At the beginning of 2018, economic indicators are confirming the recovery scenario. Above all, the yields of government bonds are on the rise. Why is that the case, and what does it mean for the financial market as a whole?
Author: Felix Dornaus
Senior Fund Manager
The spring meeting of the International Monetary Fund was held in Washington from 20th to 23rd April. This event was the reason for an investor conference that I attended in order to get an idea of the status quo of the global economy as well as of risks and opportunities.
The big trends of the past weeks such as the appreciation of the US dollar, the weakening oil price, falling yields, and the outperformance of Eurozone equities have reversed in the past days and weeks, in some cases drastically so.
What is behind all of this?
When both demand (i.e. economic growth) and supply (i.e. production growth) are weak and the central bank policies are very loose, we have a textbook example of an environment causing yields to fall and/or remain low. Indeed, yields were high after the Great Depression in 2008/2009. Having transitioned to a slow, weak, and fragile recovery, yields have started to fall and bond prices have started to rise (i.e. asset price inflation). Even if the economic regime remains unchanged, the market environment may change; the higher the asset price, the lower the expected return or yield.
Real global economic growth was surprisingly weak in Q1. The preliminary estimate for the annualised growth rate of Q4 2014 to Q1 2015 is only 1.5%. This is mainly due to disappointingly weak growth of the GDP in the USA (+0.2%), in China (+5.3%), in the UK (+1.2%), and in Japan (+1.5%; estimate). Brazil (-2.4%) and Russia (-11.5%) have even shrunk (both figures are preliminary estimates). In line with this situation, the data surprises have been largely negative, and the trend of downward revisions for economic growth has continued.
Bond investors are faced with a difficult environment. Do corporate bonds offer the chance of a halfway decent yield?
Stampfl: The statement that bond investors are faced with a difficult environment is actually an erroneous one. A balanced portfolio consisting of bonds from the peripheral countries and the core countries across all sectors would have seen a very good risk-adjusted performance in the past weeks and months. Also, complementing the BB segment with corporate bonds generates a certain degree of surplus yield, which in funds like Reserve Corporate causes is used to boost the development. That is like switching from winter tyres to summer tyres in spring. It facilitates a smoother running and lower fuel consumption. Or, translating it to the case of the fund, it results in a surplus yield at lower volatility.
The new normal
The importance of China for the global economic and financial system continues to grow at a rapid pace. Last year the country set a new milestone by becoming the world’s biggest economy. The total value of goods and services produced in a year exceeds that of the United States. Thus, at 30% China accounts for the largest contribution to global economic growth.
The most important central bank in the world, i.e. the US Fed, made an announcement yesterday that attracted a large deal of attention from investors. The bank withdrew its assurance to remain “patient” before the Fed funds rate would be increased. This paved the way for a possible abandonment of the zero interest rate policy, if economic need be. The new formula goes like this: the Fed funds rate will be raised once the labour market has improved more and the FOMC is optimistic about inflation rising towards the medium-term target of two percent.
The US dollar has appreciated significantly vis-à-vis the euro in the past months. For this trend to continue, at least two developments would have to be in place. Firstly, the US Fed would have to abandon its zero interest rate policy; and secondly, the ECB would have to remain on its path of negative interest rate policy and bond purchases.
The share price performance in emerging Europe, i.e. Poland, the Czech Republic, Hungary, Russia, Turkey, and since most recently again, Greece, has not been overwhelming in the past years. Since the middle of 2011 the MSCI Emerging Europe, the most important index for the region, had been locked into a sideways movement, which was topped off by a correction at the end of 2014 as a result of the ongoing political crises. Along with (geo-) political factors, the weakening of the economic dynamics and a lack of reforms had been causing a subdued price performance.
The environment has become a bit brighter in the past weeks.
In addition to the improvement of the economic environment in the Eurozone and Japan, more and more central banks loosened their monetary policies. For example, on 12 February the central bank of Sweden (Riksbank) surprisingly cut its key-lending rate to -0.1% and announced to buy small volumes of government bonds. The reason behind this measure is the same as for similar steps taken by other central banks: the risk of falling short of the inflation target has increased. The markets reacted in a textbook-fashion with falling yields and a depreciating currency (krona). Both are supportive to the economy. On the financial markets the continuously falling and partially even negative yields of government bonds have pushed investors into securities with a higher expected yield (bonds with longer maturities, bonds with a higher default risk, bonds in foreign currencies, shares).