State Street Global Advisors is releasing two interesting papers this week on the outlook for global bonds and currencies. The common theme is: the past is behind us and the future will be different. Here is the firm’s advice for investors of all shapes and sizes in an increasingly difficult environment.
Bonds and currencies tend to go hand in glove, which is why most Australian and New Zealand super funds benchmark their global bonds against a hedged index. But this is changing, with increasing importance, and different risk/return profiles, from credit and emerging markets bonds.
In recent times, local currencies have sent emerging markets bonds returns higher, but they have tended to come down to earth in the past year or so. Fixed income and currencies represent a complex asset class, or classes.
For Australian investors, too, their decision on currencies can make a massive difference on the performance of their portfolios. The thing about currencies is that you cannot not have a view. The currency effect is there staring you in the face and you have to know which way to go: hedged, and by how much, or unhedged.
So, with that brief backdrop, State Street Global Advisors (SSGA) is offering its views on both fixed income strategies globally and the ramifications for currencies in the outlook for the next year or so. See the papers: StSt Bonds Paper , StSt Currency Paper
The bonds paper, written by Matt Nest, the SSGA global head of macro strategies, and Niall O’Leary, the global head of fixed income, says that there is a “pretty clear picture” emerging in the US.
The paper says: “US rates are near a cyclical peak, and the yield curve will continue to flatten as the Federal Reserve (Fed) continues hiking. While we do not believe credit poses any imminent threat, pricing suggests caution. The one major segment that looks abnormal is the agency mortgage market, which is why we have reduced our exposure.
“The rest of the world is simply behind the US cycle, because the US recovery began, and took hold, sooner. It is therefore not surprising that the US will reach the end of the cycle before other developed economies.
“Given this backdrop, investors should seek to balance their overall risk posture, increasingly look to the front end of the US yield curve for opportunities and start to explore select emerging markets bonds and currencies for value.”
Currencies tend to be slightly less predictable. The currency paper – written by SSGA’s James Binny, global head of currency, and Aaron Hurd, senior portfolio manager, currency – predicts that by the second half of next year the “dispersion” between the US dollar and the rest of the world – that is, the strength of the US dollar versus the euro, sterling and the Aussie – will peak, especially if trade disputes are resolved more swiftly than anticipated.
The currency paper says: “Whether or not this step change is going to occur will become clearer after the end of the first quarter, as we get more insight into Fed’s behaviour and whether US growth is strong enough to sustain US divergence. If Europe and emerging markets do start to show signs of catch-up as the year progresses, this could hamper USD, while EUR, AUD and SEK should outperform.
“Alternatively, if the rest of the world slows enough to spur fear of recession and the US slows even faster, then USD is likely to be better supported after an initial shock and the less cyclically-sensitive CHF and JPY will likely outperform the growth-sensitive AUD and SEK.
“In such a scenario, it is difficult to predict EUR moves, as it usually holds up reasonably well in a negative environment, but investors will be quick to price out any hope of an ECB rate increase. On a related note, if we see too rapid an acceleration of monetary policy tightening in the US relative to growth, it is also likely to result in bouts of risk aversion, supporting JPY, CHF and, to some extent, USD regardless of the specific policies in those countries. “