The importance of income today (and our bond market views)

Scott Thiel |Jul 18, 2019

We see income, or carry, as the key driver of bond market returns in today’s low-for-long world. Scott explains, and shares updated granular views of various fixed income asset classes.

Central banks are shifting toward monetary easing, as they seek to cushion a global growth slowdown sparked by rising trade tensions. This policy pivot should extend the long expansion, we believe, creating a supportive backdrop for income-generating assets. We see income, or carry, as the key driver of bond market returns in today’s low-for-long world, as we write in our new Fixed income strategy All about income.

The Federal Reserve now looks ready to trim rates as insurance against any slowdown. Yet with a recession unlikely, we believe markets are counting on too many Fed rate cuts and could be disappointed. We see the Fed likely cutting rates as insurance against escalating trade conflicts, but failing to deliver on the four quarter-point rate cuts through 2020 that markets were recently pricing in.

In contrast, we expect the European Central Bank (ECB) to meet — or even exceed — stimulus expectations. ECB President Mario Draghi looks set to commit the central bank to more stimulus in his final months in office before a successor takes the reins in November. We expect ECB measures in the form of both deeper negative interest rates and more quantitative easing as a result. Elsewhere, the Bank of Japan is mulling more stimulus measures on top of its mega asset purchases, as inflation shows no sign of reaching target and the yen has remained strong.

Read more on our views and key themes for fixed income in our latest Fixed income strategy.

This dovish pivot by central banks and a slowing, but growing economy, bode well for income-seeking investors, in our view. Bond yields’ recent plunge has created challenges for investors in an already yield-starved world. With geopolitical crosscurrents and policy at the ready for easing, stability in yields is our base case for global fixed income for the months ahead.

We are overall more positive on credit markets, where valuations still look decent. Credit yields have fallen to the bottom of recent ranges, driven by the decline in government bond yields and tightening yield spreads. See the Income wanted chart below. Yet spreads still leave some cushion against the risk of rising rates.

At the same time that we see central banks’ dovish pivot extending the long expansion, we have downgraded our global growth outlook as trade disputes stoke greater macro uncertainty. We expect U.S. growth to cool to around trend-like levels just below a 2% annual rate. The eurozone is steadying after last year’s abrupt slowdown. China’s growth is finding its footing but looks to be at risk of staying sluggish due to the tariff fallout.

In the near term, tariffs and the uncertainty around trade policy could deliver a one-off boost to prices, damage business confidence, and discourage capital spending. This comes at a time when our Inflation GPS already points to upside risk in U.S. inflation in coming months.

Our views on specific fixed income asset classes

The possibility of a snapback in yields leads us to downgrade our tactical view on U.S. Treasuries. But even at today’s yields, we still see an important role for long-term government bonds as key stabilizers against a backdrop of rising macro uncertainty. We now prefer long-term eurozone sovereign bonds over their U.S. counterparts, given what we view as markets’ more realistic expectations for the ECB. And U.S. dollar-based investors can pick up an immediate yield boost after hedging euro-denominated exposures back into their home currency, because of the interest rate differential between the two regions.

The table on our Fixed income strategy site highlights our updated granular fixed income views from a U.S. dollar perspective over a three-month horizon. These views and comments are from a fixed income-only perspective, and may differ from whole-portfolio tactical views on fixed income in our Global weekly commentary and Midyear 2019 Global investment outlook. For example, we overweight Asia fixed income from a bond portfolio perspective because of these bonds’ income potential. Yet we are neutral on this asset class in a multi-asset context, where we prefer to take economic risk in equities.

The risks to our views

Global trade and strategic tensions between the U.S. and China could escalate or broaden to the Americas, Europe or other Asian economies. This could hit market sentiment, lead to an extended lull in major economies and weigh on global growth. And even if monetary and fiscal policy support helps extend the life of this cycle, we could still face the prospect of slower growth and higher inflation.

Heightened macro uncertainty could also herald a shift to a new regime of more frequent risk asset selloffs and higher financial market volatility. This is why we believe that building portfolio resilience is critical as this cycle continues to age, as detailed in our Midyear 2019 Global investment outlook.


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