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Bond yields react to economic optimism v political pessimism

28 February 2017

Bryn Jones, manager of the Rathbone Strategic Bond Fund, assesses the divergent views on the current political and economic situations and how they are affecting bond spreads

Better-than-expected UK GDP growth, as well as higher anticipated inflation has helped drive gilt yields higher during the past few months.

UK growth was revised up to 2% for 2016, making the UK the fastest-growing nation in the G7. Despite the Brexit vote, UK PMIs have remained buoyant while wages are bumping higher and unemployment remains low.

It’s a similar story in the US. Business sentiment has picked up as President Donald Trump signals imminent plans for tax reform and infrastructure spending, boosting the expectations of growth and inflation. Jobless claims are near 40-odd year lows and unemployment is very low by historical standards, but Mr Trump says he intends to create millions of jobs.

At the moment, there is a global battle being waged. On one side is optimism, led by comforting economic data in the US, UK, Europe, China and Japan. And on the other is pessimism, led by the growing uncertainty that the rupturing era of centrist politics has ushered in. It’s not just President Trump either: scandals are raining down on French politicians, leaving far-right candidate Marine Le Pen with a strong chance of making the second round of voting. French bond yields jumped noticeably during January, as did inflation in France and across the eurozone.

Before the December US Federal Reserve meeting, consensus expectations were for two or three increases in US interest rates during 2017, gradually taking rates above 1% by the end of the year. December’s 25-basis-point rate increase to 0-50-0.75% was expected by the market. Less so was the hawkish shift signalled by chair Janet Yellen, who indicated not only that the Fed expects three more increases this year, but that this is based on current projections of economic activity. The implication being that rates could rise faster still if Mr Trump gets congressional approval for additional infrastructure spending and tax reform that is apparently due within weeks. In practice, given the political challenges, any boost from presidential policies is unlikely to move the economic needle before 2018.

US government yields matter because they are the bedrock upon which all global securities are priced. We think the US should enjoy a benign economic environment with inflation gently ticking up. Meanwhile, we don’t expect monetary policy tightening in Europe or the UK. There is a chance, however, that political pressure drives more expansionary fiscal policies. This could force central bankers to become more hawkish.

Bond spreads anticipate defaults

With all this in mind, we prefer investment grade debt for our funds. It offers decent spreads that imply significantly larger default rates than history would reasonably suggest. In the UK and Europe, current pricing suggests a default rate close to 5% when the actual default rate has, in the past, rarely breached 4%. As for high-yield bonds, European spreads have tightened substantially in recent months, while US high-yield spreads are roughly unchanged over the same period. High yield usually performs better than other types of fixed income when the economy is improving because better growth should flow into company profits. Also, this type of debt is also less sensitive to the rising rates that usually accompany better economic growth because of its higher coupons and shorter maturities. However, it appears high yield is at a fairer value when compared with historic default rates.

Another year is well underway, optimism is running almost unchecked among investors. The FTSE 100 and the S&P 500 continue to carve out new all-time highs and developed sovereign bond yields are heading upwards as well. Investors need to consider carefully just how well Mr Trump will wade through the “swamp” of Capitol Hill and what he will need to jettison to get to the other side. Tax reform is the stickiest area of policymaking and his wish list is highly ambitious. Beneath Mr Trump’s bluster, there remains an inexperienced statesman with a fragile temperament. Meanwhile, the obfuscations of the UK government hardly conceal the potential pitfalls of Brexit, as recent sterling volatility reminded us. Europe has delivered a few months of improved economic data, but it’s heading into another year of political upheaval with an unemployment rate of 10% (albeit on an improving trend).

While we are cautiously optimistic, the issues that kept investors up at night last year are still out there in 2017.

 

 

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