In our monthly fixed income market outlook, Rick Rieder, BlackRock’s Chief Investment Officer of Global Fixed Income, argues that recent monetary policy announcements out of Japan and the U.S. highlight how both policy and rate divergence are themes that remain firmly on the table. Further, he contends that today’s investment environment poses a tremendous challenge to many investors, as return and income potential grow ever more scarce and the probability of capital losses has meaningfully increased. Finally, he suggests that debt investors must become more introspective today regarding their strategies, and traditional measures of debt sustainability and valuation must be augmented by analysis that adequately comprehends the tremendous secular changes at play in the world.
Market Outlook Summary:
- Unexpectedly, the Bank of Japan recently appeared to shift away from its emphasis on negative policy rates and instead announced a significant policy adjustment that seeks to effectively adopt a yield target at the 10-year part of the curve. At the same time, the central bank put forward a plan to overshoot its 2% inflation target in an intentional manner. In our view, the intent here is to modestly steepen the yield curve, helping improve financial-sector profitability, which has suffered under the negative rate regime. Meanwhile, we think it’s clear that the majority of Federal Reserve policy committee members would like to execute another rate hike in the near future. That would be consistent with a deliberate policy rate normalization path in the context of lower than historic levels of natural long-run interest rates. Thus, while the committee is unlikely to move at its November meeting (as it comes a week before the U.S. elections), we do think the probability of a December rate hike has increased materially.
- The combination of excessively low real rates and large aging demographic cohorts demanding yield/return has produced a massive scramble for income globally. Such high levels of demand drive debt market valuations to extremes, leaving little room for error. This environment results in tremendous challenges for investors that seek to match return targets, or for those who rely on yield to fund future liabilities, generate earnings, or build capital. In fact, pension managers are being impaired in their ability to invest in such a way as to match liabilities, banks are having trouble extending credit to build their net-interest-margins and earnings, and insurance companies’ business models are under increasing pressure. Additionally, the probability of capital losses has meaningfully increased with stretched fixed income asset valuations and we have recently witnessed a significant spike higher in the equity/bond return correlation. That suggests that bond allocations have for the time being become less effective at mitigating overall portfolio risk (see Figure 2 from the market outlook).
Figure 2: Spike in the stock/bond correlation adds to investor challenges
Source: Bloomberg, data as of September 2016
- As a result of evolving monetary policy regimes around the world, a broad-based global scarcity of return/income potential, questionable corporate capital allocation decisions, and elevated levels of political and policy uncertainty, we think debt investing today requires very careful introspection. In our view, the stability of growth around the world depends a great deal on the sustainability of its funding, at every level of the economy. And when considering issues such as credit quality and debt sustainability we must not only look to credit rating measures, or traditional metrics of interest coverage, but must also now focus on other vital considerations that are often overlooked, such as the assessment of debt sustainability relative to the growth/inflation paradigm of the industry under analysis. That latter tool is particularly critical during periods of dramatic economic transformation; such as we are facing today.
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