Bond market headaches: The Fed and Greece but select opportunities remain

The hardening of Fed rhetoric around the provision of guidance has added to general nervousness around the outlook for US monetary policy, and this has proved a headache for bond markets. As a result, the risk of a policy error, in our view, has increased.

That said, we do not see the possibility of a rate hike as early as September as a sell signal for bonds. We think global growth and inflation are likely to be capped in an environment where high debt levels and ageing populations in much of the developed world are likely to continue to act as a large impediment to economic growth. In addition, in the US, there are many signs of ‘good deflation’ such as more efficient business processes that have been keeping a lid on inflation pressures. In this context, we don’t think the global economy would be able to handle markedly higher rates and expect any tightening of global monetary conditions to be gradual.

In this context, we continue to retain a bullish view towards the US dollar.

Greece saga taking time to play out

The Greek saga meanwhile will continue to dominate headlines and induce bouts of volatility in credit and peripheral sovereign debt. We believe that there will probably be further flashpoints between Greece and its creditors in the months ahead. We therefore took profits on our Greek government bond position prior to the Greek parliamentary vote on July 15th. Ultimately, our belief is that at less than 2% of European GDP and with much of Greece’s debt held by the public sector, the fallout in the event of “Grexit” is unlikely to be a Lehman moment.

A sell-off in peripheral government bonds (such as in Spain, Italy and Portugal) could lead to more aggressive intervention by the European Central Bank (ECB) to keep a ceiling on yields.

Given this, we believe having a large weighting in medium and long-dated triple ‘A’ rated government bonds, with the aim of mitigating deflationary tail risks is a sensible route for us to take.

Why we like Cypriot government bonds

We like the outlook for Cypriot government bonds, which we added to the portfolio earlier this year. In contrast to the shambles in Greece, Cyprus appears to be on track with its reform programme. Financial sector over-leverage was the main cause of Cyprus’s 2012 bailout, rather than government borrowing, and the economy has rebounded strongly in recent years. The banking sector has since been successfully re-capitalised and although the overall level of government debt remains high, the budget performance has improved, meaning Cyprus is not breaching the EU’s excessive deficit procedure unlike some of its larger peers. The bonds currently offer relatively high yields among sovereign issuers and may become eligible for the ECB’s quantitative easing scheme.

India remains focus of our EM exposure

We are cautious on the outlook for emerging markets (EM), especially China, where data continued to disappoint. Our view is based on the poor economic fundamentals to be found across EM and also our bullish view on the US dollar which could create stress points in already indebted economies.

India is a notable exception to this view. Our case for holding local currency debt positions there is based on an improving economy and our belief in the likelihood of further rate cuts.

In addition, India imports much of its energy needs so further weakness in oil prices should be a plus. Elsewhere in EM, we also have selective positions in short-dated Russian names in the energy and resource sectors, including Gazprom and Lukoil. Investor aversion towards Russia since the Ukraine conflict began has meant we have been able to find companies with what we believe have balance sheets with the strength of many double A and single A-rated companies, but whose bonds trade on a yield typically more appropriate for double or single B credits.

Australian government bonds suffer in Q2, but added value year-to-date

Australian government bonds (hedged) are a core allocation within the portfolio. The Reserve Bank of Australia’s 0.25% interest rate cut in May lent further support to our case for holding the country’s bonds (currency hedged), and we continue to have a bearish outlook on the domestic economy. Our case is based on evidence of low levels of business investment, weak coal and iron ore prices, an uncompetitive exchange rate and low wage growth.

We believe the economic slowdown in China will continue to dampen the economy, while the government’s strong finances should mean concerns around a possible downgrade of Australia are over-played.

In our view, we would need to see a considerable deterioration in fundamentals for a downgrade to happen. Today, we consider the debt metrics for the Australian government compare most favourably versus other leading developed nations.