The eight-year rally in global bonds came to a screeching halt in the early hours of November 9 as it became apparent that fiscal stimulus and higher inflation in the US would be the order of the day following Donald Trump’s shock presidential election victory.
The post-poll rout in the bond markets saw the Global Aggregate index yield rise by 25 basis points in just 11 days to November 20. “It is a temporary death for the search for yield,” declares Valentijn van Nieuwenhuijzen, chief strategist and head of multi-asset at NNIP Investment Partners in the Netherlands. “It is down but not completely out – it is too early to be sure.”
JPMorgan says two-thirds of the 100 biggest bond funds globally produced an average return of 6.4% up until the end of October this year, but since then they have lost 1.5% and their average year-to-date return declined to 4.9%. According to data provider EPFR Global, investors withdrew $8.2 billion from US bond funds in the week after the election, the largest withdrawal since January 2013, during the so-called ‘taper tantrum’.
Given that Trump is still some way from taking office, this reaction seems quite premature.
“The expectation that pumping stimulus into a US economy already at full employment will raise inflation is still there, but it is right that there is an assessment of how quickly this additional inflation will come through,” says Paul Donovan, global chief economist at UBS Wealth Management. “There are few to no shovel-ready infrastructure projects available in the US and there is the small matter of getting any fiscal stimulus through Congress. The consequences of the infrastructure projects lie more at the end of 2017.”
Indeed, he points out that deflation could even be more likely in the short-term, saying: “Any moves into tariffs and protectionism would have a more immediate impact on inflation, and those effects should be considered as having exactly the same consequences as an increase in a sales tax because that is what a tariff is.”
Despite this, the bond market looks set to bear the brunt of a new great rotation into equities. The 10-year treasury yield was 2.327% by November 20, having been 1.867% on November 8. Two-year treasury yields, the most sensitive to any rate rise, rose to 1.08% – their highest level since 2010.
“Concerns regarding the decline of the neutral interest rate and worries over secular stagnation have been kicked into the long grass, and with inflation already starting to move higher, it seems appropriate to extrapolate this trend further in the months ahead,” says Mark Dowding, partner and co-head of investment grade debt at BlueBay Asset Management. “We could be on the cusp of a more normal-looking rate cycle and will look back at price action of the past several years in more anomalistic terms.”
Van Nieuwenhuijzen puts the extreme and immediate reaction in the market down to the high level of cash balances sitting at many funds and a consequent willingness to invest.
“The US election is not the only thing driving markets,” he says. “The move in bond yields started before Trump. This is a balancing act. We have a clear preference going into 2017: we don’t like government bonds,” he says. “The reflation trade is on, and further damage is likely to occur next year. The risk of accidents in global trade has gone up, and it is very difficult to quantify those risks.”
However, asked by Euromoney if the market is ignoring the deflationary impact of threatened trade tariffs that could come into force before any inflationary fiscal spend can happen, van Nieuwenhuijzen says: “That potential scenario is far more appropriate than it was before the Trump outcome. I can easily imagine protectionist and populist voices coming to the forefront, which could justify a reassessment of our bond allocation. We already decided to reduce our strong underweight on bonds late in the week of November 8. This is not the only thing at play, but it is one of the elements that could shift you back to bonds.”
JPMorgan estimates that the size of future US fiscal stimulus could be between 1% and 3% of GDP. A fiscal stimulus of 1% of GDP would add around $200 billion to the US government deficit starting from the second half of 2017. The combination of a $200 billion increase in bond supply with the associated $200 billion decline in bond demand would translate into a $400 billion deterioration in the balance between bond supply and demand next year, effectively an 85% reversal of the improvement in 2016.
In the week following the election result, returns in the IG index were minus 1.15%, while the high yield sector fared much better at minus 0.35%. Indeed, the year-to-date total return in high yield was still 14.28%.
Sentiment in high yield remains robust, with many arguing that the sector is far more insulated from the impact of inflation than its investment grade counterpart.
‘Bigger trends at play’
Kennedy argues that any improvement in the US economy will feed through more quickly to these borrowers. “High yield has a higher correlation to improved earnings through revenues, operating margins and free cash flow,” he says. Sunaina Sinha, managing partner at placement agent and secondary market adviser Cebile Capital in London, echoes that sentiment.
“Bonds across the spectrum have already responded in a unified way,” she says. “We are entering a period of higher growth, higher inflation and rising bond yields. High yield will do well as there will be a greater ability for corporates to repay debt. The impact of this in high yield is greater than for other types of bond as this sector is more sensitive to the ability of the borrower to pay back. Investment grade is more sensitive to inflation expectations.”
The repositioning that has taken place since November 8 has again brought the issue of bond market liquidity to the fore. As Euromoney goes to press, however, there have been few signs that the high-yield end of the market is experiencing stress.
The most obvious comparison is the market reaction to the UK’s Brexit vote in June, which triggered a series of open-ended real estate funds to halt redemptions. “The real estate outflows that we saw immediately after Brexit really are a good example of a bad setup,” Zak Summerscale, head of credit fund management at ICG in London, told Euromoney before the US election result. “This is a deeply illiquid asset class packaged in liquid form. Look at every high-yield fund that saw significant redemptions last year (except Third Avenue) and they met them. Funds have still met every redemption, even when forced sellers.”
Summerscale dismisses concerns about liquidity in high yield and believes that volatility in the market is now simply a more accurate reflection of sentiment. “People have got very lazy in credit because banks would always step in and make a market. Volatility has been historically misstated because of the part that the banks played. The problem is not about liquidity, it is about price. No one talks about small-cap equity funds not having liquidity, but liquidity there is the same as that in high yield.”
Rate rise ‘done deal’
The most immediate impact of Trump’s victory in the US election will be at the Fed, where a rate rise in December is now seen as almost a certainty. “A Fed hike in December looks like a done deal, and we now believe that a further four rate hikes will follow in the ensuing 12 months, compared to the one move priced into market forward contracts,” says BlueBay’s Dowding. “There is certainly a sense that we have witnessed a historic and a seismic event, and although treasury yields have risen materially, this move is far from overdone at this point with yields only back to where they were at the start of 2016.”
Despite the sharp change in sentiment towards bonds among investors, bankers remain optimistic that there will still be plenty of primary market activity to keep them busy. “The sharp movements in interest rates, and therefore the secondary prices of bonds, will likely lead to more active liability management opportunities in 2017,” says James Garvey, head of capital markets and strategy at Lloyds Bank in London. “Bond issuers will look to re-coupon debt in order to refresh the pricing of their outstanding bonds and promote secondary market liquidity.”
Whatever happens, the markets will be digesting the long-term implications of Trump’s election victory for many months to come. What has been witnessed so far is merely the beginning.
“None of this is going to be quick,” says Sinha. “The reaction of the market is a reflection of a repricing of risk premia and inflation expectations. This is the realization by the market that this is a gear shift. There is a new cycle beginning, and risk premia in market were not pricing this in.”