Fixed income outlook : what's next ? (Photo : Capital Group)

Fixed income outlook : what's next ? (Photo : Capital Group)

What’s going to happen to the macro economy in this new post-pandemic world? “It’s like looking across a valley: we know we need to go down to go up; we are not sure how far down or for how long, but we will get to the other side,” says Jeremy Cunningham, a fixed income investment director at Capital Group.

How is Capital Group’s fixed income approach distinctive?

Capital Group manages USD 450 billion in fixed income assets * and sets itself apart with its strong, consistent returns, its unique approach of analysts investing in their ideas, and its track record - 100% of our fixed income funds returned above peer group median for the 5-year period to 31 December 2020**. We believe it’s always important to build your portfolio from the bottom up. You can’t look at top level valuations alone and invest on that basis.

What is the outlook for 2021 for fixed income?

We think that emerging markets are fundamental as we start to see more growth throughout the world. It is important to have an overarching macro view, but be very specific about which economies you are allocating to. For example, many sub-Saharan African nations benefit hugely from China’s investment and development, which can offer strong yield opportunities. The local currency emerging markets may offer a lot of value. Entering into 2020, local currencies were undervalued to an excessive degree and when the pandemic hit they became even more so with the ensuing devaluations. We think the US dollar could retain some strength in the near term because the strength of its recovery will allow that. However, over the medium term we expect a weaker US dollar and that is the perfect opportunity to take advantage of very attractive valuations in local currencies at some point in the future.

How do you see interest rate movements in the short, medium and long term?

We do not expect monetary tightening anytime soon in the developed markets. It’s difficult to envisage the Federal Reserve (Fed) or the European Central Bank (ECB) raising interest rates within the next 24 months at least. Inflation is relatively volatile, growth is starting to rebound, although we still need some clarity as far as the recovery is concerned. We have had a huge fiscal stimulus in the US, which is going to put money back in consumers’ pockets. As long as we’re in this current phase where we await clarity about the sustainability of the recovery, no policy will be tightened. That’s all pretty much priced in by the market. So the short term is very anchored. The movement we see today on the bond market is at the longer end where we are further down the line in the recovery. The market is beginning to price that in and look much further ahead with respect to demand for risk premium, and inflation one day returning to the economy. That’s where you see yield curves start to rise more steeply.  

How do you see inflation movements in the short, medium and long term?

In developed markets, such as the US, we think inflation will spike in the near term (i.e. within the next 12 months) and then plateau in the medium term (within 18 months). The Fed is very open and clear that it will not increase interest rates even if inflation rises above its target. With that, given the labour market weakness, we don’t see inflation increasing sharply in the medium term. In Europe we see a similar sort of pattern and don’t anticipate a rise in inflation that would trigger the ECB to take action. In emerging markets inflation is picking up, and some central banks have tightened policy in certain areas. Given the growth and underlying structure in some of the economies we could see inflationary pressure pick up but we don’t think it will be too dramatic. We don’t anticipate any structural change, but it’s a purely mathematical base effect; there is going to be a spike in inflation to counter where it fell last year. 

Is there any segment that would give better results than elsewhere: corporate, governments, emerging market debt etc.?

It can be difficult to compare one segment with another. The decision of whether to buy investment grade corporate bonds or high yield corporate bonds depends on how much risk you want to take. The difference between the yield on high yield corporate bonds and the yield on investment grade corporate bonds grows over time. Due to its very nature, by allocating to higher yielding corporate bonds you are taking on more credit risk. An allocation to an investment grade corporate bond doesn’t give you a lot of yield but gives you a core, high quality allocation. 

Given a portfolio that is invested in high yield corporate bonds and emerging market debt, driven by valuations, we would be tilted towards emerging markets, to an extent of 60:40 or 55:45. Emerging markets, particularly local currencies, are offering better value from a risk versus reward perspective. The fundamentals are more supportive of the valuations that are on offer. 

Many markets have moved a long way. You have to be specific and know exactly what risk you are buying, company by company. There are a lot of companies out there that won’t survive, but also many that will and those are the ones you need to have the exposure to. That’s why we spend so much time on our research at Capital, to make sure we are filtering out the very best with a long-term view.   

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* As at December 2020. Source: Capital Group

** Sources: Capital Group, Morningstar