Bond market in 2017

The entwined threats of rising inflation and tightening monetary policy are more unequivocally negative for the bond market than for other asset classes in 2017.

That’s the view of Luca Paolini, chief strategist of Pictet Asset Management.

In the developed world, Paolini said those forces are strongest in the US, where inflation is on track to top 2% for the first time since 2014.

Against this backdrop, the chief strategist outlines five things in the bond market that investors should be aware of.

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US government bonds

Paolini said that Trump’s policies are likely to add to inflationary pressures through tax cuts and public spending increases.

‘Based on the projections of the nonpartisan Committee for a Responsible Federal Budget, we estimate that the budget deficit will nearly double to average 6.1% of GDP over the next decade if Trump’s policies are implemented,’

‘That is likely to prompt greater monetary policy tightening than previously expected from the Fed, in turn leading to higher US government bond yields and a steeper yield curve.’

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High yield bonds

Having benefited from the 2016 rally in US high yield bonds, Paolini said the firm has now turned neutral on this asset class.

‘On our valuation models – where the cheapest level in history scores 100 and the most expensive scores zero – US high yield has retreated from 75 in February to 11 now,’ he said.

‘Debt ratios for non-financial companies are at historic peaks and the corporate default rate has risen to a six-year high of 4.8%. These metrics suggest that we are past the peak in the credit cycle.’

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EM local currency debt

One notable bright spot in fixed income, particularly when it comes to valuations, is EM local currency debt, according to Paolini.

‘As well as offering some of the highest yields in mainstream fixed income, EM corporate bonds tend to have shorter durations, making them less vulnerable to interest rate hikes,’ he said.

‘The opportunity is far from risk free, however – possible threats to performance include a stronger US dollar and Trump’s protectionist stance on global trade.’

Among EMs, Paolini said he prefers Latin America due to encouraging signs of progress on structural reform as well as the region's exposure to commodities and energy, whose prices should rise.

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Inflation-linked bonds

‘With global producer price inflation surging to five-year highs, inflation-linked bonds are starting to look attractive again but we continue to think that gold is a better hedge in the long-term,’ he said.

‘After the recent price fall, it is also more attractive from a tactical perspective.’

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Currency markets

In the currency markets, the dollar is indeed likely to strengthen in the coming months due to stronger US growth and the Fed signalling more hikes than are currently priced in, according to Paolini.

‘But over the course of 2017 as a whole, we expect a very volatile, range-bound performance, with the dollar currently circa 20% overvalued on our models.

While in the UK, Paolini said that weak growth may materialise eventually as Britain progresses with the EU exit, in the short term, he believes the UK economy and assets are more likely to exceed expectations, which in turn presents potentially attractive investment opportunities.

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