bond returns are being driven by expectations of monetary easing and an unerring search for yield. The result is yields that are increasingly falling below policy interest rates. This may only reverse when the policy mix changes. There is more talk of fiscal spending to take the burden off monetary policy. Demand stimulus might help improve the growth outlook and raise real long-term interest rates. However, this will be slow moving given the political challenges facing a more aggressive fiscal stance. In the meantime, emerging markets are a good place to search for yield.       

Stop It – Many Britons experience cringes of embarrassment when they see how a small minority of their countrymen act when they travel to Europe. This is usually confined to the beaches of the Costa del Sol, the Greek Islands, or some town centre unfortunate enough to be hosting a football tournament. This year, however, the summer kicked off with the unedifying spectacle of recently elected British representatives to the European Parliament staging an infantile protest during the opening session performance of Beethoven’s “Ode to Joy”. If ever there was a metaphor for how some Britons have seen Brexit as an excuse to turn against the outside world, this was it. Luckily for Europe, if Brexit is delivered (still a big if) then they will no longer have to endure this kind of behaviour. At the same time, the rise of the Brexit Party as a force in British politics tells us that returning to any kind of stable political harmony in the UK is a long-way off. Sadly, this has economic implications. Just this week we had awful numbers from the business sector with the purchasing manager indices for manufacturing, services, and construction slipping further. The construction index fell sharply to its lowest reading since 2009. Confidence in both the residential and commercial construction sectors is low and until there is some clarity on the UK’s future relations with the European Union, it is unlikely that we will see much of an improvement. The purchasing manager data came on top of a fall in net mortgage lending and reports of stagnant house prices, even with mortgage rates ahead lower again. Taken together, a negative print for Q2 GDP is looking more likely.    

Gilts to the moon – Against this backdrop, gilt yields fell dramatically over the last week. The 10-year benchmark yield is now at 0.70% and is within a few bullish sessions of the all-time low of 0.50% reached in August 2016. The 5-year gilt yield is already below 0.5% such that the British pound yield curve is now inverted between 3-months and 10-years and heavily inverted at the short-end with 3-year gilts at just 0.44% compared to base rates of 0.75%. It seems only a matter of time before the Bank of England (BoE) cuts the base rate. Mark Carney recently suggested that the market was focused on the worst-case scenario for Brexit. I’m not sure that a no-deal Brexit is priced in given where sterling is trading and given that UK credit spreads are well below the peaks of 2015 and 2018.  Moreover, the FTSE mid-cap index is trading some 30% higher than the levels reached in the immediate aftermath of the June 2016 referendum. The rates market is simply pricing in the expectation that the Bank will need to cut rates in the months ahead because the economy is already slowing, the global trend is towards easier monetary policies and Brexit is not likely to be sorted out. The market is about 50:50 on a cut in November but the bet must be that the Bank goes before then if the data really gets weaker and the politics becomes even messier (a potential vote of “no-confidence” against the new Conservative Prime Minister leading to a general election could happen). Yields are low in the UK, but they are low everywhere and the direction of travel can still be southerly, with gilt yields still 100bps above Germany and with the BoE having more scope to reduce official policy rates than the European Central Bank (ECB).

Spend it – The two candidates to become prime minister have both spoken of their plans to boost public spending. Expect to hear more aggressive fiscal policy plans from politicians across Europe over the next year, especially as there is a recognition that monetary policy has neared its limits. In many countries there is more fiscal room than at any time since the financial crisis. In the financial year that ended in March 2019, the UK government borrowed £17.8bn less than it had in the previous year and that was the lowest rate of borrowing for 17 years, according to the Office for National Statistics (ONS). The Office for Budget Responsibility said, in its March outlook, that the deficit would continue to decline to below 1% of GDP in the next few years. This is not a bad position to be in when the economy faces a lot of uncertainty and is slowing. There are clearly over-promises being made but with yields so low and the economy in need of some spending from the state (government spending growth has been running below the growth in receipts for some time now) there appears to be room to provide some demand stimulus in the years ahead. Not that this should bother the gilt market just yet.

New era in Europe? – Talking of Europe, the big news this week was the nomination of Christine Lagarde to take over from Mario Draghi as President of the ECB. What Ms Lagarde may lack in terms of academic credentials in the field of monetary economics, she should make up for with her political experience and wide-range of contacts gleaned from heading up the International Monetary Fund (IMF) for the last eight years. Again, this could be important in determining whether Europe’s rulers can agree on more active fiscal stimulus. One would think that the experience of being at the head of the IMF, with its involvement in the Greek bailout along with orchestrating credit facilities for the likes of Argentina, Mexico, and Ukraine in recent years, would impart a sense of the importance of more balanced economic policies than those that have been in placed in the Euro Area in recent years. Of course, there is an internal challenge in Europe in that northern Europeans with healthy government balance sheets are not overly enthusiastic about what can be perceived as spending to help the periphery. Some modest progress on this front might be happening now as there have been more positive noises from the EU about Italy’s revised budget plans. The ECB has not been able to deliver a sustainable above trend expansion in Europe nor remove the deflation risks.  Instead, we have potentially counter-productive interest rate levels in the Euro Area. The bond market is crying out to be used by borrowers – we will even pay some of them for the privilege of lending them money! 

Politics demands stimulus – Austerity delivered a re-shuffling of the political hegemony in many countries in recent years. It would be a brave politician that stuck with a hair-shirted approach to fiscal policy especially given the general improvement in cyclical financial balances and the structural decline in borrowing costs. If we see an easing up of fiscal constraints, even in line with the increased flexibility that the lowest ever bond yields afford, should that give us more optimism on the macro front? Politicians surely understand (maybe except for the hard Brexiteers) that voters like income and like jobs almost more than anything. That logic suggests President Trump will reach an agreement with China having agreed to resume talks after the G20 meeting last week. Why? Because to allow an escalation of the trade dispute would put American growth and jobs at risk going into an election year. While the political elite of a few years ago were happy that the likes of Bernanke, King, and Draghi bailed them out, today’s vintage might take the slightly different view that while central banks keep rates very low, they have the luxury of spending to appease an electorate looking for more in terms of infrastructure and public services. The potential impact is an increase in the supply of high quality fixed income assets into the market and some stimulus to demand. It is also likely to be inflationary given that there is little spare labour market capacity anywhere and populist/nationalistic policies are making that worse. I think investors need to think about the impact on sector spending, margins and inflation premiums if we did get a more proactive fiscal policy stance.

Attack the savings glut – There is a lot of talk in markets and amongst economists of the need for fiscal stimulus. The US did it in 2018. The OECD expects the US budget deficit to be between 6.5% and 7.0% of GDP as a result. In contrast much of Europe is projected to have budget surpluses. The US has positive real yields, the Euro Area has negative yields. Not only is growth and productivity weak in Europe, but savers and future pensioners are not being served well by the current level of yields. Savings need to be tapped to boost productivity and real economic returns. Until this happens, yields will remain very low as there is too much demand for the available supply. You don’t hear talk of a bond bubble much these days as low or negative yields have become the norm, but the market has seen a tremendous decline in yields so far this year – more than can be explained by potential changes in monetary policy. Unless governments arrest the long-term structural savings glut, yields will stay low and more and more of the global debt stock will have negative yields. There is too much demand for yield and not enough supply. How else can you rationalise Greek 10-year debt at a yield of 2%, Italian debt at 1.6% and German 30-year bonds at 0.2%?

Meanwhile, emerging market yields stand out – Against this backdrop, emerging market bonds look very attractive. On the JP Morgan Emerging Market Global Diversified Bond Index, the current yield is 5.44%. This has come down like all global yields, by around 50bps over the last month, but still offers higher returns than almost any other bond index. The high yield component of the index has a current yield of 7.4%; more than 140bps higher than the US high yield corporate index. Of course, global trade tensions are a dark cloud over the outlook for emerging markets, but equally there are many countries that would benefit from most positive policies in the developed world. From a bond point of view there continues to be decent issuance in emerging markets while fundamentals are, overall, quite positive. The diversification offered within emerging market bonds suggests that the sector will continue to be a beneficiary of the search for yield and even short-duration strategies should continue to offer good returns. Our view on Treasury yields is that they remain low, oil prices appear to have a floor for the time being because of geo-political risks and the dollar will struggle to rise further from current levels. All these factors should be supportive for positive returns from emerging market debt.