Fixed Interest Review Q2 2016
Once again the bond market has perplexed investors with the second quarter ending on historic low yields. The phrase ‘lower for longer’ has never been more apt, incredibly, calendar year to date has seen the ten year UK Gilt yield fall by 44%. This has mainly been driven by the extreme fears ahead of the EU Referendum vote in the UK. Indeed, Central Banks have cited the ‘Brexit’ risk as the main driver for leaving interest rates unchanged. During the quarter we have witnessed the German Bund yield on ten year maturity go negative. In Switzerland, there are now only two issues which offer a positive yield and rates are negative out to 2049!
The Federal Reserve became more dovish as the quarter progressed with the likelihood now of possibly only one increase during 2016. Despite full employment levels in the US economy, Janet Yellen believes there are now long term forces that will mean that aggressive interest rate rises are not needed. She has cited poor productivity growth and aging populations as two key areas of concern. Productivity is a major worry as it is one of the principal drivers behind wealth creation. Currently US labour productivity is trending close to the lows seen post the Second World War. From 2010 to 2015, labour productivity rose just 0.6% per year on average. That’s after averaging nearly 1.9% growth in the previous six years and 2.8% in the decade from 1994 to 2003.
The concern for the US Central Bank following the exceptionally weak May jobs number is that since 1960, an employment growth slowdown has preceded every recorded recession. A September increase in interest rates could also be problematic given the impending US Presidential election. US Treasuries are still offering investors a yield pick-up over other Sovereigns given the rate risks but as time goes on the premium could look tempting. Currently the ten year Treasury is yielding 1.6% and the thirty year issue is offering 2.4%.
UK GDP data has been weak in recent weeks and the Referendum is clearly having a major impact on delaying spending decisions. It is hard to estimate the full impact but in the medium term it is likely to have knocked between 0.5-1% from 2016 GDP. The overall growth rate for the current year has been revised down to 2%.The benefit of a ‘Remain’ vote could not only see a relief rally in markets but also a growth spurt in H2 as capital expenditure projects are given the go ahead. It will be interesting to see the Bank of England response to the Referendum. They believe a ‘Leave’ vote could ‘materially alter the outlook for output and inflation’. They are likely to boost the liquidity in the banking system rather than target interest rates, certainly in the initial stages.
During mid-June, the German ten year yield turned negative for the first time in its history. Indeed over 50% of German bonds are now ineligible for the ECB QE due to the yield being less than the deposit rate. Many analysts believe that if the Central Bank does not relax the parameters that the number of German bonds it can buy will run out by the end of the year. Unfortunately a stronger Euro has led to a sharp slowing in trade levels with virtually flat new German manufacturing orders. The ECB has also struggled to meaningfully boost the credit cycle, with lower borrowing rates not actually substantially increasing the levels of net borrowing. Forecast GDP growth across the region in 2016 should be 1.7% with a 1.8% expansion predicted for 2017.
Clearly Europe is hugely worried by the ‘contagion’ that would impact the region, should a ‘Leave’ vote occur in the UK. Debates on membership are likely to occur in many countries, notably those in Northern Europe which have a close trading relationship with the UK.
Progress in Japan remains painfully slow and there currently seems to be a weakening in the momentum of core inflation, falling below 1% in the core rate for the first time in nearly a year. We expect further easing by the Bank of Japan in July and the current ten year yield is an incredible -0.16%. Indeed, the IMF has recently called for a more flexible monetary policy framework - "Without bolder structural reforms and credible fiscal consolidation, domestic demand could remain sluggish, and any further monetary easing could lead to overreliance on depreciation of the yen," the IMF said.
High yield credit spreads look set to continue to widen with both rising levels of corporate debt and falling profit margins acting as drags on the sector. We highlighted last quarter the concerns regarding liquidity and these have not abated. Issuance in the sector has been running at approximately 40% below 2015 levels.