Fixed Income

Trump, bonds and the global
re-flation trade

Ben Edwards |16-Dec-2016

Will 2017 provide us with opportunities to actively manage risk in volatile markets?

If only we had known that the resolution to the multi-year disinflationary malaise that has gripped the economic world for eight years was an unexpected presidential victory for Donald Trump! It seems a little too easy to me, however, had we known then what we know now, there would have been as many bond manager’s selling UK Gilts at 0.60% and US Treasuries at 1.40%1 as there are now highlighting the obviousness of the recent move. While hindsight is 20/20, admittedly better than my foresight, we got a few things right over the summer and protected investors in the BlackRock Corporate Bond Fund* and BlackRock Sterling Strategic Bond Fund* from much of the volatility in bond markets.

We reduced our exposure to interest rates after the referendum in June and continued to reduce throughout the summer, reaching our most defensive position as Gilt yields hit their lows in August. Not because we expected the end of the global bond bull market, but because the yields assumed a level of infinite policy accommodation that seemed at odds with a rapidly falling pound and relaxed fiscal stance. We reduced exposure to interest rates again after the US presidential election. Not because we expected the end of the global bond bull market, but because a Trump presidency demanded both an uncertainty premium that wasn’t present and a recognition that many of his proposed policies, if enacted, could lead to inflationary pressure and a more hawkish Federal Reserve. Both of these decisions served our investors well.

Next year will provide us with opportunities to actively manage risk in volatile markets

Where does that leave us with Gilts now offering 1.40% and Treasuries closer to 2.50%?2 Perhaps disappointingly, it leaves us closer to fair value, in my opinion, and with the BlackRock Corporate Bond Fund and BlackRock Sterling Strategic Bond Fund closer to “home” at 6.5yrs and 4yrs of duration3, respectively. With risks now more balanced, the one certainty is that next year will provide us with opportunities to actively manage risk in volatile markets.

Ultimately, dollar strength is the binding constraint on the US economy and future rate hikes

In the US, markets seem to be crediting Trump with all of the upside and none of the downside of policy proposals. Benefits of fiscal expansion, tax cuts and deregulation are assumed, while the negative effects of lower world trade and political instability are, for the moment, ignored. Ultimately, dollar strength is the binding constraint on the US economy and future rate hikes. With expectations for US monetary policy clearly at odds with the rest of the world we may see the effect of recent currency moves take hold, dampening growth, before many of Trump’s policies are enacted.

In the UK, measuring the effect of a potential BREXIT a few months after the vote is folly, but our expectation is that resilient consumer spending will give way to weaker business investment and construction in the new year. The effect of this more fragile growth outlook on gilt yields will be offset, to some extent, by higher government borrowing and higher, currency induced, headline inflation. One of our core themes – that BREXIT will ultimately be worse for Europe than for the UK will be tested next year, as will the pound's ability to depreciate further versus the Euro, a currency which continues to face political and economic headwinds.

Structural factors (including demographics, weak productivity and excess savings) that drove yields lower persist

The US story has changed, no question. But I can’t help but remember that Japan and Europe are still undershooting their inflation target significantly. China is in consolidation mode after a twelve month debt binge and many emerging economies will likely struggle with a stronger dollar and world trade that may be even lower than the current tepid levels. While the efficacy and permanence of quantitative easing has been rightly questioned, the structural factors (including demographics, weak productivity and excess savings) that drove yields lower persist. With Christmas soon upon us, 2017 is shaping up to look a lot like 2016 – diverging regional economic paths, questioning of accepted policy tools, heightened political risk and general uncertainty. In my view, fertile ground for active fixed income managers.

Ben Edwards
Director, lead fund manager of BlackRock Corporate Bond Fund and co-manager of the BlackRock Sterling Strategic Bond Fund
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1Source: Bloomberg as at 12/08/16
2Source: Bloomberg as at 12/12/16
3Source: BlackRock as at 12/12/16
*Source: Morningstar, as at 30/11/16 the BlackRock Corporate Bond Fund's performance was top quartile over 3 and 5 years in the IA Sterling Corporate Bond sector. The BlackRock Sterling Strategic Bond Fund was top decile in the IA Sterling Strategic Bond sector for 6 months ending 30/11/16. The BlackRock Sterling Strategic Bond Fund launched on 17/5/16.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of December 2017 and may change as subsequent conditions vary.

Fund Specific disclaimers:
BlackRock Corporate Bond Fund:
Overseas investment will be affected by movements in currency exchange rates.
Where some or all of the fund's charges are taken from capital rather than income, this will increase yield but decrease the potential for capital growth. The Fund invests in high yielding bonds. Companies which issue higher yield bonds typically have an increased risk of defaulting on repayments. In the event of default, the value of your investment may reduce. Economic conditions and interest rate levels may also impact significantly the values of high yield bonds. The Fund’s investments may have low liquidity which often causes the value of these investments to be less predictable. In extreme cases, the Fund may not be able to realise the investment at the latest market price or at a price considered fair. The fund invests in fixed interest securities such as corporate or government bonds which pay a fixed or variable rate of interest (also known as the ‘coupon’) and behave similarly to a loan. These securities are therefore exposed to changes in interest rates which will affect the value of any securities held.

BlackRock Sterling Strategic Bond Fund:
Two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to repay the principal and make interest payments. Fixed income securities issued by governments can be affected by the perceived stability of the country concerned and proposed or actual credit rating downgrades. The Fund invests in fixed interest securities issued by companies. There is a risk of default where the issuing company may not pay income or repay capital to the Fund when due. The Fund’s investments may have low liquidity which often causes the value of these investments to be less predictable. In extreme cases, the Fund may not be able to realise the investment at the latest market price or at a price considered fair. The insolvency of any institutions providing services such as safekeeping of assets or acting as counterparty to derivatives or other instruments, may expose the Fund to financial loss. The Fund uses derivatives as part of its investment strategy. Compared to a fund which only invests in traditional instruments such as stocks and bonds, derivatives are potentially subject to a higher level of risk.

CARS ref: UKRSM-0310