It’s Been Quite a Run for Global Fixed Income

Franck Dixmier | 11/11/2016
Franck Dixmier

Summary

Interest rates globally fail to accurately reflect fundamentals because QE has distorted markets, says our Global Head of Fixed Income. Investors have certainly benefited from the run-up in prices, but how much lower can rates go when over USD 10 trillion in global bonds have negative yields?

Key takeaways
           
  • The ECB’s securities purchase programme is the real cause behind the historic fall in euro-zone bond yields.
  • Full employment in the US, combined with accelerating wage inflation, could force the Fed’s hand.
  • We anticipate a series of measured Fed hikes that will be more restrained than in previous tightening cycles.
  • In this environment, managing portfolio duration will be of paramount concern to portfolio managers.

Do not be oblivious to the obvious

It would be stating the obvious to acknowledge that current interest-rate levels do not accurately reflect prevailing fundamentals in terms of growth and inflation. Although yields in the euro zone are certainly being driven lower by a growing structural imbalance between savings and investment, the securities purchase programme implemented by the European Central Bank (ECB) is the real cause behind the historic fall in bond rates.

Investors have not been hard done, however, as their portfolios have largely benefitted by delivering surprisingly positive performances. And there certainly have been some surprises. A few years ago, would any reasonable investor have anticipated that in 2016 over USD 10 trillion of global bond assets would be yielding negative rates? Or would any reasonable investor have imagined that one day it would be necessary to pay in order to grant credit to a corporate issuer? In this somewhat irrational world, it is now time to accept that this windfall effect is soon going to come to an end. Past returns have, to a certain extent, already been “pre-empted”, as payback time is drawing near. But when will this be?

Central banks hold the answer

Once again, the world’s central banks hold the answer. The US Federal Reserve, after having struggled so hard to remain inactive, is running increasingly short of valid arguments to defend its unjustifiable position. The full employment situation in the US and a steadily accelerating rate of wage inflation are clearly indicating an imminent increase in interest rates over the coming year. However, given the highly unusual character of the forthcoming monetary-normalization phase, we are anticipating a series of measured rate hikes which will be much more restrained than in previous cycles.

The ECB, on the other hand, has only one option. Despite its tentative comments at the beginning of October regarding the potential tapering of quantitative easing, which was mooted in order to test the market reaction to the idea of progressively scaling back monthly securities purchases, the ECB can realistically only press ahead with its planned programme. It is either that or consider stepping it up, given the low level of inflation in the euro zone.

Interest-rate implications

What are the implications for interest rates? The markets have so far remained relatively immune to the idea of an increase in the federal funds rate. Before too long, however, investor anticipation is likely to be reflected in a flattening of the US Treasury yield curve and in higher long-term rates compared to the current levels. As core interest rates are unlikely to remain unaffected by this scenario, particular attention must be paid to managing portfolio duration.

In Europe, German bund rates are currently pricing in a high-risk environment, including political, geopolitical, macroeconomic and financial risks, which are unfortunately unlikely to abate in the near term. More specifically, key issues such as the future of the euro zone in the context of Brexit, amid a general rise of populism in Europe accompanied by protectionist leanings, are likely to cause nervousness in the markets, which of course will benefit the bund as the ultimate safe haven.

It is therefore becoming increasingly necessary to seek out diversification strategies in order to increase portfolio returns while reducing the overall level of risk, and also to guide investors through this progressively more challenging environment. The only solution, over the course of the next few months, will be to continue providing flexible, proactive and conviction-based asset management.

For more information, read the 4Q 2016 Fixed Income Quarterly

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. Bond prices will normally decline as interest rates rise. The impact may be greater with longer duration bonds. High-yield or “junk” bonds have lower credit ratings and involve a greater risk to principal. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted. This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission (SEC); Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; and Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

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Franck Dixmier

Global Head of Fixed Income, CIO Fixed Income Europe
Franck Dixmier is Global Head of Fixed Income and Chief Investment Officer Fixed Income Europe. Franck is a member of the Global Executive Committee at Allianz Global Investors. He joined Allianz Group in 1995.

3 Reasons to Get Active

Greg A. Meier | 15/11/2016
Capital Market Monthly

Summary

Our Capital Markets and Thematic Research team says one of the biggest reasons for investors to go active is because unprecedented central-bank stimulus has increased correlations. Once monetary policy normalizes, lower correlations could help stocks trade more on fundamentals.

It is no secret active management has been challenged recently. Over the last three years, USD 1.3 trillion has moved into passive strategies, while USD 250 billion exited active funds. This shift – while notable – is misguided for three reasons.

First, the fair evaluation of an investment strategy should cover a full market cycle. A 2012 study from Robert W. Baird & Co. shows that while 59 per cent of managers add value over one year, 73 per cent do when measured over a five-year period. This concept is critical because of how abnormally long the current cycle has become: The S&P 500 Index hasn’t experienced a bear market in the 7.5 years since the financial crisis ended. To put that into context, the recovery from the Great Recession – the worst in 80 years – now equates to the fourth-longest US economic expansion and the second-longest S&P 500 bull run in history.

What this means is that since the market troughed in March 2009, the rising tide that has lifted risky assets has simultaneously diminished the need for downside protection – an area where active managers have historically shown expertise. In fact, during the 2000-2002 tech-market bust and the 2008-2009 financial crisis, active managers in the US large-cap space – one of the most competitive markets, globally – outperformed their passive peers by 471 basis points and 100 basis points, respectively.

We firmly believe that analysing corporate fundamentals makes active managers better equipped to see and navigate storms that darken the horizon. Active managers can benefit by underweighting underperforming assets or simply moving money into cash. When markets get rocky, passive vehicles not only own the entire downside of the index being tracked, they should underperform the index’s losses after accounting for fees.

Second, the shift toward passive is troubling because of how the instruments are used. Frequently, passive investors buy index funds for tactical rather than strategic reasons, meaning they expect to move in and out of positions quickly. But when markets are volatile, there isn’t always enough liquidity to trade efficiently. A good example is the “flash crash” on August 24, 2015, when the Dow Jones Industrial Average briefly fell nearly 1,000 points, its largest-ever intraday loss. Circuit breakers (trading halts) were triggered almost 1,300 times, and the prices of some popular Exchange Traded Funds (ETFs) disconnected from their underlying assets. For instance, a USD 2.5 billion US consumer staples ETF lost 32 per cent of its value, while the companies in the fund were down 9 per cent. Poorly timed trades in vehicles investors mistakenly think are highly liquid can result in outsize losses.

Third, passive managers have benefited from unprecedented monetary stimulus from the world’s central banks. Since the financial crisis, all of the major central banks have cut interest rates into record-low – in some cases negative – territory. They have also launched asset-purchase programmes (quantitative easing [QE]), distorting the fundamental process of price discovery by private investors. The recent flood of central-bank stimulus has buoyed capital markets generally, which has resulted in an increase in cross-asset correlations. This is important: When correlations are low, stocks should trade based more upon company-specific characteristics. When correlations are high, corporate fundamentals – and the work active managers do digging through balance sheets, income statements, pay-out ratios, etc – go out the window.

From this standpoint, it is encouraging to see that some central banks are either in the process of normalizing policy or considering it. With US labour conditions strong and inflation accelerating, policymakers at the US Federal Reserve are keen to continue the first US rate-hiking cycle in a decade. Across the Atlantic, European Central Bank officials seem to flirt with the idea of tapering QE. Even the Bank of Japan’s new “yield curve control” policy may result in a slowing pace of asset purchases.

Reduced monetary accommodation is a natural part of the economic cycle – it should dampen cross-asset correlations and further support the argument for getting and staying active.

For more information, read the November edition of Capital Markets Monthly or listen to the audio version on Soundcloud.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association]; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

© 2016 Allianz Global Investors. All rights reserved. 80833

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Greg A. Meier

Strategist, US Capital Markets Research and Strategy
Mr. Meier is a strategist and a vice president with Allianz Global Investors, which he joined in 1999. He is responsible for developing research and analysis for the firm’s investment professionals and Sales and Client Service teams, and for conveying the firm’s views to clients. Mr. Meier’s work focuses on global capital markets, macroeconomics, monetary policy, fiscal policy and retirement issues. He was previously a performance analyst and a financial writer with the firm. Mr. Meier has 15 years of investment-industry experience. He has a B.S. in business administration from the University of Montana and an M.B.A. from the University of Washington.
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