We remain defensive regarding US Treasury bonds with a preference for short maturities.
Asset purchase cuts and strong economic growth will keep upward pressure on eurozone core bond yields.
UK yields may move higher in sympathy with the US but upside risks will be limited by softer inflation.
Emerging debt still offers better yields but investors should be selective and stick to short maturities with US yields rising.
We still favour short maturities, inflation-linked bonds and peripheral debt.
Move on up
"Bond yields will inevitably rise further"
Odds are in favour of higher yields across the board. Long-term bond yields remain below levels that their fundamentals would justify. Given the gradual increase in inflation, the term premium – the premium demanded by investors to compensate for the interest rate and inflation risk which comes with long-dated bonds – is set to grind higher. Also, cuts in asset purchases and higher debt issuance could push yields further north.
US government bonds. Bond yields picked up in early 2018 as inflation fears returned. Concerns have ease somewhat since but risks are still tilted to the upside. The tax boost will keep growth above potential but it will entail much more debt issuance. We still favour inflation-linked bonds and short maturities to hedge against inflation surprises and rising yields. Overall, the upside in yields will be capped by the low chance of rate hikes in Europe and Japan, the wide gap in yields and skilful Fed communication.
Eurozone government bonds. We would avoid core eurozone bonds given their unattractive yields and the repricing that is likely to come from the end of quantitative easing in late 2018. The ECB already cut its monthly asset purchases in half in early 2018, from €60bn to €30bn. Peripheral bonds should perform better thanks to solid growth, stronger fundamentals and attractive carry. Inflation-linked bonds remain a good diversification tool as well.
Emerging debt – still juicy
"Carry and not spread compression will be the performance driver."
UK government bonds. Growth prospects are dull but the risk of a cliff-edge exit in 2019 has decreased significantly since an agreement has been found on a transition period before full withdrawal from the European Union at end 2020. Inflation has finally started to recede. This could delay the next BoE rate hike although this remains highly uncertain, given that historically-low unemployment keeps wage pressure strong. Although higher global rates will put pressure on Gilt yields, domestic conditions are pushing in the opposite direction. All in all, we expect less upside in yields than in the US and eurozone core.
Emerging debt. After a bout of tightening, emerging bond spreads have widened in reaction to the recent market sell-off. This move has been modest and we do not anticipate sustained widening. Global and domestic factors are still supportive. Global liquidity is abundant, the dollar remains on a downtrend, and macro fundamentals are improving in most emerging countries. After a strong 2017, 2018 is likely to be bumpier. Bouts of volatility may shake markets and rising US yields will reduce the gap between developed and emerging market yields. However, robust fundamentals and muted inflation means this asset class remains attractive. Investors should favour countries with improving macro backdrops and limited refinancing needs. Local-currency debt may provide interesting diversification features.
Sources: SGPB, Bloomberg, 03/04/2018. Past performance should not be seen as an indication of future performance. Investments may be subject to market fluctuations, and the price and value of investments and the income derived from them can go down as well as up. Your capital may be at risk and you may not get back the amount you invest.