More volatility could see flight to quality

Further volatility seems to be on the menu at the start of 2015. A flight to quality could be sparked by the falling price of oil, the possibility of a US interest rate hike, and concerns that yesterday’s (January 25) Greek elections could cause repercussions in the eurozone if the left-wing coalition Syriza is elected.

Russ Koesterich, global chief investment strategist at BlackRock, notes that in the first week of this year it was the ‘safe-haven’ bonds that fared better, as “the combination of risk aversion and lethargic global growth pushed up prices and drove yields lower”.

He explains that investor anxiety appears to have been driven primarily by geopolitical concerns regarding politics in Greece and the economic situation in Russia.

But he notes: “Neither the issues in Greece or Russia are particularly new. What is changing the investment landscape is the growing likelihood that the [US] Federal Reserve will hike interest rates this year for the first time since 2006.

“More evidence to support that view came from the December employment report. Job growth continues to accelerate, as evidenced by the 252,000 in net new jobs last month.”

Mr Koesterich adds: “Wage growth unexpectedly fell and the labour participation rate is still stuck at a 37-year low. But these issues are structural, not cyclical, and therefore do not lend themselves to continued monetary accommodation. With the economy on solid footing, the Federal Reserve should start to move sooner rather than later, probably by June.”

Christine Johnson, head of fixed income at Old Mutual Global Investors (OMGI), notes that the more difficult it gets for emerging markets, amplified by factors such as the falling price of oil, “the more there is a flight to quality and a demand to get out into safe-haven assets”.

She points out that slower growth in emerging markets and the weak backdrop in Europe is resulting in flows back into developed market bonds. This is essentially an unwinding of the carry trade that resulted from quantitative easing (QE).

But with the ECB expected to implement further monetary easing measures, including full QE, how will this affect credit markets?

Chris Higham, manager of the Aviva Investors Strategic Bond fund, points out market expectations for ECB stimulus remain high, “and as a result European investment-grade markets have continued to see spreads tighten in contrast to other credit markets”.

He says: “Mario Draghi has stated his commitment to expand the ECB’s balance sheet, as other central banks have done before him, but we are unlikely to get the full detail of this until after the Greek elections have taken place.

“The main concern of both the ECB and the Bank of Japan are inflation expectations. European data showed the currency block had moved into deflation in December, largely driven by falling energy prices.

“The recent downward move in oil prices has further complicated the outlook for inflation.”

But the oil price decline is not all bad news, with Ms Johnson noting it can have a major impact on the US consumer, in a similar way to a tax cut or a wage increase.

“The US could have very strong growth and we could see deflationary pressures dropping off,” she says.

“It could be a year of two halves with much better growth [later in the year], and that could see the Federal Reserve a bit behind the curve.”

However, what is clear is that volatility will remain a key issue in the early part of this year and, as Mr Koesterich notes, adopting a more tactical approach to their portfolio could be the best strategy for fixed income investors.

Nyree Stewart is features editor at Investment Adviser