Bond Markets: a macro-economic cocktail that calls for a selective approach

Investors should adapt to this new reality, just as they are being buffeted by a number of economic crosswinds: a strengthening US dollar with its disruptive impact on emerging economies, the knock-on effect on developed nations, deteriorating US fundamentals sparked by a turn in the credit cycle, but an improving economic outlook for Europe, helped by supportive monetary policy.

Against this background, finding investment opportunities is a delicate exercise. With such uncertainty, I believe it is important to focus on quality and liquidity.

The world, in my view, is facing three major challenges: levels of global debt, demographics and deflation.

Since 2007, global debt has increased by $57tn, outpacing world GPD growth. The rise in debt is particularly noticeable in countries like China where the level of corporate debt has scaled new heights, in particular debt issued by non-financials (energy and construction).

When it comes to demographics, the falling birthrate in developed countries has led to the ageing of the population, notably a drop in the population aged between 24 and 52. This age group is the one that drives consumption and economic growth. In other words, demographics will most likely weigh on economic growth over the next few years.

While we are optimistic about the outlook for government bonds because of these two factors – debt levels and demographics - we think what is most important is the phenomenon of “good deflation”, which comes from disruptive technologies and the way firms such as Google, Uber and Amazon change how to do business.

Slowly but surely, these disruptive technologies are taking pricing power away from companies and putting it into the hands of the consumer. As a result, firms are finding it increasingly hard to increase prices, hence “good deflation”. By contrast, deflation, or disinflation, is a long term trend, and has more to do with global overcapacity. Firms are simply producing too much, helped by quantitative easing which has led to a misallocation of capital.

Another consequence of QE has been an increase in the prices of every asset, particularly when it comes to house prices. Housing is the most important component of inflation, looking at the inflation structure in the US. QE has led to higher prices of houses, and then to higher rents. Without this component, inflation in the US is close to zero and the US Federal Reserve, in our view, should focus on that point.

Additionally, the official US unemployment rate is 4.9%, but it doesn’t take into account the participation rate. Factoring this in the real unemployment rate is closer to 13%. Pressure on wages is not that significant, particularly as the jobs created are mostly low-paid jobs in the services sector, including many part-time positions, while the jobs lost were largely well-paid positions. We think therefore there is slack in the labour market.

The manufacturing PMI in the US is about 48, so below a reading of 50 that signifies the sector is expanding: in other words, this key indicator is suggesting there is more than a 50% probability that the country is heading into recession. Services PMI is still above the 50, but it usually takes the same route as the manufacturing PMI (historically, the manufacturing PMI leads the way.)

We think the US Federal Reserve was mistaken in raising the rate in December, because it increased volatility in emerging markets. Despite recent acknowledgment by Janet Yellen of increased macro weakness both within the US and globally, the path of interest rates in the US remains far from clear. For all these reasons, we prefer to stay away from US corporate debt.

In addition, we are avoiding emerging credit markets. Emerging debt, particularly emerging corporate debt, has been growing significantly in the last few years.

The debt burden has getting heavier as loans were often taken out in US dollars. At the time, servicing the debt was relatively cheap but the strengthening of the US dollar has raised the cost of repayment by quite some margin.

Emerging market dollar reserves are falling, suggesting investors are unwinding one of the biggest carry trade we’ve ever witnessed. Since 2009, between seven and nine trillion have been borrowed in US dollars and invested in emerging assets (Chinese financial markets, Chinese housing market, Brazilian debt). Given the fall of local currencies and recession in emerging countries, the situation seems perilous and we prefer to avoid it, even more so as we think it is only a question of time before Saudi Arabia break its peg with the US dollar and China proceeds with a devaluation of its currency.

As a major player in the commodities market, China’s slowdown has an important impact. Commodity prices are currently low and are likely to stay low for a while.

Only gold is likely to hold its own, helped by its reputation as a safe haven asset especially if a currency war breaks out, which we believe is bound to happen sooner or later, and above all, when the Fed starts reversing its monetary policy.

The European economy has started to deleverage, unlike the United States. Europe has good momentum, judging by current PMI levels, and its monetary policy is supportive.

In short, we continue to see opportunities within European credit, investment grade bonds and high yield, although we are adopting a more defensive stance and security selection remains paramount.