Fixed income investors should avoid emerging market debt and UK government bonds in the current environment, with both asset classes in the firing line this year, says Kames Capital’s David Roberts.
Having dropped at the end of 2016, a valuation opportunity has seen investors return to emerging market debt, while uncertainty over the Brexit process has prompted a move back towards gilts as part of a risk-off trade.
Both have delivered positive returns year-to-date amid a shift in investor sentiment but Roberts, head of fixed income at Kames, says the two sectors face severe headwinds, especially given recent moves upwards for valuations.
“Emerging market debt is currently the least appealing asset class, hotly followed by gilts,” Roberts says. “EM debt looks expensive following its recent recovery, while in the medium term it is vulnerable to US rate hikes and the strong dollar.
“Meanwhile, gilts also look vulnerable. While they have benefitted from a risk-off environment caused by Brexit, if investors adjust for inflation then yields are simply too low, especially if we see CPIH hit 3% by the third quarter of this year.”
Roberts added gilts could be an easy option for sellers of fixed income later this year because of both political and monetary events.
“There are significant and clear dangers to gilts from both the Bank of England and the Scottish referendum,” says Roberts. “We are ending Quantitative Easing (QE) in the UK, which means international investors become more important to the UK than they have been, and that is a challenge. Meanwhile at the margin, the referendum vote – which could now be drawn out for the next 12-18 months – is a negative.”
Rather than emerging markets or gilts, Roberts has highlighted a number of other areas across the fixed income spectrum which continue to look attractive.
“Investment grade debt looks fine until the last remnants of euphoria play out, although it is not an asset class to get rich in, while we are slightly more constructive on high yield,” he says.
“It is a pro-cyclical trade so if you are worried about the end of the cycle then you can find a case not to buy it, but here and now it is our favourite place to invest.”