This year may be remembered for its low volatility and the strong performance of nearly all asset classes across almost all geographic markets. But 2018 may follow a different playbook. Compressed bond yields and tight credit spreads present challenges—and volatility could make a comeback as monetary policy turns and political controversies resurface.
What should European fixed-income investors watch out for? Six factors look likely to have most IMPACT on bond portfolios.
Inflation. US inflation could surprise on the upside if growth accelerates as oil prices stabilize, labor market slack narrows and wage inflation pressure builds—and it could be further stoked by fiscal stimulus. Sustained inflation shocks could force a more aggressive rate-hiking response from the US Federal Reserve (Fed) than markets currently expect. Inflationary pressures in Europe are more muted, but stronger-than-expected regional growth and, consequently, an improved inflationary outlook might see the European Central Bank (ECB) slowing its quantitative easing (QE) program faster than markets are pricing in.
As developed-world bond yields come under pressure from stronger inflation and rising rates, some emerging-market (EM) debt could rally as falling inflation allows local central banks to ease. Keep an eye on Mexico where inflation is set to drift lower throughout 2018.
Monetary policy. With the global recovery strengthening, central banks across the developed world will press ahead with monetary policy tightening. Four more rate hikes are on the cards in the US in 2018 and we expect the Bank of England to raise rates at least once more next year. The ECB isn’t likely to hike before 2019, but QE tapering will exert upward pressure on euro-area bond yields. The shift towards less bond-friendly policy will likely be gradual—but markets could be caught off guard if big inflation or growth surprises see policy quickly turn less accommodative.
Populism. Concerns about globalization, immigration and austerity will continue to drive support for populist politicians with unpredictable policy agendas that could trigger market unease. Potential hot spots include Italy, where the anti-globalization, Eurosceptic Five-Star Movement may gain ground as general elections in May approach. Spain is vulnerable given uncertainties associated with Catalonia’s bid for greater independence. In Germany, Chancellor Angela Merkel is still struggling to form a workable coalition government. Continued stalemate could force fresh polls—with a risk that the populist right-wing Alternative für Deutschland might rock the boat.
Latin America has a busy election schedule in 2018. Polls in Colombia in May, in Mexico in July and in Brazil in October could all spark political tensions that might drive up political risk premiums on these countries’ sovereign bonds.
Active selection. With some bond valuations looking stretched—and scope for markets to turn more volatile—security selection will matter more in 2018. European financials should continue to benefit from the improving economic backdrop. We favor the more subordinated (AT1) debt issued by national champion banks that have strengthened their balance sheets most. US mortgage-backed credit is an attractive income generator and diversifier that’s benefiting from the US housing market’s continued recovery. We’re emphasizing credit-risk transfer securities (CRTS) whose floating rates are appealing as US interest rates rise.
China is seeking better balance between the pace of growth and its quality—which will bring greater emphasis on greener policies, overcapacity cuts and financial deleveraging. This is likely to curb growth in the longer run and 2018 could prepare the transition to this new economic era. We’re not expecting a hard economic landing for China, but markets might see some volatility as they digest the implications of softer growth.
Trump. Last, but certainly not least, President Trump’s policy agenda is a significant wildcard for the global economy and financial markets next year. President Trump will face considerable pressure to deliver on big policy pledges ahead of mid-term elections in November. The US economy will almost certainly prove strong enough to weather policy controversies—but business confidence could suffer if there’s prolonged uncertainty about the timing (and extent) of significant legislative shifts.
• Keep your balance. Compressed bond yields have forced investors to take on greater risks to earn decent returns. Bond portfolios that balance riskier exposure with higher-quality bonds should prove more resilient if markets suddenly turn volatile.
• Dial down duration—particularly in Europe. With yields on some euro-area government bonds (particularly Bunds) still very compressed, it seems prudent to tone down duration (interest-rate) risk in Europe. Upward pressure on yields could turn unruly if ECB policy shifts faster than markets currently expect. And duration dynamics could quickly impact on US bond prices if US inflation consistently overshoots Fed expectations and prompts the Fed to pick up the pace of rate rises.
• Seek out relative value in credit. More positive growth trends are likely to underpin global credit markets, but it will pay to seek out pockets of relative value—like higher-yielding AT1 bonds issued by Europe’s most recapitalized banks and CRTS issued by the US government housing agencies.
• It’s not too late to reap emerging-market tailwinds. Emerging-market debt enjoyed a strong 2017—next year may prove trickier, but it’s not too late to find attractive opportunities. Most emerging-market countries stand to gain from improving economic fundamentals, stable or falling inflation and high real yields relative to developed-market debt—although these tailwinds could be partially offset by higher US interest rates and a stronger US dollar.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.