Update Magazine I/2020 DOWNLOAD THE COMPLETE MAGAZINE

As the virus has spread rapidly since mid/end- February, some of our assessments had to be adjusted. Reality has overtaken our forecasts for 2020. Our long-term expectations have not changed materially, however.

Early this year, our global bond market experts and economists discussed the short-, mediumand longer-term outlook for bond markets. Despite some differences in perspective, there were a few common convictions that became clear However, the coronavirus crisis has made us rethink our forecasts for 2020.

1 

Interest rates will remain low in 2020

Back in January, we expected interest rates to remain at a very low level this year. This forecast is essentially based on continuing expansionary monetary policy. In 2019, central banks once again showed the markets that they are prepared to loosen the reins in the face of economic headwinds – i.e. to cut interest rates and make additional liquidity available. After unexpectedly announcing a U-turn in its monetary policy at the end of January 2019, the Federal Reserve has to date lowered the fed funds target rate by 75 basis points since the summer. While the expansion of its balance sheet through the provision of additional liquidity and purchases of US T-bills was intended purely to stabilise the US repo market from a technical viewpoint following the disruptions in September last year, it ultimately also provided support for the bond market. In the eurozone, the European Central Bank cut its interest rate on deposits once again in September, and resumed its bond purchases until further notice. And all this took place before the coronavirus hit.

Even if the cyclical outlook had improved, the two most important central banks were unlikely to change their current monetary policy in the foreseeable future. The Fed in particular has emphasised that it would raise interest rates again only if inflation remained “persistently” above the target of 2%. The short-term surpassing of the inflation target does not therefore constitute grounds for a change in monetary policy. An interest rate hike was in any case not an option in the long run for the ECB, which has regularly pointed out that inflation is well below the medium-term target level of just under 2%.

While we were busy discussing a potential recovery at the beginning of the year, any such hopes became obsolete by mid-February at the latest. We assume that the coronavirus pandemic will push the world into a deep recession. At the beginning of the year, sentiment indicators initially raised hopes of an economic upswing, particularly since there were signs that the trade tensions between the US and China were being diffused, and Brexit was finally implemented. But even back then, all that glittered was not gold. The global economic cycle had entered its eleventh year. In the US, private domestic consumption had slowed, and worldwide, investment activity had lost momentum due to weak earnings growth. This came as a surprise, particularly in the US, where growth exceeded potential, and corporates continued to benefit from the current administration’s tax cuts. In addition, global debt levels had returned to levels last seen ahead of the financial crisis in 2007– 2009. This means that the virus hit a global economy which was already vulnerable. And just as the coronavirus is particularly dangerous for senior citizens with pre-existing conditions, the global economy was particularly vulnerable to this external shock.

The depth, seriousness and length of the recession will ultimately depend on the spreading of the virus, the pace of contagion and the secondary effects. The virus will not only dampen demand, but also lead to major production disruptions. In addition, funding costs will rise for both corporates and households. With global debt high, the risk of a financial crisis is significant. Sentiment indicators dropped to record lows in some cases in March. Against this background, we have become cautious about spread products in comparison to government bonds, which are currently performing well – even though corporate bond valuations are low by now. Government bonds are likely to benefit from the current growth environment. Still, things are not that simple. As liquidity is low, government bonds are quite volatile. It is therefore necessary to review positions daily.

2 

Low returns expected in long term

There was and is a consensus that yields on bond markets are set to remain low for the next few years, regardless of any cyclical developments. The main argument is that we are in a low-trend growth environment, which, according to economic theory backed up by empirical data, determines long-term interest rate levels. But what are the arguments for the expected low-trend growth? One explanation is weak demographic development. The size of the working population is already contracting in Japan and Europe, while growth rates are falling rapidly in the US and Asia, excluding Japan. At the same time, productivity growth is declining, even if this is surprising in times of major technological change.¹

The voices of those who anticipate a “Japanification” of the bond markets in Europe and ultimately also in the US in the long term – ie, a further drop in yields over several years – are growing ever louder. The main argument here is that in the next recession, central banks will find themselves forced to cut interest rates further. Sooner than expected, the coronavirus crisis has proved this view to be true. Furthermore, expansionary monetary policy, particularly since the financial crisis, has created an environment that has favoured a further increase in public and private debt to new record highs around the world (see Chart A/). Experience has shown that high levels of debt tend to curb growth in the longer term. High global debt levels also make central banks reluctant to raise interest rates to a “normal” level again, as the private sector is in some cases dependent on low financing costs. We could say that the spirits that the central banks have conjured up are not going to go away any time soon.

However, there are also valid arguments suggesting that there will not be a further decline in bond yields in the medium to long term, or even indicating that there could be a slight rise in yields, at least over the next few years. Although friction in international trade due to trade disputes dampens real growth in the long term, it also has an inflationary effect at the same time. The same applies to global climate change, which, from an economic viewpoint, can be regarded as a long-lasting supply shock to the worldwide economy. The ultra-expansionary monetary policy of the last few years (and the last few days) could also prompt investors to start pricing in the risk of a rising inflation rate again, particularly if central banks take further steps to ease monetary policy, or decide on a monetary policy that is structurally looser. The latter is an entirely realistic scenario. As part of its strategic review of its monetary policy, the Fed is examining whether to switch to a multi-year average figure for its inflation target. This would open the doors to keeping interest rates low even at an inflation rate of over 2% – the current inflation target – as inflation has undershot the current target in the years since the financial crisis. In the eurozone, a similar discussion is expected to take place soon within the ECB.

A/ DEVELOPED MARKETS: DEBTS/GDP IN %

Source: Allianz Global Investors, BIS, Refinitiv. Data as at Q1 2019

If monetary policy normalises in the long run, this would therefore suggest that market yields would also return to normal. Yet even in this scenario there would be limits. We estimate that even in a climate of “normal” interest rates, central bank rates would rise to only about 3% in the US, 2% in the euro zone and less than 1% in Japan owing to low trend growth – which is still very low in a historical context.

Either way, we expect annualised returns on bond markets to be a low single-digit figure, and to be higher in the US than in Europe and Japan – too low to allow most investors to fulfil their long-term obligations. (see Chart B/).

B/ EMERGING MARKETS: DEBTS/GDP IN %

Source: Allianz Global Investors, BIS, Refinitiv. Data as at Q1 2019

3 

Spread markets preferred over government bonds in the long run

In an environment of low yields and bond market returns, segments of the bond market that promise additional income compared with government bonds, in the form of a credit and illiquidity premium, are therefore extremely attractive at first glance. This is the case when the global economy is not entering a recession, at any rate. For that reason, many market participants took a “risk-on” position and overweighted spread products in comparison to government bonds until a few weeks ago – i.e. before the coronavirus crisis. While an imminent recession is not our baseline scenario, as outlined above, we cannot rule it out completely (see Chart C/), notably following the spreading of the coronavirus. Moreover, interest mark-ups (spreads) for corporate bonds in both the investment-grade and the high-yield segment were very narrow in a historical context in January. The additional income that could have been generated compared with government bonds would probably have been considerably lower this year than last year anyway, even without the coronavirus. Our bond market experts therefore adjusted our portfolio positioning in January, taking into account cyclical assessments and the portfolio’s risk profile. The “hunt for interest mark-ups” that characterised the last few years had already become more difficult to find back then.

However, anyone with a long investment horizon spanning several years should continue to incorporate credit and illiquidity risks into their portfolio from a structural viewpoint. Over the entire cycle, this should lead to additional income of around 70 basis points for corporate bonds, and approximately 200 basis points for high-yield bonds, in the context of historical excess returns for the respective asset classes compared with government bonds.

The current environment in particular, with growth prospects that are less clear than before, an incipient recession, heightened political uncertainty, a possible realignment of monetary policy and sometimes major turmoil on the bond market, suggests that any active portfolio decisions will have to be adapted to the respective conditions.

C/ 10-YEAR ROLLING US GOVERNMENT BOND RETURNS P.A. VS US 10-YEAR UST RETURN (10-YEAR LEAD)

 

Source: AllianzGI, GFD.

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¹ https://lu.allianzgi.com/en-gb/pro/insights/update-magazine/the-difference-between-productivityand- innovation

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