Strategy: Bond yields firm as markets accept limited span of loose policy

01 Nov 2016

  • Is global growth improving?
  • Markets spooked by higher bond yields
  • Asset allocation: enough risks to stay cautious

Equity markets generally continued to struggle in the past week. After setting an all-time high in the middle of August, the S&P500 index has trended lower and European and emerging equities have moved broadly sideways for the past two months. Japan is the exception as recent yen weakening has been supportive. We think the main headwind for equities at this point is investor concern over higher interest rates. Amid the uncertainties over the course of monetary policy, bond yields and political developments, we favour a cautious asset allocation.


US economic growth improved strongly from the first half of the year, with the 2.9% QoQ annualised pace of the third quarter the fastest since the third quarter of 2014. That is where the positive news ends though; the details of the GDP report revealed weakness. Consumption growth slowed and business investment in larger equipment fell for the fourth straight quarter. Residential investment was negative.

So what drove headline growth? Exports surged, driven by soybean exports after droughts in Latin America, where there was a slight increase in inventories. Since exports should fall back after the (one-off) surge and inventories are still high relative to business sales, we conclude that half the Q3 growth came from two unsustainable sources. Moreover, growth in household real disposable income has lost some steam after peaking in December 2014. The September drop in capital goods orders excluding defence and aircraft, low capacity utilisation in manufacturing and modest profit growth do not bode well for investment.

We think the recent data will still be strong enough for the US Federal Reserve (Fed) to raise policy rates in December, even if the current pace of growth looks unsustainable to us. That said, the US economy should continue to grow. The Markit manufacturing and services PMIs improved recently, both remaining firmly in growth territory.

The numbers in Europe have been more positive lately. The manufacturing and services PMIs both rose, bringing to a halt the downward trend that started in late 2015. The Economic Sentiment Index rose to its highest since last December, with strong gains in Germany, Italy, the Netherlands and Spain. In Germany, the Ifo index improved further after its surge in September. Thus, leading indicators point to a reacceleration of growth.

This renewed optimism may be related to the modest impact of the Brexit vote so far. We still expect the UK economy to slow further as business investment is hit. Growth in the eurozone was 0.3% QoQ in the third quarter, unchanged from the second and close to its trend rate, meaning that inflation should increase only gradually from the current 0.8% core rate.

Data from Japan has been quite weak recently. Industrial production was flat QoQ in September and several measures of consumption have been anaemic. The economy certainly does not look strong enough to create sustainable inflation: core inflation is moving in the opposite direction to what the Bank of Japan wants.

In emerging economies, most manufacturing PMIs improved. In China, the index jumped to its highest since July 2014, driven primarily by domestic, stimulus-driven factors such as infrastructure and construction spending. Measures for South Korea and Turkey remained below 50, signalling contraction, but growth in most emerging markets appears to be improving after the weakness seen in the first half of the year.


Despite the generally positive economic numbers recently, equity markets have struggled, while in credit markets, spread narrowing seems to be ending amid investor concerns over higher interest rates. In our view, the economic environment has not changed much, leaving the Fed on track for a gradual and modest tightening of policy, the ECB and the BoJ in accommodative mode and emerging market central banks in a position to cut rates further.

In the US, market expectations for short rates and the Fed’s current projections are not aligned. The median of Fed policymakers’ projections currently calls for one rate rise this year and two increases in 2017. Markets are discounting just two rate rises between now and the end of next year. That looks like a minor difference in views and we believe that one more increase than currently discounted should not necessarily derail equity markets. But a change in the markets’ perception of the upcoming Fed moves would likely have a greater impact on financial assets than policymakers changing their view.

As for ECB policy, the tapering genie seems to be out of the bottle, even though the ECB itself keeps insisting that this topic is not being discussed. Still, if growth holds up, policy hawks may see a chance to press for a slower pace of asset purchases after March 2017. The quid pro quo could be a six-month extension of the asset buying programme. This would mark the start of tapering, but the ECB would likely focus its message on the extension. Bond scarcity could also justify a slower pace: if there are fewer bonds for the ECB to buy, it could keep market interest rates down with fewer monthly purchases. We do not expect the ECB to slow its asset purchases after March. However, the point is that monetary policy is no longer a one-way street towards more stimulation. This is now reflected in higher bond yields in Germany and the US.

The weak economic data has not spurred the BoJ into action, perhaps unsurprisingly since it has just set up a new policy framework. After the latest policy meeting, governor Kuroda once again had to postpone the date at which the BoJ expects to reach its 2% inflation target. Leaving policy on hold, the outcome of the meeting felt like the BoJ acknowledging it has come to the end of what it can do. Taking a broader perspective, this lack of action has fed the market’s view that the peak of global stimulative monetary policy is now behind us.


Ten-year yields in the US have risen to above 1.8% for the first time since May. German yields have also risen back to May’s levels. If everything were well, equity markets should be able to cope with these higher bond yields. We expect yields to stay low for a protracted period since there are not many inflationary pressures outside of the US or apart from commodities, and trend growth rates for GDP have fallen globally. But low does not mean that benchmark yields in Germany should trade at around zero, even when nominal growth in the eurozone is above 2.5%. It is the same in the US: yields are also significantly below nominal growth.

Besides, not all is well. Recent economic data has shown weakness, the US political outlook keeps shifting, Europe is not free from political risks either and equities look expensive historically. It is not easy to find attractively-priced asset classes these days, but in a low-growth, low-inflation environment, credit tends to outperform equities. Eurozone inflation-linked bonds look attractive, mainly because they reflect an overly pessimistic view on future inflation.

In emerging markets, monetary policy easing should lead to lower yields and should thus be beneficial for local currency bonds, but most of the easing has already been discounted. We have a neutral position. A stronger US dollar would be a risk. We have kept our underweight in hard currency emerging market debt given the increased leverage and poorer credit ratings.

In currencies, we also see China as a risk. The Chinese renminbi has fallen clearly against the dollar without markets giving it much notice. Net capital outflows have risen again lately, causing the authorities to introduce measures to curb the seepage. While earlier this year corporate debt repayments dominated the flows, they now seem to reflect more capital flight.

We are underweight commodities, partly because we do not see scope for sustained oil price gains. OPEC members including Iran and Iraq are unwilling to cut output, as is Russia, which is not a cartel member. Thus, prices have fallen to the middle of the range seen since May.

WSU 01Nov16

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