Fixed Income Focus: Outlook for 2016

By David Absolon, Investment Director at Heartwood Investment Management

• Global central bank divergence is expected to be a dominant theme as the Federal Reserve looks to tighten rates, while quantitative easing programmes continue in Europe and Japan
• Developed sovereign bond yields are expected to rise moderately and we continue to believe it is prudent to maintain a short duration profile
• Credit markets are likely to face more headwinds, although fundamental investors can find select valuation opportunities

Looking towards 2016, global central bank divergence is expected to be a dominant theme. We expect the US economy to retain its role as the engine of global growth in 2016. However, growth is likely to remain modest compared with previous economic cycles, allowing the Federal Reserve to proceed on a very gradual tightening path. The Bank of England is likely to follow the Fed’s lead and initiate its tightening policy later in 2016, in contrast to Europe and Japan, where ongoing central bank stimulus is expected to support those economies’ mild recoveries.

Based on our expectations of moderately expanding global growth, we continue to believe it is prudent to maintain a short duration profile in fixed income by holding exposure to shorter-dated bonds and constraining our market weight to this asset class. We expect US and UK treasury yields to rise moderately across the curve in response to gradual central bank tightening. Meanwhile, the US dollar is likely to sustain its strength versus the major currencies, although given the significant move over the last year we expect it to stay within a stable range.

While our duration view remains unchanged, our credit view has evolved to reflect shifts in corporate credit fundamentals. We believe there will be fewer opportunities across the broader credit universe. The Investment grade corporate bond market is likely to encounter a more challenging environment than in previous years, as interest rates rise and, at the margin, fundamentals weaken on higher leverage ratios in some sectors. However, we should note that demand for investment grade corporate bonds among institutional investors remains strong, and any potential sell-off is likely to be contained.

It is worth highlighting that although both Investment grade and high yield credit spreads have widened in the second half of 2015, the absolute level of yields remains historically low. Typically, high yield bonds benefit from a recovering economy as the prospects of default fall. But this is an atypical recovery and given the very low level of absolute yields, the cushion available to absorb capital loss as interest rates rise is much shallower, due to lower coupon rates. Nonetheless, for active investors, we believe there are select valuation opportunities in certain areas of the high yield market, such as energy, where the sell-off has been indiscriminate and the fundamentals of a number of issuers have been overlooked.

We have taken a cautious view of the emerging market debt asset class on concerns about the strength of the US dollar and perceptions of Federal Reserve tightening. Economic fundamentals have deteriorated across the broader asset class (for both hard and local currency markets) as financial conditions have tightened in many emerging market countries. We are retaining our cautious outlook over the next six months. However, we also recognise that central banks in the emerging markets will be better positioned to continue with their programmes of supporting growth and inflation as we see more certainty surrounding Fed policy. Furthermore, should the strong US dollar trend stabilise, over the longer term, these markets should begin to show more interesting opportunities.