Fictional supervillain Ernst Stavro Blofeld once said to James Bond, “You’re a kite dancing in a hurricane, Mr. Bond.” Fixed income investors can relate to what it must be like to be this kite.
Central bankers have made such distorted statements and plans over the last few years that judging the future direction of prices has become a real challenge. Add in oil price plunges plus Chinese and European banking wobbles and the more pessimistic investors would argue it’s near impossible.
Investors and expert commentators regularly talk about headwinds and tailwinds facing markets to help decipher the nuances of markets and to search for clues for where we may be headed next.
Are the winds now changing? In particular, what will central banks’ next moves be? These are just two key questions we are asking ourselves right now.
Slightly complicating the matter is the fact that the central banks of two of the developed world’s largest economic regions – the U.S. and Europe – are moving in different directions. These actions are not without precedent. In reality, it is only since 2008 that we have seen a concerted globalized approach to monetary policy activity.
Ultimately, the length of the Financial Crisis and its aftermath leaves us in a situation where divergence from these global efforts is likely to cause some uncertainty. There is little doubt that a significant emerging market or, worse still, global growth shock, would lead to further action from the U.S. Federal Reserve (Fed), and potentially a return to coordinated action.
With oil, the crux of the problem is with supply. Equilibrium levels are expected to be achieved once again, but not until late 2016. The oil price environment has already led to some defaults from North American shale oil producers. That said, supply is already being taken off-stream. In addition, Iran has been less successful in bringing oil back to the market than many had hoped.
With oil, the crux of the problem is with supply.
In terms of China and the effects on the global economy, markets in the U.S., UK and particularly Europe have overpriced the risk of recessions emerging. Deflation risks do persist for the time being and there has undoubtedly been some slowing of data, with China being the greatest cause of concern.
We started the year believing that we may finally see signs of inflation, but bond markets have swiftly priced in the opposite, and risk assets generally are pricing in a material slowdown. The key point for us is that economic data is far more positive than financial markets are pricing. Jobs are still being created in the U.S. and Europe, to such a degree that the Fed hiked interest rates in December.
As we entered the year, as if we didn’t have enough to worry about already, it became apparent that the risk of global economic slowdown was being increasingly priced in to the financial sector. Negative numbers from Credit Suisse and Deutsche Bank only served to pour fuel onto the flames. As a result, additional tier 1 instruments – new – style subordinated instruments which are converted to equity as bank capital falls below certain levels – have performed disastrously. Deutsche Bank has relatively low levels of available distributable items, causing market participants to cast doubt on whether the bank will pay coupons on the instruments.
With so many gusts blowing in different directions, it can be hard to keep a grip on the true direction at any one given moment. We stand ready to change direction as the conditions (data and facts) change. It is at this point we are reminded of another great quote, this time from one of America’s greatest inspirational authors William Arthur Ward:
"The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails."
The winds may not be permanently changing for European corporate bonds, but in such an uncertain environment where flexibility is the key to successful navigation, we’re staunchly in the realist camp, ready and able to adjust.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and differences in accounting methods; these risks are generally heightened for emerging market investments.