Investors will need to be both patient and agile to extract further value from bond markets for the remainder of 2014, according to Schroders’ Gareth Isaac.
The manager of the group’s Strategic Bond fund said US Treasury yields remain low, as do government rates across the developed world, in spite of a broad improvement in economic data.
Meanwhile, in credit markets and peripheral eurozone sovereigns, valuations are now looking stretched. The prices of bonds move inversely to yields, meaning if yields are low, prices are high.
“We retain our belief the US and the UK will outperform the wider global economy in 2014, but this has been a painful viewpoint so far,” he added.
“Key trades to take advantage of the theme – being short US and UK bonds and holding the US dollar in favour of various other currencies – have failed to bear fruit. Low levels of headline inflation have allowed the Federal Reserve and the Bank of England to maintain an accommodative stance beyond the time we could normally expect discussions of tightening.
“However, we believe disinflationary trends in the US and UK economies are now coming to an end. Unemployment levels have been falling consistently and signs of wage inflation have begun to appear, so we expect central banks to shift their rhetoric to prepare markets for initial stages of policy tightening.”
Conversely, Mr Isaac said the European Central Bank (ECB) is acting too cautiously in implementing monetary easing, with several eurozone economies slipping into deflationary trends.
ECB president Mario Draghi announced in June a raft of measures to try and stimulate the European economy, by effectively charging banks to keep deposits with the ECB and providing cheap money for banks to lend to businesses. Mr Draghi’s aim, market participants have argued, has also been to weaken the euro, which would be a tailwind for exporters.
“In spite of the ECB’s June rate cuts taking the deposit rate into negative territory, we still believe quantitative easing will be required later in the year,” Mr Isaac added.
“As the monetary policies of the US and the UK begin to diverge, we favour exposure to European rates over the US and the UK, as well as short positions in the euro against the dollar.”
With central bank policy driving artificially low volatility, Mr Isaac said this had instilled a degree of complacency into certain markets, primarily peripheral eurozone debt and US and European credit, pushing valuations to unattractive levels.
“These assets have seen prolonged demand from investors seeking yield in a low-rate environment,” he added.
“Although the Fed is unlikely to hike rates until 2015, any shift in market expectations may make life difficult for investors with sizable positions in these expensive asset classes.”
Moving to the emerging world, Mr Isaac said that with China walking the tightrope between structural reform, growth and reducing the amount of debt in its financial system, this would produce scares for wider financial markets and pain for China-sensitive assets.
“Structural reforms in the so-called ‘fragile five’ have begun to create some attractive opportunities,” he added.
“In particular, local currency debt in economies that have hiked their key interest rates as part of their adjustment – South Africa, Brazil, Turkey and Russia – look compelling. Though a more hawkish Fed stance could introduce volatility, we would see any short-term setbacks as an opportunity to enter markets at attractive levels.”
