If equity markets are driven by behavioural factors and sentiment, fixed income markets are driven by macro events and economic fundamentals. Currently, these are telling us that interest rates, particularly in the US, will remain low for some time yet, with implications for fixed income investors.
The US Federal Reserve has pumped unprecedented amounts of liquidity into the system and cut interest rates to almost zero, yet US capacity utilisation remains at only 79 per cent – below the long-term trend. There is no doubt the picture is improving, but the output gap has not yet recovered to a level where wage inflation is likely to pick up.
Secondly, US unemployment levels are still far from consistent with the Fed’s mandate. At 6.7 per cent, unemployment has certainly come down but this is at least partly attributable to a dramatic fall in the labour market participation rate.
Thirdly, headline and core inflation are likely to remain below the Fed’s 2 per cent target for a while. When quantitative easing (QE) first started there was much talk of hyperinflation, but the reality is that QE hasn’t stoked inflation; it has simply quelled the kind of deflation we saw in Japan.
Inflationary pressures are not, in short, an immediate issue for the Fed and the market is currently pricing in the first 25bps interest rate hike towards the middle of 2015.
If inflation is not exercising minds in the US, nor is it a pressing concern for the G3, whose Consumer Price Indices are all below central bank targets. The latest CPI print in Europe, for instance, is just 0.8 per cent; a huge 1.2 per cent below target. The ECB is more concerned about deflation than inflation, which is why it has hinted at further accommodative policy to come.
Crucially, however, Europe hasn’t resolved its banking issues in the way the US and UK have: it is making the mistake Japan made. Without strong banks, lending fails to pick up and economies can end up in a deflationary spiral. Growth in Europe may be slightly better than it was, but interest rates are clearly not rising in the near future.
In the UK, on the other hand, growth has been strong: 2.8 per cent year-on-year. While this is largely attributable to debt-fuelled consumer spending, manufacturing is clearly picking up, which gives encouragement that a credible medium-term recovery is in place.
With the Bank of England governor Mark Carney stepping away from the unemployment rate as an interest rate trigger and creating a wider forward guidance structure, the market is pricing in a first hike in spring 2015.
Japan, as it often does, stands apart. It is amazing that its GDP growth is now 2.4 per cent year-on-year while its latest CPI print is 1.6 per cent – on par with the US. While shaking the psychology of deflation will remain a challenge for Japan’s policymakers, Abenomics is clearly having a significant impact.
So where do fixed income investors find value?
High yield valuations are extreme, but the fundamentals are very solid; in this ‘carry’ environment total returns are expected at the mid single digits in the next 12 months.
