It’s fair to say that, at the start of 2016, few would have predicted we would end the year with US President-elect Donald Trump readying himself to move into the White House, and the British establishment at loggerheads over the form – hard? soft? somewhere in between? – that the country’s departure from the European Union should take. Add to this the odds of Leicester City winning the English Premier League, and one bookmaker was quoting potential winnings of £12.5 million (HK$119 million) on a stake of just £5. Even with sterling’s recent sharp decline a return like that is hardly to be sniffed at.
Following a bear market in 2015 for many parts of the bond markets, 2016 was more positive overall, despite significant volatility. As ever, central bank moves have proven pivotal. Since the US Federal Reserve hiked interest rates in December 2015 – the first time in almost 10 years – it held its fire for almost all of 2016, having just confirmed another 0.25 per cent rise that markets had already priced in.
At the other end of the scale, the European Central Bank (ECB) chose to extend its asset-purchase programme in March, while Britain also opted for further monetary stimulus – along with a rate cut – in August, as it changed course to counteract the perceived negative impact that the Brexit vote would have on the country’s economy.
Meanwhile, spreads on investment-grade credit and high-yield bonds have tightened, the latter substantially. High-yield defaults remain elevated compared to recent years, although this has been skewed by energy sector issuers. A gradual increase in the oil price should in any case reduce some of the pressure on these names. And after a torrid 2015 for emerging markets, the asset class experienced a far more positive ride in 2016, at least until Trump’s victory in November.
A sharp sell-off in government bonds was among the key reactions in financial markets to the US election result, although it is as yet unclear whether this is just another blip, or the start of a more sustained move back towards normal yield levels after years at close to historic lows.
Importantly, with the Republican Party in control of both the Senate and the House of Representatives, Trump should have the political power to advance his headline economic policies of significant infrastructure spending and big cuts in corporation tax. Expect follow-through on trade protection measures as well, starting with his stated intention to withdraw the US from the Trans-Pacific Partnership (TPP) on his first day in office. The repatriation of some immigrant workers and Trump’s border wall is also likely to stay on the agenda.
For bond investors, it’s a cocktail that adds up to increased government borrowing and firmer inflation prospects.
In Asia, much attention will be focused on US relations with China. In terms of this high-profile theme, any imposition of trade tariffs and whether the US Treasury will name China as a currency manipulator will be the key events to watch. Indeed, against this backdrop, the uncertainty of US-China relations is a critical risk in the outlook for emerging bond markets. With concerns over Fixed Asset Investment and decelerating growth, a “hard landing” in China is closer unless significant monetary stimulus is offered.
Given this view, the preference is to avoid China within a global bond strategy. The outlook for the yuan is uncertain, given that as well as the unknown development of US-China relations, further US dollar strength alone would add downside risk to the yuan framework. Better relative value can be found elsewhere in the global emerging bond markets on a selective basis. In Asia, for example, preferences include Indonesia, where sovereign valuations look appealing after the market was unduly punished amid the post-US election sell-off. Inflation-linked government bonds in Thailand are also to be favoured. In contrast, be wary about markets such as Vietnam, a country with a relatively high US export dependency relative to its GDP. As such, Vietnam is an example of a country that stands to lose out from any moves towards trade protection measures in the US, as well as Trump’s rejection of the TPP trade agreement.