Fixed income: Don’t bank on a great rotation in 2017

Charles McKenzie, CIO for Fixed Income, provides some insights from Fidelity International’s investment team:

“As 2016 draws to a close, exhausted bond investors can look back at another year of solid returns. The year will be mostly remembered for its political surprises, the effects of which are still filtering through. Investors are likely to have long forgotten that government yields are still lower than where they were at the start of the year or that credit spreads are tighter. Instead, fresh in investor minds is the sharp rise in government yields in recent weeks, which has prompted renewed speculation that a great rotation is in the wings.”

Three themes for 2017

  1. Trump…a watershed moment for bond markets?

“So is this a truly watershed moment for fixed income markets? We think not. Certainly, the near-term trend for government bond yields is higher.

“The combination of US policy shifting emphasis towards fiscal expansion, the rise in inflation expectations and ongoing question marks about the efficacy of monetary policy make us cautious on the bond market near term. But many of the same secular trends that have kept yields depressed over the past decade are still present. Low economic growth (weighed by soft productivity) and ageing demographics underscore powerful fundamental and technical supports for the bond market. The strongest dampener for yields however is debt. With developed economy leverage at all-time highs, the important question is not how high rates will go, but rather how much the global economy can withstand.

  1. Credit…still a risk worth taking

“The length of the current credit cycle has surpassed even the most optimistic expectations, defying a steady rise in corporate leverage and waning corporate profit growth globally. To some extent, super accommodative monetary policy has succeeded in delaying, if not postponing, the rise in defaults and downgrades that one would expect at this point in the cycle. Nonetheless, we expect yield hungry investors to migrate further out of government bonds and towards credit in 2017. Investment grade is our preferred segment, with high yield still attractive from a carry perspective. In contrast, US election volatility keeps us cautious on emerging market debt in anticipation of better value ahead.

  1. Avoiding the herd

“Bond investors enter 2017 facing many challenges. The economic and credit cycles are well into their mature stages, the risks for government bonds are asymmetric and weak market liquidity could amplify the next downturn. But having zero allocation to fixed income is no solution either – investors are still in desperate need of yield.

“Typically, the late stages of the economic and credit cycles are an opportune time to extend portfolio duration and reduce credit risk. Instead, the opposite is a mainstay position of many investors. The low yield environment has turned traditional asset allocation on its head as investors are betting on a cycle much longer than normal. Nonetheless, we believe there are better solutions available. To address the challenge of low government yields, shortening duration can be beneficial, but only if rates rise beyond what is priced and your market timing is perfect.

“Overall, it’s hard to see a repeat of the returns we have become accustomed to in fixed income so investors will need to make their bond assets work harder in 2017. Avoiding the herd and crowded areas of the market, embracing wider diversification and being nimble with allocation and hedging should be important parts of any strategy. But while political change could help to extend the economic cycle and push interest rates higher, investors should take comfort in the secular forces that should continue to provide an important support for fixed income markets.”

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