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The Fed has indicated that rates will not be rising any time soon and a move to “average inflation targeting” supports this. We concur and do not expect any change to the accommodative central bank policy policies and expect low interest rates to continue longer than investors expect, making it possible for both the government sector and the private sector to sustain their high debt levels. The biggest mover for yields in Q4 2020 will be the US election, where we only see one outcome for lower yields (a contested election). Overall post-election, we expect a new range to be defined between 80 to 100bp, where the lower bound is not significantly far from where the current 10 year yield of 69bp as of the 2nd October 2020. With yields this low there continues to be little value in treasuries and the risk is for slightly higher yields and steeper curves led by the long end. We continue to have a preference for investment grade rated bonds in a “range bound” environment and accommodative policy will continue to support a gradual tightening of credit spreads. We choose to remain cautious on high yield despite the relative yield on offer due to the due to a particularly catalyst heavy quarter, with resurgence of Covid-19,the US election and US – China trade risk predominant in our minds.
Brexit related risks will temper any movement in Gilts over Q4 as the end game remains opaque. The BoE seems more serious on negative rates then the Fed and appears to be shifting towards eventual adoption of NIRP as a policy tool. It is still a way to go before we could see negative rates in the UK and it is the lack of a yield that is of most concern for us. We see Fixed Income as an asset class that earns carry more than an opportunity for taking of price risk. We continue to be underweight Gilts and would only consider changing our stance post-brexit risks have been eliminated to capture a potential price move if we see more signs that NIRP will be implemented. We expect a range bound environment in Q4 2020 on the combination of Brexit end game and expectations of possible implementation of negative interest rate policies in 2021. In the GBP market, we prefer to get exposure to investment grade issuers, especially those with a strong cash pile and more global exposure over gilts. The lack of global issuers in the GBP high yield market restricts potential investments as we prefer to avoid risk to companies purely exposed to the UK economy.
Implementation of the Recovery Fund and a supportive ECB means that core rates will remain range-bound (the 10Y German yields have been stuck in -55bp to -40bp tight range since early June). Core spreads are trading at or close to their YTD lows and also close to their lows over the past decade. We see limited room for core spreads to tighten from current tight levels. At the same time, we see limited risk of any material widening in core space due to the ECB’s Pandemic Emergency Purchase Programme (PEPP) and EU Recovery Fund safety nets. Periphery spreads have tightened to core but there is little in Q4 to suggest that they will widen. We do not see value in the core developed government bonds that are on the whole negative yielding and prefer countries on the periphery like Greece and Italy. Investment Grade bonds offer yield in an asset class that is searching desperately for some return, combined with ongoing support from the ECB this makes it a preferred fixed income exposure area for us in EUR. Whilst there is higher yield on offer from high yield issuers, we remain cautious due a particularly catalyst heavy quarter, with: i) a second wave of Covid-19 infections in Europe already leading to discussions around new national lockdowns; ii) the US election; iii) the UK – EU trade negotiation deadline; and iv) US – China trade risk.
In this environment for lower interest rates and suppressed yields globally, the case for a “hunt for yield” may see allocations to selected Emerging Market bonds (both credits and Sovereign Bonds). However, the recovery of EM economies could be stop-start in nature given ongoing risks of COVID-19 related restrictions. Any vaccine may not be available to them until after the developed countries secure their allocations, and this could be a potential drag in the future. With the US election and US/China trade risks being clear catalysts in this quarter, there is little to recommend holding EM at the current moment. We prefer to remain selective in our sovereign and credit choice within the space noting that the ICE BofA US Emerging Markets External Sovereign Index is yielding 4.2% (as of 2nd October), which is not far from its decade low of 3.79% and ytd has provided a total return of just 0.39%.
Past performance is not a reliable indicator of future returns. Forecasts are not a reliable indicator of future returns. If the information is not listed in your base currency, then the result may increase or decrease due to currency fluctuations.
If not otherwise indicated, all graphs are sourced from Dolfin research, October 2020.
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