Attractive entry points in US and European fixed income

 

Need to know •    US and European bond markets have sold off aggressively as inflation rises and the major central banks embark on hiking cycles. We expect the conversation to now shift towards the dwindling outlook for growth and see inflation pulling back from the highs. •    We believe that long-term fair value levels for US Treasury yields have been over-shot. In Europe, government and corporate bond yields have turned decisively positive, yet we see the current market pricing of policy tightening by the European Central Bank as extremely difficult to achieve. •    Current US and European yields and credit spreads are now at very compelling valuation ranges for long-term investors, in our opinion.

Too deep into bear markets?

US Treasury (UST) and Eurozone bond yields have risen aggressively, throwing global fixed income markets deep into bear market territory. Much of the selloff was caused by constant and repetitive comments from Federal Reserve members who talked yields higher as they pushed the market’s implied expectations of the Fed’s terminal rate from 2% towards 3%.

We believe that long-term investors should sit up and take notice now of compelling valuations in fixed income. The selloff in yields has been significant and may well stabilise here or indeed pull lower, in our view, making current levels an attractive entry point.

Key to the future will be whether inflation is peaking, growth is slowing and if market expectations are over-shooting the terminal Fed funds rate. We note that in 2019, the previous and only rate-hike cycle since 2008, the Fed managed to raise interest rates to just 2.5% only to aggressively lower them back to 1.5%.

 

Parallels with 1999

The 10-year Treasury yield has almost doubled from 1.5% at the start of this year to almost 3% currently, marking the fastest and most aggressive Treasury selloff in over 20 years. The last time Treasuries sold off more than currently occurred in 1999 when yields spiked from around 4.9% to 6.7% after Russia defaulted on its domestic debt at the end of 1998. While markets normalised later in 1999 amid a late-stage US equity bull market and oil rallying from USD10 to more than USD26 per barrel, the nearly 200bps yield spike preceded a number of key events which happened post 1999:

• The dotcom bubble burst, fuelled by a selloff in US technology stocks
• The US economy cooled as recessionary conditions arose
• A rate-cutting cycle ensued until 2003

As such, 10-year yields then proceeded to plunge from 6.7% to 3% until mid-2003. 

We see many similarities between today and 1999: UST yields have dramatically sold off; technology stock valuations are not synchronised with the ability of those businesses to generate long-term cash; equity valuations are in historically higher valuation bands; and surging commodities and oil are compounding the rise in inflation. Today’s crypto mania has many parallels with the dotcom mania of 1999. Interestingly, both periods coincide with a Russian default – on domestic debt in 1998, and on external debt in 2022.

By any measure, the current Treasury selloff is statistically significant. Yet despite the massive moves, investor sentiment remains largely nervous and ultra-concerned about inflation going forward. Most importantly, should the economy slow down in coming years, markets are not prepared for the ensuing potential drop in yields, should that occur.

 

European yields turn positive

Whilst the yield pickup was initially US-centric, the pressure eventually spread to European government bonds in early February, as the European Central Bank (ECB) expressed explicit guidance that they were moving away from their ultra-loose policy stance.  This has seen German 10-year yields rise almost 150bps from August 2021 lows to 0.97%, breaking into positive territory for the first time since mid-2019. Even more noteworthy is the move into positive yields for Germany 2-year notes for the first time since 2014, with the market pricing an aggressive and imminent hiking cycle by the ECB.

Eurozone futures currently price 80bps of ECB hikes by year-end, which would leave their benchmark rate at 0.3%, the highest level in more than 10 years.

Overall, European bonds now yield positively across the board past the 2-year-plus duration point, even in Switzerland. In fact, Japan is now the sole developed market sovereign with negative yielding debt at the 2-year-plus point. Looking at the Eurozone periphery, yields are near UST levels, with Italy 10-year notes yielding 2.65%. In the European corporate bond space, negative-yielding debt has been completely wiped out.

As a result, the drawdown in European government bond total returns is comfortably the largest of the 23-year Eurozone era. At 12% from peak to trough, it is almost double any prior drawdown episode in the Euro-Aggregate Treasury Index, including the sovereign liquidity crisis of 2011-12.

 

Softer growth to eclipse inflation

We expect the conversation to now shift towards the dwindling outlook for growth. While we do not expect the US economy to experience a sharp recession similar to 2000-2003, we do expect US GDP to fall progressively this year and next.

The Fed appears off the mark here in terms of timing, jawboning UST yields higher just as US growth appears set to slow, in our opinion. However, after insisting for most of 2021 that inflation was transitory, the Fed found itself behind the curve. Now it appears to be adopting a hawkish stance to save its institutional credibility and avoid being wrong again, but it is doing so exactly as inflation is peaking and appears set to wane, in our view. 

Figure 1 shows US growth and inflation are expected to drop according to market consensus data from Bloomberg. This would also lead to lower UST yields over the next one-to-two years.

 

Figure 1. US GDP and CPI are projected to fall towards long-term trend levels

Source: LOIM, Bloomberg. For illustrative purposes only.

 

Our base case view is for inflation to progressively drop from here, with Q1 2022 US inflation levels representing the peak. Inflation can only remain this high if there are repeated and regular inflationary shocks going forward – and these are not expected to arise due to trends in long-term secular consumption, demographics, debt and technology. High base-effects should now lead to disinflationary trends heading into 2023. Europe may well see inflation levels peak later than the US, due to prolonged and more direct and persistent impacts from the Russia-Ukraine war and associated sanctions. However once these shocks are baked in, we would expect similar disinflationary trends to take hold through 2023.

 

Have yields over-shot? 

In this context, we expect pronounced uncertainty about how aggressively the Fed will hike and taper its balance sheet to abate after the May policy meeting and into Q3 as changing inflation and growth trajectories become more evident. We continue to believe that long-term fair value levels for UST yields have been over-shot, and are currently at the higher end of the ranges.

Similarly, in Europe, we see the current market pricing for policy tightening to be extremely difficult to achieve for the ECB, with some economic indicators already pointing to growth slowdowns on the back of the Ukraine war and Russian sanctions. Whilst we understand the ECB’s desire to achieve some sense of normality in its monetary stance, we also struggle to see how aggressive policy tightening will help address war-driven supply side constraints for staple consumer goods, such as food.

 

 

Europe faces an additional headwind to a sharp tightening cycle due to peripheral sovereign debt servicing. Like the Federal Reserve, through QE the ECB has the capacity to essentially print currency to meet obligations, but such action may not be suitable for the broad range of economies that its policy serves. The ECB has always faced policy headaches from the diverging needs of core versus peripheral economies. Still, although often contentious, previous bouts of QE have come in low-inflation periods. If a sharp hiking cycle destabilises highly leveraged peripheral sovereign balance sheets – for example, Italy’s debt to GDP ratio is 30 percentage points above pre-Covid levels – before inflation materially eases across the Eurozone, core European nations are unlikely to be willing to introduce fresh bouts of stimulus. We see this as another variable to incorporate in an already complex balancing act for the ECB, which could see hikes fall short of current pricing.

Going forward, some semblance of market stability could return as investors slowly realise the extremity of the recent selloff, in our view. Previous UST selloffs have been capped at around 3% yield, namely the Fed’s taper tantrum in 2013 and its 2018 hiking cycle.

Figure 2 shows the inflection point between the low historical 10-year rolling UST returns of and yields having risen now, leading us to conclude that returns should go up from here.

 

Figure 2. US Treasuries – 10-year rolling returns vs 10-year yields

Source: LOIM, Bloomberg. For illustrative purposes only. Past performance is not an indicator of future returns.

 

Compelling valuations 

Fixed income market drawdowns are unsettling, especially when they are so pronounced. Just four months into the year, global, emerging market and Asian credit markets have each had their worst annual performance since 2008¹.

That said, there is a silver lining to the cloud: current US and European yields and credit spreads are now at very compelling valuation ranges for long-term investors, in our opinion. We believe the combination of a slowdown in global growth, future disinflation and simply time could yield significant returns for corporate bond investors from here over a three-to-five year horizon, and beyond.

We see options to add risk in European corporate credit, particularly to the many corporates with strong fundamentals and decent cash buffers. Volatility is admittedly high relative to most of the last decade (although only half that of March 2020) and the situation needs to settle. However, for investors willing to withstand some higher volatility, spread products are offering interesting returns. As always, the key will be to invest in companies with future-proof, resilient and sustainable business models.

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