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Fixed income-differing momentum in Europe and the US

Fixed-income investors should be more than satisfied in terms of performance, as till date the income generating asset class proved to be one of the top performers.

In Europe the performance is primarily attributed to the fuelled monetary policy in early March, while the remarkable gains in mainly Emerging Market hard currency debt and US high yield were driven by investors fetching higher yield.

Thus surely against most odds the fixed-income class turned to be a strong performer in 2016. However, where are bonds heading in the last two months of 2016?

Initially, a clear distinction should be made between the current situation in Europe and the economic reality being experienced in the United States. Let’s face it, the monetary policy implemented a few years ago in the US did trigger the necessary appetite for investment spending and consumer spending (which accounts to circa 70 per cent of GDP) which in turn is pushing economic growth towards acceptable levels.

Just as a side note, last Friday the US economy grew by an annualised rate of 2.9 per cent, while expectations were those of a 2.6 per cent growth. By the way, this is the strongest growth rate since the third quarter of 2014.

Over the past six months the improved economic numbers were pushing U.S 10 year Treasury bonds through volatile paths with low yields of 1.37 per cent in early August to highs of 1.86 per cent on Friday.

So what should we except from the US Fixed income market?

My view is that apart from the Presidential election which might trigger some tightening in yields in case Trump gains momentum in the coming days, we should continue to experience a steepening curve in the coming months.

Investors are now pricing a 70 per cent probability of a rate hike in December which technically will trigger a correction across all bond market segments. Interestingly enough, last week the I-shares US High yield (HYG) exchange traded fund, which is a very good proxy of how investors are viewing the asset class, continued to experience outflows, as the odds of a December hike increased.

In line with equities, re-pricing is warranted, however historically we’ve seen that over longer periods of time we should recoup, in line with an improving economy.

Thus moving forward, in my view investors who want to lock a strong performance for 2016, should consider realizing some profits on their U.S. bond exposures following the just below 16 per cent total return rally experienced in the first ten months of 2016 and re-dip accordingly following the possible re-pricing. Others who have a longer-term view should hold-on. 

Is the situation for European debt similar?

In my previous article, I had put forward my views on why the European Central Bank (ECB) might be diplomatically unleashing chatter of possible tapering post March 2017.

Indeed, the said chatter triggered a remarkable sell-off in European Sovereign debt which amounted to circa 580 billion Euros this month. An interesting fact is the noted sell-off within five-year German sovereign paper which rose by 0.11 per cent last week to higher yield levels of -0.39 per cent, thus very close to the -0.4 per cent deposit rate established by the ECB.

The sell-off also alleviated some pressure of supply constraints which the ECB was facing over the past months. This will surely give the ECB some more time in terms of how and when it should start considering reducing its quantitative easing program.

I’m still of the view that reducing the program post March might be premature, however, in line with the movement in yields it might be now wise to lock-in some profits and possibly consider re-allocating when we have more assurance of the ECB’s intentions.

On the contrary, European high yield debt should hold-on and maintain the current low volatile pace (as opposed to the sovereign yield curve) ,as investors are aware that the ECB has no intention to increase rates and thus it would be rational to hold-on to solid high yield credit names which offer attractive coupons and a low default probability.

Realistically, fixed-income managers are struggling to find attractive value in Europe, while the possible re-pricing in the U.S. and the selective niche opportunities in Emerging markets might still offer attractive returns to investors. That said, a word of caution, investors should not expect attractive returns if they are not willing to loosen their risk profile going forward.

Disclaimer: This article was issued by Jordan Portelli, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website. 

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