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Fixed-Income Insights

Economic and monetary policy prospects for the United States look quite different from those of other economies globally as 2015 begins. How could this affect fixed-income investments?

 

In Brief

  • As 2015 begins, the global investment landscape is marked by divergence of economic prospects—and potential central bank policy paths—for major economies.
  • While the United States appears poised for an acceleration in economic growth, Japan and the eurozone confront stagnant economies, while China faces a slowing growth rate.
  • Meanwhile, the U.S. Federal Reserve appears ready to begin raising interest rates, while central banks elsewhere pursue quantitative easing.
  • A third divergence is evident in currency valuations, especially with regard to weakness in the Japanese yen and euro versus the U.S. dollar.
  • The key takeaway—As 2015 unfolds, the divergent prospects for the U.S. and other economies will influence investment opportunities for fixed income in different ways. 

 

Since the global economic slowdown in 2008, investors’ pursuit of economic returns has evolved. In the first post–crisis phase of global recovery, shell-shocked investors tepidly responded to broad-based economic improvement. The next step saw a “risk-on, risk-off” environment wherein investors vacillated with changes in economic growth and policy responses by central banks.

What about now? In 2015, there is a clear divergence of the performance of global economies—and the policies central bankers are embracing to address their countries’ economic concerns. This two-track world raises the prospect of longer-lasting differences among investment opportunities—especially in fixed income.

Separate Ways
A cursory look at this divergence reveals macro themes that separate the United States from much of the rest of the world. The U.S. economy, marked by steady, if sluggish growth in the past few years, appears to be on the brink of acceleration. This is in stark contrast to the recession in Japan, the economic struggles in the eurozone, and slowing growth in China. Investors seeking assets that will improve with stronger growth seem likely to favor the United States.

Monetary policy also separates the United States from other major economies. While U.S. Federal Reserve policymakers contemplate the timing of an interest rate “liftoff,” other central banks are headed in the opposite direction. The European Central Bank, for example, is about to embark on a sizable quantitative easing (QE) program; the Bank of Japan continues its aggressive bond purchases; and the People’s Bank of China has ramped up monetary easing efforts by making additional funds available to banks of all sizes.  With interest rates on fixed-income securities in Japan and Europe noticeably lower than their U.S. counterparts, and with access to Chinese debt restricted, the United States continues to offer greater appeal to global investors. This relative rate advantage seems destined to widen, at least among short-term debt securities, as the Fed begins its policy normalization process.          

Devaluation Drive
A third major divergence between the U.S. economy and other developed economies is currency. The Japanese yen, the euro, and the Chinese yuan have recently declined in value, while the U.S. dollar has gained. If this currency disparity continues, the additional return from dollar strength will make U.S. investments even more appealing. The weakness in the Japanese yen is most obvious. While it may be a function of less investment demand for a country in recession, the falling yen appears to many as a conscious policy choice in order to promote export growth in the Japanese economy, while helping to increase inflation through higher-priced imports. 

The euro seems to be following the yen for similar economic reasons, to the relief of German vehicle and equipment manufacturers who compete with currency-advantaged Japanese companies. With 45–50% of the German economy driven by exports, the economic fate of the eurozone may depend on a weakening euro. 

It would not be much of a surprise, then, to see devaluation of the China’s currency as 2015 unfolds. With economic growth slowing, China’s export machine can ill afford to grant a 10–20% economic advantage via a weaker yen to Japanese competitors. And if the yuan strengthens relative to the euro, Chinese exports to Europe will be disadvantaged, further compromising Chinese economic growth. The resulting currency race to weakness seems likely to result in U.S. dollar strength. Once again, this divergence will make many U.S. investments more attractive from a global perspective.  

Disparate Impacts
This brief examination of relative economic strength, differing monetary policy objectives, and varying currency valuations seems to signal, we believe, a divergence in investment performance that favors U.S. assets. Within fixed income, relatively strong U.S. economic growth and an improving dollar should favor U.S. high-yield securities. However, high-yield in Europe and in emerging markets may suffer from issuer bankruptcy fears related to slow growth, expectations of adverse currency movement, or increased corporate or market liquidity concerns. At the same time, though, selective opportunities may be available outside the United States in dollar-denominated or hedged non-U.S. debt of companies that can successfully capitalize on export opportunities that benefit from local currency weakness.

Divergence also can be expected among other fixed-income securities in the United States. To the extent stronger U.S. growth allows some increase in inflation toward the Fed’s 2% target, longer-term U.S. debt can be expected to react accordingly, underperforming less responsive shorter maturities and economically sensitive securities. Yields on short-term debt likely will move higher in response to expected interest rate hikes by the Fed, attracting global investment flows to securities with relatively attractive yield, especially compared to their rate sensitivity. For instance, yields on U.S. two-year Treasury securities already exceed those of the 10-year German government bond, according to Bloomberg. Perceptions of favorable U.S. currency performance could make U.S. short-term investments even more appealing. Even a U.S.-specific asset class such as municipal bonds seems likely to experience its own form of divergence, as changes in tax rates, minimum wage, and energy prices affect the financial health of borrowers in different ways.

The theme of divergence in 2015 means that the analogy of a “rising tide lifts all boats” may not be applicable to the global investment environment. Instead, regional squalls may create problems for some asset classes or sectors, while favorable winds will benefit others. Sound research and thoughtful analysis are likely to increase value in an environment that, unlike the gradual recovery and risk-on risk-off investment mentality of recent years, will be characterized by differences in economic growth, monetary policy, and currency valuation for key global players. Stay with us over the next several weeks as we examine more deeply the opportunities for divergent returns within key fixed-income asset classes.

 

ABOUT THE AUTHOR

THE EMERGENCE OF DIVERGENCE

What’s the watchword for fixed-income investors in 2015? Divergence. In this series, Zane Brown looks at the prospects for widely varying performance—and investment opportunities—within:

Global Economy & Policy 
High-Yield 
Emerging Markets
• Municipal Bonds

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