Australian Fixed Interest - 2017 Outlook
What lessons have you learned from 2016?
History has shown us that markets can, and do, deviate meaningfully away from economic fundamentals for a variety of reasons. This has especially been true of bond markets over the past few years as the added complexity of unconventional monetary policies pursued by central banks has had the effect of depressing bond yields around the globe. In many cases, this has taken valuations to extreme levels with negative yields.
The temptation is to always find reasons to validate or rationalise market pricing. However, the lessons learned are that whilst these developments can influence markets for a period of time, markets always revert back towards some concept of fundamental ‘fair value’. Whilst markets have not necessarily passed this phenomenon, history is likely to show that buying bonds with negative yields was never a prudent use of investors’ capital.
What are the key themes likely to shape the markets in which you invest in 2017?
Central bank policy action will be a key factor shaping the performance of the global bond market in 2017. In the US, markets are pricing little by way of further monetary tightening by the Federal Reserve. Should economic conditions develop in such a way that warrants a more aggressive response, we would see longer term yields come under further pressure, off what is still a very low base. Of particular focus will be whether recent signs of inflation drifting higher is the start of a more sustained upward cycle in inflation.
The US election result has added materially to the uncertainty around this, with the prospect of a loosening in fiscal policy focused on public infrastructure raising fears of wage pressures intensifying in the construction sector. How Trump’s plans for fiscal expansion ultimately play out will be key to shaping the performance of bond markets over the next one to two years. Across Europe, markets will focus closely on how the European Central Bank will manage the winding back of the Quantitative Easing programme.
Locally, it would seem we are getting very close, if not at the end of the monetary easing cycle. Whilst the Australian economy is continuing to perform reasonably well, as we move through 2017 and beyond, we can expect to see a meaningful slowdown in residential construction, especially in the apartment sector. This will require other parts of the economy to take up the slack and how this unfolds will be central to how the Reserve Bank of Australia will manage policy over the next few years.
What are your highest conviction positions moving towards the new year?
We remain committed to strategies that aim to preserve capital when valuations are stretched, as they have been for much of this year, excluding the most recent period where the significant bond market sell-off has restored some value. As such, yield curve ‘steepening’ biases and allocations to inflation-linked bonds are all defensive strategies employed in this context. Conversely, returns are being sought from spread sectors such as high quality corporate debt that offers investors a reasonable yield enhancement in what still remains a low yield environment.
What should investors expect from your asset class and your portfolios moving forward?
For some time now we have been encouraging investors to be realistic about the returns that fixed interest can deliver in the future. It is fair to say that just how far bond yields have fallen around the world has surprised many and this has allowed returns from bonds to hold up reasonably well over recent years.
Investors need to recognise that this tailwind to fixed income performance is receding and may well change direction in the years ahead. If we do head into a rising yield environment, with yields so low, there is minimal income to protect investors from the negative impact of higher yields on bond prices. This should be of particular concern for investors in index funds where yields are close to historical lows and duration, because of the long-dated issuance of governments, is at an all-time high. Fixed income strategies that focus more on absolute performance rather than relative to a benchmark are likely to fare considerably better in a rising yield environment.
Glenn Feben joined Henderson Global Investors in 2015 as Head of Australian Fixed Interest following a long tenure with the IOOF Group and Perennial Investment Partners since October 1987.