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Fixed Income and FX Portfolios - CIOs’ investment strategies: Q&A

Summary

Global Bond Investment Outlook

 

European Bond Investment Outlook

 

Japanese Bond Investment Outlook

 

US Bond Investment Outlook

 

Emerging Market Bond Investment Outlook

 

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December 2017

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Decembre 2017

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Global Bond Investment Outlook

Q1 / How do you believe investors should play the 2018 investment environment in terms of positioning and risk budgeting?

We are observing a major discrepancy between the signals sent by the performance of risky assets (credit, equity, EM debt) and those coming from the sovereign bond market. We can still see the repression on the bond risk premium coming from CBs with yields at their lowest historical levels.

In this environment, we believe investors should favour a reduced duration exposure on G4 government bonds, especially on Germany and Japan, where valuations are still at very stretched levels and do not reflect the synchronised global growth recovery and the monetary policy normalisation in progress.

For global fixed income investors, in 2018, most of the risk budget should be deployed on relative value strategies, in our view, with five high conviction ideas:

1. Inflation linkers vs nominal, favouring an inflation break-even exposure;
2. US vs Euro rates, pointing at a spread tightening between the two yield curves;
3. Yield curve management, focusing on the US yield curve flattening and on the flattening
of the Euro curve in the 10-30Y bucket;
4. EM vs DM, preferring long EM debt;
5. Dynamic spread management, with a preference for hard currency EM debt, credit and peripheral countries.

Q2 / How should the investment approach change in 2018 compared to 2017 and why?

The valuation levels and divergences in adjustments of CB policies as well as some volatility in the macro data and tension in the geopolitical landscape, in our view, call for a stronger focus in 2018 on relative value strategies and volatility hedges in global fixed income.

Q3 / What are the main issues/events to watch during the year and why?

We see five factors to watch in 2018. First, on the macro side, the evolution of the inflation outlook, and in the US, the job market (non-farm payroll). Regarding the US, it will also be important to assess President Trump’s policies – in particular, potential tax reform: how and when it will be implemented could drive movements in rates. Among the other issues to watch, we focus on the Chinese outlook and how Chinese authorities will manage the slowdown, and the commodity outlook (also considering the recent rise in oil prices and tensions in the Middle East).

In Europe, the main events that could affect the global fixed income markets are the Italian elections (in the spring) and how the Brexit negotiations unfold.

GBIO 1/ World real GDP growth forecast 2/ Possible surprises to watch for in 2018

Q4 / In your view, what are the biggest opportunities and risks not priced into the market for the new year?

We believe that the markets still underestimate the possibility of an acceleration in inflation and of a faster normalisation of CB policies. Thus, we view an underweighting of duration exposure in Japan, core Euro and the UK and an overweighting of break-even inflation as appropriate strategies in this market. In addition, credit should remain mildly
supported vs govies in global fixed income, with a focus on quality and liquidity provided by the investment-grade segment. Regarding EM bonds, we still see some areas of value in local currencies, where selection will remain key.

Q5 / And what strategies do you suggest to mitigate risk?

To mitigate risk, investors could implement a combination of strategies: an exposure to the US dollar, reduced duration to core markets, and exposure to option strategies with a view to benefitting from a rise in implied market volatility.

 

Eric BRARD, Head of Fixed Income

Laurent CROSNIER, Head of Global Fixed Income

European Bond Investment Outlook

Q1 / How do you believe investors should play the 2018 investment environment in terms of positioning and risk budgeting?

A combination of low inflation, strong growth, very accommodative monetary policy and favourable liquidity conditions suggests, to a certain extent, a positive investment environment for bond investors. We are aware that valuations are not historically attractive, and we also think that they could remain expensive for some time. In the meantime, however, there will be plenty of opportunities for active, flexible investors to generate alpha1.

We like the credit market. In particular, we believe investors should remain overweight on financials versus industrials, and subordinated versus senior debt. This view is for 2018 overall, as the ECB gave comfort on the continuation of the Corporate Sector Purchasing Programme (CSPP). We believe investors should be underweight on core rates, but with a low risk budget.

Duration exposure will not be a key axis at this point in the cycle. On peripheral bonds, we believe investors should be progressively moving from an “overweight forever” approach to more dynamic positioning. At this level of spreads, political and economic developments will probably offer more volatility – hence, more opportunities to be under/overweight.

Finally, the specific part of the market that has not priced in a recovery story is the inflation-linked segment. That’s why we believe investors should favour inflation-linked bonds versus nominal bonds – at least until valuations recover.

Q2 / How should the investment approach change in 2018 compared to 2017 and why?

A strong focus on fundamentals with a very flexible approach to fixed income will be key in 2018, as it has been in 2017. We are conscious of expensive valuations, low volatility and market positioning: hence, we believe that a tactical approach to investing will be very important to address market challenges. A good example of how to be tactical is in peripheral bonds. The political turmoil in Spain and the general election in Italy next year are market movers and we should see more opportunities in these relatively liquid markets going forward.

Q3 / What are the main issues/events to watch during the year and why?

In 2016 and 2017, the focus was on politics. We believe 2018 will be about central banks. The ECB in particular will be a key driver for bond investors next year. We think the negative repo rate contributed significantly to the compression in risk premia and volatility. As long as the normalisation of ECB monetary policy remains far off, a regime shift (in yields as well as in volatility) is not our central scenario.

Q4 / In your view, what are the biggest opportunities and risks not priced into the market for the new year?

Inflation is the macroeconomic variable to watch. It is the biggest potential opportunity, as break even inflation2 is cheap in the eurozone. It is also the biggest risk for the credit market, as higher inflation might force the ECB to implement a faster tapering process.

Q5 / And what could be the strategy to mitigate risk?

With a positive view on credit, an overweight position on inflation-linked bonds could be a good hedge against the potential risk of a rise in inflation and a more hawkish ECB. Volatility trades could also be a good tool, in our view.

 

European

 

Eric BRARD, Head of Fixed Income

Marie-Anne ALLIER, Head of Euro Fixed Income

Japanese Bond Investment Outlook

Q1 / How do you think investors should play the 2018 investment environment in terms of positioning and risk budgeting?

In 2018, we foresee moderate GDP growth, supported by stable growth in corporate earnings, a rebound in Capex, an increase in government spending for development/redevelopment of infrastructure, and far-below-target inflation. Based on this view, we don’t expect to see significant changes in the corporate bond market or in the mortgage-backed securities (MBS) market, which we expect will be quiet and stable based on an unexciting housing market. Investors should favour a short-term credit ladder3 portfolio of up to three years and a significant overweight (by more than 10%) in MBS with interest rate risk hedged. Based on our economic outlook, we don’t expect a significant change in monetary policy.

While maintaining the basic structure of a yield curve strategy which consists of cushion positions, term structure positions, and mean-reversion positions, we believe investors should rotate the emphasis on positions from time to time to capture movements in the JGB (Japanese Government Bond) curve. It could be said that current monetary policy provides opportunities to generate stable excess returns through yield curve management, though the level of “excess” is gradually shrinking.

Q2 / What are the major changes in your investment outlook for 2018 compared to 2017 and why?

Based on our view of the market, as mentioned above, we don’t expect to make any significant changes in our investment outlook in 2018, particularly as regards the BoJ maintaining its current monetary policy.

Q3 / What are the main issues/events to watch during the year and why?

As the mandate of the current BoJ Governor Kuroda will end in April 2018, the market may have concerns about the continuity of the current monetary policy, which has been exceptionally accommodative since he took the role as governor. However, it is almost the market consensus that Haruhiko Kuroda will be reappointed as governor for another term. So, there is little expectation of changes being made to monetary policy early next year. However, as the economy grows and consumer prices continue to increase, albeit at a more gradual pace, the BoJ may be forced to review monetary policy by the end of 2018.

It is expected that the BoJ will make a slight change to the “Yield Curve Control” policy by adopting a wider range 

for the 10-year yield, which is currently contained in a 0-10bps range, or by changing the target maturity to be controlled from 10 to 5 years. Either change will affect the level of 10Y yields as well as the shape of the curve in at the longer end.

Q4 / In your view, what are the biggest opportunities and risks not priced into the market for the new year?

It is a widely shared view that equity markets are too stretched, not only in Japan. Global credit markets are also perceived as being “too rich”. So, we may see a relatively large drop in equity markets, with the consequence that credit markets correct as well. Market correction itself should be negative for credit investment; however, a short-term
credit ladder portfolio could outperform the market due to much shorter spread duration. Moreover, it may be possible to utilise any market correction as an opportunity to improve the credit spread profile of a portfolio by investing maturity proceeds into bonds with much higher spreads.

Q5 / And what could be a strategy to mitigate risk 2018?

In our view, investors should be most concerned about and aware of the liquidity of a portfolio’s holdings. JGB are still very liquid, though they are now less liquid than they were five years ago. As the Japanese credit market is somewhat illiquid, we believe investors should focus on credit shorter than 3Y in duration to maintain a credit ladder portfolio up to 3Y, which may provide a steady cash flow, as redemption proceeds from corporate bonds are paid every two to three months.

Japanese

 

Eric BRARD, Head of Fixed Income

Shinichiro ARIE, CFA,Head of Fixed Income Japan 

US Bond Investment Outlook

Q1 / What is your outlook for the US economy and interest rates in 2018?

The team remains constructive regarding both US and global GDP growth. Within the US, solid employment may continue to support consumption, while the economy may also continue to benefit from higher corporate profits, reflecting improved global growth, easy financial conditions and lower regulation. The prospect for tax cuts has increased as well; that may further bolster corporate profits and the economy in 2018. While the market has now priced in higher expectations for a 2017 December rate increase, the market has priced in a 1.69% Fed Funds rate (early November) by the end of 2018, well below the median level of the FOMC (Federal Open Market Committee) projections of 2.13%. We believe the market continues to be “behind the curve” in its view on the appropriate level of interest rates. Despite the Fed’s concern about relatively low inflation, we believe it will proceed with planned rate increases in 2018.

Q2 / What could be the impact of this outlook on fixed income porfolio construction?

Given the outlook above, we believe investors should continue to be positioned for rising interest rates and a solid economy. With a multisector fixed income approach, the focus should be on being overweight on diverse credit sectors and underweight on U.S. Treasuries. Most US government debt, we believe, is unattractive, while credit sectors may
benefit from stronger growth, lower taxes and less regulation. In addition, a short duration position could be beneficial in a rising rate environment. We believe the market may be behind the curve, given solid GDP growth, little slack in the labour market, strong global PMIs, and an average inflation rate of 1.5-2% over the rest of the year and into 2018. Given this view, another high-conviction idea is for long-duration TIPS (Treasury Inflation Protected Securities), as we believe that break-evens do not accurately reflect the longer-term potential for 2% inflation.

As valuations have become extended, a way to protect investors’ fixed income portfolios is to reduce credit risk. Strong fundamentals – strong economic growth and the prospects for corporate tax cuts – are counterbalanced by stretched valuations. Total investment-grade corporate spreads stand at post-crisis lows, and reflect lower quality and overall longer duration relative to their historical levels. The valuation picture is more nuanced within the high-yield market. While spreads are low at around 3508 bps, they remain well above their 2007 tights of 241 bps, although we believe the potential for further spread compression is more limited. Again, the fundamental outlook for the high-yield markets is positive, with strong economic growth, higher energy prices, and the prospect for tax cuts, although the proposed interest deduction limit could hurt more highly-levered companies. However, in light of extended valuations, it’s important to progressively reduce high-yield exposure and upgrade the quality of this high-yield exposure while maintaining a positive bias to the market, given the greater opportunity to add excess returns from sector as well as security selection. Additionally, investors could have a neutral view to agency MBS (Mortgage-Backed Securities). Overall, including the focus to non-agency MBS, we believe that investors should remain positive on Residential Mortgage-Backed Securities. Agency MBS currently offer fair value, but can be used to upgrade the overall fixed income portfolio quality. In addition, fundamentals for the housing sector remain strong, given improving employment, still low mortgage rates, and still attractive home price affordability.

Q3 / What key developments will likely impact US fixed income during the year and why?

Central bank normalisation policies will have a meaningful impact on the US fixed income markets during the year. Given that the Federal Reserve is in the early stages of its balance sheet unwinding programme, investors will be closely monitoring its effects on the yield curve and the supply/demand balances in the US fixed income market. Additionally, the details and timetable of a potential ECB tapering programme later in 2018 will have broad implications for global interest rates, particularly given that the Fed’s unwinding programme will already be well under way. The US political landscape will bear close watching, as tax reform could occur early in the year, which may add stimulus to the domestic economy and meaningfully impact corporate tax rates. The effectiveness of the Trump administration and the viability of its legislative agenda could potentially be challenged during the year by the ongoing special council investigation being led by Robert Mueller. Additionally, the outcome of the mid-term congressional elections and whether this leads to majority control by the Democratic party may become a key consideration to administration policy going forward.

Q4 / In your view, what are the biggest opportunities and risks not priced into the market for the new year?

Given both the strong domestic employment trend and GDP data, we believe the potential drivers of higher-thananticipated inflation exist. Nascent signs of wage growth acceleration, service inflation, tighter labour markets in key industries such as homebuilding, and more restrictive immigration policies may contribute to higher price levels in the coming year. The potential for tax reform also has the capability of providing an additional catalyst to inflation. We believe investors should be positioned for an uptick in inflation with short duration exposure while also allocating to TIPS. Additionally, given the positive underlying fundamentals of the residential housing market, which has been aided by the strong employment trend and lack of supply, a positive bias towards RMBS could be appropriate. A potential risk to monitor in 2018 is that while tighter corporate spreads and higher leverage are currently counterbalanced by strong fundamentals, a slowdown in global growth or a change in central bank policies has the potential to result in spread widening and/or volatility. To mitigate these risks, investors should consider a more cautious exposure to investment-grade and high-yield corporates.

Q5 / And what could be the strategy to mitigate risk?

Limiting downside risk and avoiding permanent impairment of capital will be paramount in a world of stretched valuations. This can be achieved through a disciplined approach aimed at limiting issuer concentrations, combined with strong fundamental credit research, avoiding at-risk sectors, and avoiding market value loss in rising interest rate environments. We believe investors should continue to adhere to these core tenets as they look to mitigate risk in the coming year.

 

US Bonds

Kenneth J.TAUBES, CIO of US Investment Management

Emerging Market Bond Investment Outlook

Q1 / How should investors play the 2018 investment environment in terms of positioning and risk budgeting?

Our base-case scenario for 2018 looks for moderate mid-single-digit returns for hard currency EM debt and highsingle- digit returns for local currency debt.

Emerging markets should continue to reward investor confidence through a combination of strong macro and corporate performance. This reflects in both current account surpluses and healthy margins in both the national and corporate sample. In the recent past, such conditions have been consistent with a material market deepening effect in both the hard and local currency arena. In our view, a continued market deepening theme will provide a positive backdrop for performance generation through security selection. As the only asset class globally to offer both real growth and real rates in fixed income, EM appears well positioned to continue to attract positive flows in 2018, thus potentially offering a year that at least initially reflects conditions visible in the second half of 2017. The year has been notable for steady inflows, as investors sought exposure to both the shorter duration and higher yields offered by EM bonds. Minus external risks, we think this may continue into the new year.

That said, inflationary pressure in EM appears to be moderating, leaving only a residual disinflation lever to local currency performance. Energy prices present a material risk to this view, especially in light of recent developments in a number of energy-producing countries, such as Saudi Arabia, Venezuela, Iran and the Kurdish region. In our base-case view, we expect moderating energy prices to contribute to a general easing of financial conditions.

Q2 / What are the major changes in your investment outlook for 2018 compared to 2017 and why?

External challenges may play a larger role in 2018. This is because of the increasing importance of the economic recovery that is becoming more visible in both the US and Europe. EM activity is highly sensitive to exports; hence, demand increases from both the developed world and China can have a material impact on performance. EM spreads remain tight vs historical averages, reflecting higher investor expectations regarding global growth. In turn, this global growth expectation appears to be a second derivative of a US economic recovery.

This apparent dependence on a US economic recovery points up the timing of potential US tax cuts as both a catalyst and central risk to EM performance in the new year.

Should the Trump administration succeed with material tax reform, we expect the resulting increase in activity to support the Fed’s case for further tightening. This may continue to support a view of short duration.

Q3 / What are the main issues/events to watch during the year and why?

We continue to look for evidence of continued growth recovery in the developed economies, as this is reflected in a positive demand backdrop for emerging markets. EM growth tends to be reflected in services, which then shows in returns. At a local level, inflation and financial condition indexes should provide insights into domestic economic performance, which potentially will offer insights into local activity levels. This matters across most countries, but is arguably critical for higher-risk countries.

As rates in the developed world begin to creep higher, we think selection will become more of a performance differentiator. The ability to avoid issuers with weaker fundamentals compared to their peers will help mitigate negative performance contribution. 2018 will be a year of elections in Latin America, with Mexico and Colombia potentially swinging to the left. This may be reflected in higher domestic yields, which in turn potentially presents an opportunity. Lastly, geopolitical tension could be reflected in more volatile energy prices. It is always a good idea to keep an eye on oil prices.

Q4 / In your view, what are the biggest opportunities and risks not priced into the market for the new year?

EM have generally performed well for fixed income investors over the last three years, and we think 2018 could offer another year of positive returns. However, the sources of that return are changing in line with the market’s dynamics. In 2018, these dynamics potentially will balance differently compared to previous years. In past years, the asset class has seen positive inflows, at least partially because of the positive yield premium offered by the asset class over its peers. But in 2018, the central driver of returns might reverse towards the shorterduration characteristics of the class, as investors seek safe havens from rising rates. At time of writing, external risk appetite remains positively disposed towards EM risk. The performance tailwind presented by inflows should continue into the new year. We continue to look for positive returns from local currency, where we think the combination of a high grade, liquid, shorter duration asset class, that offers high yield, should remain compelling. In the hard currency space, we are looking for returns both within the corporate and sovereign space. In our view, a combination of more secure sovereign coupon may work well when blended with a broader approach to credit.

Q5/ And what could be the strategy to mitigate risk?

We are conscious of risks and their possible impact on performance, both positive and negative. In 2018, a short duration positioning should be central to a risk management approach, which potentially mitigates the effects of rising rates while also potentially suppressing some of the impact of volatility. An active research-driven approach can also be helpful to mitigate risk, by better understanding the dynamics of issuers and potentially identifying negative outcomes.

Mauro RATTO, Head of Emerging Markets

 

 

1. The additional return above the expected beta-adjusted market return; a positive alpha suggests risk-adjusted value added by themoney manager versus the index.

2. Breakeven inflation is the difference between the nominal yield on a fixed-rate investment and the real yield on an inflation-linked investment of similar maturity and credit quality. 

3. A bond ladder is a portfolio of bonds in which each security has a significantly different maturity date.

BRARD Eric , Head of Fixed Income
CROSNIER Laurent , Head of Global Fixed Income
ALLIER Marie-Anne , Head of Euro Fixed Income
ARIE CFA Shinichiro , Head of Fixed Income Japan
J. TAUBES Kenneth , CIO of US Investment Management
RATTO Mauro , Head of Emerging Markets
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