A sharp rise in yields has been painful for bond investors but better times lie ahead. We expect rates to peak and the euro to strengthen later this year, opening up some interesting opportunities for global bond investors.
After a strong 2020, during which the LF Canlife Global Macro Bond Fund delivered a return in excess of 9.5%,[1] the first three months of 2021 have proved much harder going. Bond yields have been rising more quickly than expected, with a 70bps upward movement in 10-year US Treasury yields at the start of 2021.[2]
Given the low starting point of yields at the end of 2020, this was a drastic move in a short space of time. The reset in yields quickly percolated through to other markets, creating a near-perfect storm for bond investors. The sell-off has been sharp and happened much faster than forecast, but what we are seeing is a repricing that reflects a nascent economic recovery and a modest rise in inflation. It does not presage a structural bond bear market.
We expect that Treasury yields have further to rise but will halt near the 2.0% level in Q3 of 2021. Higher yields across global bond markets will provide an attractive entry point for fixed income investors by giving them access to higher coupons and potential capital gains. Patience will be rewarded.
Inflation fears
The markets are testing the Federal Reserve’s (Fed’s) resolve to see if it is serious about holding rates at current levels and allowing inflation to rise temporarily above its long-term 2% target under the Fed’s new average inflation targeting mandate.
Underlying the rise in yields is fear that high levels of monetary and fiscal stimulus could cause inflation to take off, potentially to levels substantially above the Fed’s long-term 2% inflation target.
Of particular concern is the impact of President Biden’s US$1.9bn economic stimulus package which, by some estimates, is six times the amount required to address the gap between actual and potential US economic output.[3]
The Fed’s tightrope
For the Fed, two things are at stake. First, to maintain favourable financing conditions that support economic recovery by capping the recent rise in real interest rates. While a rise in nominal rates is an encouraging sign that the economy is recovering, a rise in real interest rates would increase the cost of servicing debt. With corporate debt levels at record levels, this would clearly diminish the prospects for a successful economic recovery. Secondly, the Fed must preserve its credibility and commitment to targeting average inflation.
Following the Federal Reserve Open Market Committee on 17th March, the Fed re-acknowledged the need to strike a balance between the improved economic outlook and its commitment to keep rates on hold until “substantial further progress” has been achieved, particularly in relation to reducing unemployment. However, there were indications that the Fed could raise rates before 2024, with 7 out of 18 Fed officials contemplating a rate rise in 2023. This brings the Fed closer to alignment with market expectations of at least two rate rises in 2023.
Unemployment trumps inflation
We expect the current rise in inflation expectations to fall back during 2021, primarily because high levels of unemployment mean that we will not see wage inflation for quite some time. At 6.2% the official US unemployment rate is high (an estimated 10m jobs have been lost in the pandemic so far), but it does not include a large number of people who have simply stopped looking for work. Once estimates of this group are included, the US unemployment rate is closer to 9%. Although the US economy is recovering quickly, there is still plenty of slack in the system.
In addition, we are likely to see a further rise in US unemployment as government support for companies is removed, causing an increase in redundancies and insolvencies – particularly among smaller and mid-cap companies. Unemployment is therefore likely to continue to rise even as the economy recovers.
Inflation as measured by US CPI for February was 1.7%, up from the 1.2% figure seen in 2020.[4] Supply inflation in the form of one-off increases in prices caused by disruptions in supply chains during the pandemic will continue to exert upward pressure on prices over Q2, but these are temporary price distortions. For inflation to start to grow in a sustained manner we would need to have a combination of reduced supply and strong demand.
Demand-led inflation could rise as the record levels of savings accumulated during lockdown are spent. However, we believe that people are likely to remain cautious, particularly given the elevated levels of unemployment. In addition, a large proportion of savings are held by higher income owners, who are more likely to retain or invest their savings.
From 2008 to 2020 we experienced the longest economic expansion ever, yet inflation never rose above 2%. Now we are in a worse economic position than in 2008, with higher unemployment, more government and corporate debt and a growing numbers of companies at risk of insolvency.
Given this, it is difficult to envisage inflation becoming anchored substantially above the 2.5% level. The bond markets appear to agree, with current breakeven figures for US inflation anticipating a level of around 2.6% in 2 years but falling back to 2.3% over 5 years.[5]
Rising stars
During 2020 a major theme in credit markets was the increase in fallen angels – investment grade names being downgraded to sub-investment grade ratings. Now, as the prospects for economic recovery improve, we are seeing this trend reverse, which opens up some interesting investment possibilities.
Of course, not all fallen angels are resurrected as rising stars and find their way back to investment grade status, but those that do historically outperform the market and generate additional returns relative to the market.
During the recent challenging months for bond markets, the LF Canlife Global Macro Bond Fund’s exposure to credit, particularly its selection of BB-rated corporate names, has provided a welcome boost to performance. We have been adding carefully-selected corporate bonds that stand to benefit as the economic recovery gathers pace. These include subordinated bonds from investment grade issuers, which offer extra yield from fundamentally strong, high-quality companies in return for accepting a lower position in the capital structure, and names such as Rolls Royce that have the potential to become rising stars.
Currency counts
Unusually among its peers, the LF Canlife Global Macro Bond Fund does not hedge foreign currency. This is because currency movements can provide significant diversification and an additional ‘third lever’ for generating returns alongside interest rates and corporate bond spreads.
For example, as the COVID-19 storm took hold in March 2020, our holdings in ‘safe haven’ currencies such as the US dollar and yen helped minimise losses during the sell-off. They also provided liquidity that we used to invest in high-quality corporate bonds at very attractive yields as companies came to market to issue debt and shore up their balance sheets. This will deliver long-term benefits to our investors in the form of higher coupons for years to come.
The US dollar has recently weakened relative to other major currencies, despite rising US interest rate expectations. This may seem unusual, but it is in fact a natural reversal of the move into safe-haven currencies we saw during 2020. As the world economy comes out of recession, and investors move towards riskier assets, some decline in the US dollar is therefore to be expected.
In due course, the relationship between higher US rates and higher US dollar exchange rates will be re-established, most probably later in 2021 when interest rates stop rising. In the meantime – and in stark contrast to last year – we are able to shift our focus towards generating additional returns from more cyclical, recovery-oriented currencies such as sterling and euro.
[1] Morningstar, bid to bid, with income re-invested for [C] share class
[2] Bloomberg, as at 15th March 2021
[3] Washington Post, The Biden Stimulus is admirably ambitious. But it brings some big risks, too. Lawrence H Summers, 4th February 2021
[4] Bureau of Labor Statistics
[5] Bloomberg, as at 15th March 2021
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