Curmi & Partners

Quarterly Update and Outlook

Q1 2017

Fixed income markets have been well supported by a number of factors including slow but positive growth, no acceleration in inflation, a stable default scenario and robust risk appetite. The view that the European Central Bank’s (“ECB”) extraordinarily accommodative policies have peaked continued to gather pace. During the ECB conference of March 2017, with interest rates and Quantitative Easing (“QE”) measures remaining unchanged, ECB president Draghi commented: “There is no longer that sense of urgency in taking further actions. That urgency that was prompted by the risks of deflation isn’t there”. The ECB also highlighted the improving picture illustrated by most economic data releases. In the US, the Federal Reserve (“Fed”) raised interest rates by 25bps to 0.75%-1.00% in March, in what was a much expected move and the 3rd rate increase since the 2008 financial crisis. The Fed’s message was that the economy continues to improve at a moderate pace and that rates will continue to rise. However, a cautious approach to rate hikes was highlighted, and it was also noted that the Fed will be monitoring the impact of the expected shift in spending and tax policies implemented by Trump.

Similarly to recent months, going forward fixed income markets are expected to benefit less from central bank action compared to recent years. This is particularly the case for the US dollar (“USD”) market, but the scenario has also started to change also for the Euro market, even though the ECB is expected to remain more active in maintaining a “cap” on rising yields. Benchmark yields climbed higher and yield curves steepened into the new year, reflecting this shifting perception on central bank policies in addition to: the improving economic scenario, expectations on the reflationary impact of Trump’s economic policy, increasing investor risk appetite, and strong equity markets.

During recent weeks, there was an element of reversal in these trends, with yields somewhat retracing lower. This was driven by factors including doubts on Trump’s ability to implement certain policies and French politics. However, the view remains that yields will in the long-term continue to rise. Investors should moderate expectations in terms of capital upside, whilst further spread compression seems possible even though credit spreads are already near all-time lows. Rising benchmark yields are likely to have a negative impact on total returns particularly in the sovereign and Investment Grade (“IG”) sectors.

The Euro market is likely to offer less attractive opportunities than the USD market, especially in IG due to current pricing levels. In the High Yield (“HY”) sector, both USD and Euro markets are not cheap but there is scope to seek attractive individual credits.  This is particularly related to the additional yield and the relative resilience in terms of interest rate risk. Emerging markets (“EM”) have already been performing well and volatility has been low. However, the view is that EM debt remains a good source of yield, within a context of the positive global economic scenario and more stable or improving energy and commodity markets.