Q4 Fixed Income Outlook – External Influences

The bond market has generated strong returns so far in 2014 driven largely by factors outside of the U.S. Specifically, growth in Europe has continued to surprise to the downside, pushing inflation expectations to low levels. This decline in inflation expectations has gotten the attention of the European Central Bank, who recently responded by cutting short term interest rates into negative territory, and by planning to expand their balance sheet further with targeted asset purchases. In addition, geopolitical concerns emanating from Russia, Ukraine and the Middle East have driven government bond yields to incredibly low levels. 10-year government bonds in Germany now yield near 1% while 10-year government bonds in Spain (once shunned for fiscal concerns) now yield less than those in the U.S. (Exhibit 1).

Exhibit 1: U.S. Treasury yields now exceed those of many global peers

While these factors have influenced domestic bond markets, the internal factors affecting the U.S. are different, and are likely to become more important over the next few months.

First, U.S. growth is on firmer footing than global peers. This is evidenced by a strong rebound in growth in Q2 as well as a meaningful decline in the unemployment rate year to date. In fact, our own measure of real-time U.S. economic growth is currently running over 4%. Importantly, the Federal Reserve has recognized that spare capacity is shrinking in the U.S. and is therefore expected to conclude its asset purchase program, or quantitative easing, in October of this year.

At the last FOMC meeting, committee members revised higher their expected path of short term interest rates, with an expected liftoff date sometime next year. This is important as the bond market is currently pricing in a path of short term rates below the Fed’s own forecast. As the Fed comes back into focus, we expect U.S. interest rates to rise, driving further divergence from their European counterparts. Therefore, we are positioning portfolios with a shorter duration to protect against rising interest rates. In this environment, we think a duration of 2-3 years makes sense in bond portfolios but as always, it is very important which sectors that duration comes from.

Secondly, we continue to think that corporate bonds are more attractive than their government counterparts, supported by strong fundamentals and reasonable valuations. However, the most attractive bond market opportunities may be outside of the corporate market. Specifically, many areas of the mortgage backed securities market look more attractive to us than corporate bonds. In addition, some international markets that are less exposed to changes in G10 monetary policy remain attractive. These include Asian markets such as Korea and Indonesia, as well as markets undergoing positive structural reform like Mexico and Peru.

In this environment, external factors are affecting domestic bond prices like never before. We think it is important for investors to remain flexible in order to protect themselves from some of the policy potholes that may lie ahead in some areas, but also to capture opportunities in others.

Exhibit 2: Recommended fixed income portfolio