Fixed Income Boutique
The year has started on a high note with investors hyped up on big expectations and valuations reaching new highs. Market participants seem to feel they have been teleported back to early 2009 heralding the onset of a massive new credit cycle that will boost every asset class for the next years. However, as things stand today, the blue-sky scenarios of a strong US recovery supported by a massive blue wave of increased fiscal expenditures, a “reflation-without-inflation” world and a return to pre-crisis corporate profit margins have been nearly fully priced in everywhere. This is why the potential for disappointment in the first part of the year is big and investors should prepare for volatility, which could arise from the following scenarios:
Should several of the above scenarios conspire to derail the current market rally, the Fed as well as other major central banks are likely to step up their quantitative easing measures again, which would send bond yields back down. Commodities, US high-yield bonds and a number of emerging market sovereign bonds would suffer. Equities would see some stress and credit markets would be pricing in more defaults.
In contrast, if the blue skies remain cloudless, the equity rally is likely to continue while investors will make a massive shift into the real economy, which will most likely benefit retail, leisure, travel and discretionary consumer goods. As a result, sectors of the new economy might see flows drying up a bit. In fixed income, emerging-market, investment-grade corporate as well as high-yield credit spreads, especially in the energy and real economy sectors, will continue to compress.
On a bumpy road with volatile prices, investors should invest in assets that either have not fully priced in the blue-sky scenarios yet or that have nominal yields big enough to protect against any disappointments. Big-yield securities are less sensitive to duration and the income they provide can cushion volatility. Examples are good-quality yields in financials, in some emerging market sovereigns and corporates, and in some high yield. In emerging markets, corporate credit currently offers big yields at increasing margins and falling debt levels, whereas EM sovereigns are getting crowded and yield potential is decreasing. European financials and insurance companies are attractive as their fundamentals are sound and the European Central Bank will make sure they continue to be properly financed. The energy sector is likely to thrive this year as long as China powers on and consumer cyclicals look attractive from a valuation standpoint. Overall, active duration management with the option to go short duration and solid portfolio construction will be key in mastering the months to come.