Fixed Income Investing In A Changing Market

Sarang Kulkarni of Vanguard
While rising bond yields and widening credit spreads set the scene for most of 2018, global credit markets have staged a strong recovery in the first quarter of 2019.
Changes in interest rate policy from the US Federal Reserve and the European Central Bank have lent support to the view that base rates stay out of restrictive territory.
In China, one of the largest economies in the world and key player in global trade, the stimulus program helps stabilize slowing growth.
Progress in trade talks between the US and China reduces the risk of escalating tariff wars, and on Brexit, the UK and Europe continue to take steps to achieve an orderly exit.
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Demand for fixed income has been strong as seen with the recent 10x oversubscription for the recent Saudi Aramco deal.
While these supportive factors may persist for a while, we believe these tailwinds may fade and be replaced with stronger headwinds, resulting in a less supportive environment for risk assets.
For starters, valuations are higher than they were at the start of the year. While central banks have been dovish in their outlook, this change has been prompted by a weaker economic outlook.
In the US, the yield curve inverted for a while, in some case an early warning of an upcoming recession.
In the current case, the inversion was driven by the market pricing in future rate cuts by the Fed, something that might not materialize as soon as the market expects. This would drive bond yields higher, potentially risking a repeat of 2018.
Trade wars are far from over, especially as we approach US elections next year. After China, the US administration may turn their attention to Europe.
As such, the volatility seen in financial markets in the last six months, illustrated by a rising VIX, frequent and large movements in emerging market FX and interest rates, and in some parts of the global credit markets - we believe is here to stay.
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This normalisation in volatility poses a challenge both to global markets, and to active fixed income managers. The credit bull market of the past few months has seen attractive returns simply from the market beta.
Tougher market conditions will mean an increased dispersion in performance, make it harder to profit from directional plays, and accentuate the importance of risk control.
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