Fixed income investing in 2020

With investors adopting a cautious stance and central banks reaffirming accommodative measures, what will 2020 look like for fixed income investors? In the first of a series of mini interviews, Kevin Zhao (our Head of Global Sovereign and Currency, Fixed Income) talks about how investors can navigate today's challenging markets.

Stay tuned for the rest of this series of interviews sharing Kevin's insights on global flexible fixed income investing.

Q: Low spreads, negative interest rates and stretched valuations are complicating the life of fixed income investors. How can investors navigate given these challenging market conditions?

A: Lack of yields doesn’t mean lack of opportunities. That's why we advise investors to go global and be more flexible. Bonds almost everywhere performed extremely well in 2019 as central bank intervention continued to support prices. At one point a staggering $14 trillion of bonds traded with a negative yield (prices move inversely to yield). But in 2020 it is unlikely that all bonds can match the returns experienced last year, and generating good returns will require a more selective approach. Investors must also pay attention to the impact of tail risks as yields have fallen significantly and the sensitivity of bonds to interest movements has increased. A sound approach will be to balance the resilience of the portfolio to unexpected exogenous shocks, while maintaining the flexibility to profit from any market repricing.

With this philosophy in mind we have broadened our horizons from G7 developed country bond markets that traditionallyformed the vast majority of investors' global bond holdings. These countries are typically characterized by very low real yields and actually account for the vast majority of bonds that are trading at negative yields. Instead our investment horizon is focused on the G20, which includes several countries such as China and Brazil, typically thought of as emerging markets. G20 could be labelled "the New Global" because it is a much better reflection of the global economy today.

Q: The European Central Bank has launched a review of its monetary policy. Which changes can investors expect and what might be the implications for fixed income markets?

A: The ECB policy review is useful for the new President Lagarde to bridge the difference between the hawks (mostly from the surplus northern countries) and doves (mainly deficit countries) in the Governing Council (GC), and may be able to establish a set of common analytical frameworks for the GC to make their future policy decisions. Although the review is unlikely to trigger a meaningful change in the ECB's policy responses this year, we do believe that the ECB policy rate has reached its effective lower bound (ELB). We expect a diminishing impact, for the economy or financial markets at large, of any further cuts in the deposit rate or increase in asset purchases. In our view macro-economic policies should shift to fiscal stimulus by countries with fiscal and current surpluses such as Germany and the Netherlands.

As it stands the Stability and Growth Pack (SGP) is deflationary and one of the major causes (along with demographics and technology) for falling inflation and interest rates. The twin surpluses (current account and budget) have created massive excess savings for the Eurozone. This in turn exacerbates global imbalances and pushes down the Eurozone’s equilibrium interest rate, where policy balances the demand for money, well below zero. As a result, the Eurozone monetary policy stance is actually neither accommodative nor reflationary, in spite of a historical low ECB rate of -50bps and large scale asset purchases. The solution is a mandatory shift for countries with twin surpluses to run budget deficits in excess of nominal GDP growth for a couple years and until Eurozone core inflation meets the ECB target of 2%. In addition, a Eurozone revitalisation investment vehicle, primarily financed and owned by the surplus countries, could be a ground-breaking policy to recycle the excess saving into long-term productivity enhancing investment projects.