Keep on expecting the unexpected

Opec appears in disarray, there’s still too much supply, geopolitical tensions between Saudi Arabia and Iran are not helping matters, and there are concerns about global economic growth.

Inflation is a difficult variable to predict and, in the past couple of years, it has always been low compared to the consensus among economic forecasters.

This opens up potentially interesting opportunities on both the upside and downside in terms of the oil price and inflation levels. Inflation-protected markets globally have priced in almost no recovery in inflation expectations. Indeed, the market has extrapolated the recent drop in oil prices to long-dated inflation expectations – effectively saying oil prices will stay low for 10 years.

In Europe, inflation is expected to take more than 30 years to return to the 2 per cent level. So long-dated inflation breakeven rates are extremely low, because the inflation market is completely out of fashion. Any significant bounce in the oil price would lead to an immediate rise in inflation breakeven rates, particularly as these rates have fallen to recent lows.

Were the oil price to fall to the low $20s, on the other hand, it could have significant implications for other asset classes. US credit markets, with their relatively high weighting to the energy sector, might underperform. But there are other potential losers, such as banks that specialise in lending to the energy sector.

This year could be all about supply and demand for fixed income. As economies continue to expand and budget deficits gradually fall, many countries have less need to issue bonds.

Fixed income bulls point to this reduction in supply, along with the presence of big buyers like the European Central Bank (buying €60bn a month, every month, until March 2017), as a reason why bond yields may be underpinned around current levels. So in net terms, after taking account of redemptions, the supply of euro-area government bonds will be negative.

But the picture may not be so rosy. Many emerging market countries are having to sell portions of their reserves to support their economies or protect their currencies. These are generally held in either US dollar or European bonds, and liquidating these holdings will put upward pressure on bond yields.

This effect could be compounded by markets anticipating the end of European quantitative easing (QE). If the ECB gives no signs of extending its QE programme, markets will, by the start of the third quarter of 2016, start pricing the withdrawal of the ECB as the biggest buyer of euro-area sovereign bonds.

After relatively skinny returns in 2015, some investors may re-allocate away from fixed income benchmark funds and more towards alternative sources of income. If this occurs against a backdrop of a reasonably strong economy and higher inflation, investors will demand a higher yield to invest in government bonds.

The year ahead, like the one just gone, may well be characterised by surprises, from central banks, inflation, liquidity issues or geopolitical risks. After all, nobody predicted that the oil price would fall to current levels, and there are many issues that could signal higher volatility for markets.

For instance, how many Fed rate hikes will there be? Will the ECB announce further QE measures? Will wage growth recover in global economies? Will the UK still be in the EU at the end of 2016? The year will demand careful management of potential shocks in fixed income markets and awareness of liquidity risk, especially in high yield and emerging markets.

Active managers should thrive, as they can still find opportunities to generate alpha in this uncertain climate. In years gone by, when returns from fixed income were more attractive, alpha generation was almost a luxury as beta returns were quite high.

With predicted returns from fixed income set to be in the low single digits at best, alpha generation becomes much more important. It will pay to look towards selection at country level, but also to relative value opportunities created by the divergent actions of central banks. While the normal sources of alpha will still be available (credit selection, foreign exchange, country spreads etc), investors also need to be vigilant for new ones. Last year taught us that some supposed certainties weren’t so certain (the Swiss franc currency floor, US dollar/yuan peg). There might be more of these in 2016.

Tanguy Le Saout is head of fixed income Europe at Pioneer Investments