As we approach the end of the year, three fixed income fund managers at Kames Capital give their views on what 2018 could hold in store for bond investors.
High Yield – 2018 a key year for the asset class
David Ennett, Head of High Yield and co-manager, Kames High Yield Bond Fund
“2018 is shaping up to be a key year for the high yield bond market. In 2017, the market effortlessly shifted from ‘recovery mode’, following the 2015/16 ‘shale energy’ crisis, to rallying in conjunction with the global expansion we see around us. As a result, investors will enter 2018 contending with the offsetting influences of tight valuations against improving macroeconomic – and therefore corporate – fundamentals.
“How do we see these competing factors playing out in 2018? We think the big beta-driven moves of 2016 and early 2017 are behind us. We expect to see a modest amount of yield spread tightening in 2018, but overall we think current valuations are both full and justified. Investors should remember, however, that the vast majority of returns in the asset class accrue from the compounding effect of high levels of income or carry, through time, and not through the rather more eye-catching beta moves of recent periods. As such, we feel the supportive global environment will continue to lead to muted volatility within high yield and therefore it remains a very good source of income. Furthermore, high yield’s negative correlation with government bond markets leads us to conclude that, in the current improving environment, deriving good levels of income without taking material duration or interest rate risk is attractive.
“Overall market forecasts, however, will be less instructive in 2018; ‘what’ you own will become much more important than simply how ‘much’ risk you own. One of our core expectations for 2018 is the potential for more dispersion in the market. In other words, the range of outcomes within each part of the risk spectrum will be greater as stock-specific factors will become more important in a broadly stable, but mature credit market. We are beginning to see signs of this already, particularly in the US where certain issuers in the telecommunications, retail, and healthcare sectors have experienced material sell-offs as their individual risks mount, and a beta rally is not there to bail them out. As positive as the macro backdrop may be, within high yield the particulars of any company ultimately prevails, for better or worse. This is a theme that will continue to unfold in 2018.
“We feel our approach – careful stock selection with an emphasis of high quality cash flow from resilient businesses – will be of particular benefit in this environment.”
Strategic Bond – Three scenarios facing fixed income investors
Juan Valenzuela, co-manager, Kames Strategic Bond Fund
“In 2017, economic activity has been broad-based and synchronised across both developed and emerging markets. Encouragingly, the composition of growth has been balanced. Domestic consumption was a key contributor with healthy employment and real disposable income along with lower savings. This was complemented by a boost in investment activity, something that has been lacking over the past few years (weak global productivity is a vivid reflection of this dynamic).
“The positive momentum of global growth suggests a healthy 2018. However further positive surprises appear unlikely. Less activity in Asia, in particular China, is likely to exert downward pressure on growth. In Japan, GDP has been unsustainably high in recent quarters, at 1% above economic potential. We do expect growth in the Eurozone will continue but the brisk pace of 2017 is unlikely to persist.
“Overall, the macroeconomic environment remains positive, but the second half of 2017 might have been as good as it gets. Global growth is likely to be above 3% in 2018, but it has limited room to beat expectations.
“Where will any surprises come from?
- The upside surprise
“A more forceful increase in investment is most likely. Since the global financial crisis, corporate capital expenditure has been subdued. A lack of confidence in the business sector along with plentiful ‘cheap’ labour has kept investments below pre-crisis levels. In light of increasing confidence, healthy profits and falling slack in employment, companies might finally gain the confidence to commit to investments. With readily available credit and elevated confidence, animal spirits might return to the corporate sector.”
- The downside surprise
“The NAFTA negotiations are proving very challenging and could collapse. In 2016 there were US $2 trillion of trading flows between the US and Mexico-Canada, and China. A collapse of trading flows would be very negative for global growth, meaningfully increasing the risk of recession. This could also have an impact on the tax reforms in the US as legislators may not support the tax bill if negotiations breakdown.”
- The unknown
“In recent years, monetary policy has been very predictable. The ‘central bank put’ has worked extraordinary well, providing support for risk markets and depressing volatility. As the economic cycle moves forward and financial stability considerations start playing a more meaningful role in central banks’ decision-making, their reactions will become less predictable. In particular, the direction of the US Federal Reserve is uncertain. Although Yellen’s replacement (Powell) represents ‘continuity’, with little slack in the employment market, likely higher inflation from the second quarter of 2018 and a better global environment, the removal of accommodation might take place at a faster pace than the market is expecting.
“So how are we positioned?
“We are positioning our strategic funds with a credit bias, preferring corporate over government bonds.
“Within corporates, given tight valuations, we are cautiously optimistic. In investment grade markets, we see most value in financials versus non-financials, especially in those banks and insurers with European exposure. In high yield we maintain a slightly below average allocation; we look for companies with very predictable cash flows, and we currently prefer BB and B-rated firms and have no exposure to CCCs. We remain very selective and as we move along the investment cycle and corporate fundamentals deteriorate, stock picking will become more prominent.
“In government bonds we maintain a conservative approach. Our overall interest rate risk is towards the lower end of our historical range. We prefer the US versus Europe and the UK, and we see opportunities in inflation exposure (currently expressed in the US). Our yield curve position is neutral but in the medium term we maintain a flattening bias, especially in Europe.
“In emerging markets we have a light allocation as we do not think that, in broad terms, the asset class offers a compelling proposition. We are looking for idiosyncratic opportunities, with interest in alpha rather than beta propositions.”
Investment Grade – Brexit progress to dominate outlook
Euan McNeil, co-manager, Kames Investment Grade Bond Fund
“As the experience of the past 18 months has proved only too well, predicting the outcome of political events (and more importantly their influence on markets) has generally been a fruitless task. The conventional wisdom around the likely outcomes of the Brexit vote and the US presidential election proved spectacularly wrong. The initial forecasts of domestic economic doom in the immediate aftermath of Brexit also proved to be wide of the mark (at least in part due to the prompt action of the Bank of England). However, there has been clear evidence of a slowdown in UK growth in recent months, which was confirmed in the Budget in late November by the OBR’s downgrade to UK growth. “It is difficult to disagree with this assessment given the ongoing uncertainty around Brexit negotiations. Our expectation is that this caution will also permeate decision-making at the Bank of England next year. It would be foolhardy on the part of the Bank to engage in a series of rate hikes against this backdrop.
“The single biggest (identifiable) influence on domestic economic policy is likely to continue to be progress around Brexit. If negotiations continue to be problematic – and trade talks are not concluded in a sensible timeline – then arguably the Bank of England would be forced into pursuing a more accommodative monetary policy, which would in all likelihood see government bond yields move lower. Whilst the actions of (and rhetoric from) the US Federal Reserve and ECB do not directly influence the returns of sterling-denominated credit, clearly the market’s perception of their approach will influence the direction of credit spreads. It is our expectation that the continued absence of any material wage inflation in either Europe or the US should ensure that both the ECB and Fed err on the side of caution with regard to their monetary policy, and thus their communication to the market.
“Should our faith around the caution of central banks prove to be misplaced – or should a discernible uptick in pricing pressure come through – then we would be forced to reappraise our generally benign outlook for spread product. However, if the central case proves to be correct, then our ability to generate excess returns for our client base will again be heavily influenced by stock selection, active duration management, and a willingness to rotate individual credit exposures and exploit relative value opportunities. Predicting volatility is generally as unrewarding as predicting politics, but if we continue to operate in a market that exhibits similar characteristics as those witnessed in 2017, then these same factors are likely to be similarly integral to generating outperformance in 2018.”