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This Time Next Year Rodney 2017

20 December 2016 by Mark Holman

I was hoping that investors would not ask us again to make our predictions for the forthcoming year, not because we don’t like making predictions, as that is after all the business we are in, but forecasting so far out does concern me. In 12 months so much can happen that can change our views, as 2016 illustrated perfectly. Markets started horribly as the energy crisis eventually rolled into a potential banking crisis, then we had the vote to Brexit in the UK, followed by the Trump victory and then to cap it all, Renzi lost his referendum on Italian constitutional reforms. Even if you were smart enough to predict all these events, it was still hard to profit from them. In fact being wrong on these events may well have helped returns!

Before starting this year’s outlook, it is worth quickly recapping on our views from last year.

This time last year we had not contemplated a Brexit vote and the resulting action from the Bank of England, so our view on £ investment grade bonds and gilts was far too bearish. Returns from these sectors far exceeded our own and most people’s expectations. In the US we thought that Treasury yields would grind higher to between 2.30% and 2.50% at the 10 year point, but then again, at the start of the year we had not predicted that Trump would win the election. As I write 10-yr UST are close to 2.60%, with many forecasting they will continue to drift higher.

Our credit view had the US high yield sector as a top performer as the starting yield was around 9%, compared to the current 6.3% which gives a year-to-date return of just over 15%, easily making it the best performer, although it was a volatile ride during the first 6 weeks of the year as the turmoil from the energy industry threatened to disrupt the whole sector. Similarly the banking sector had a volatile ride during the first 6 weeks, but fundamentals generally remained strong despite the volatility. Naturally there are always some concerns in this sector, and right now none more so than Italy where Banca Monte Dei Paschi is struggling to close a lifesaving rights issue. However, these fears serve to keep yields lofty and that in our view means opportunity. Generally bonds in the contingent capital sector just about made their coupons in 2016, giving the sector a healthy 6.5% year to date. Asset-backed securities actually did more or less what we expected as they were not subjected to the volatility of high rates. Fundamentals were generally stable at previously strong levels. Finally European high yield, despite offering lower yields compared to their peers in the UK and US, managed to outperform our estimates, posting returns of 8.5% year-to-date, which is impressive given it was one of our favoured “risk adjusted” picks. The technical situation driven by Draghi’s QE and the recovering US HY market really created ideal conditions for this sector in 2016. It is a pity that we did not hold more!

Moving on to our outlook for 2017, we once again have numerous events that could disrupt our view, but 2016 has been a valuable experience in the way markets have reacted.

Beginning with global risk free rates markets, we expect the Fed to take comfort from the lack of disruption from their most recent hike, and also from the fiscal stimulus that we are expecting from the President elect. Inflation is slowly moving towards their target, and the Fed is likely to act as it gets closer. We expect two or three hikes in 2017. Longer dated bonds are going to be harder to predict as the move higher in rates in recent months has already been aggressive. We expect 10 year US treasuries to end the year between 2.75% and 3%, but they could well overshoot in the interim period. That forecast however does not include unknown market surprises, and it should be noted that the rates gun is once again loaded and could therefore be a powerful risk-off tool if any market surprises question US growth or stability.

For the UK we have only really had the shock of the UK referendum result, with the real fundamental impact yet to come. Predicting this is tough, but we start with the view that it is certainly negative, we are just not sure how negative or over what time frame. We are also looking at currency imported inflation hitting us in 2017. Predicting gilt yields in this environment is not a high quality decision, but overall we see higher yields this time next year and a market that will struggle to make positive returns. Our investment committee thought the Central Bank would remain on hold all year, but they acknowledged Carney could be quick to act either way.

In the Eurozone Draghi has already announced tapering, although he refuses to name it as such. From April until December the ECB will buy €60bn a month rather than €80bn a month as the current program dictates. We think this was necessary as the technical drivers were becoming very strong and some unwanted consequences were drifting into markets. Whilst we expect no change in rates in 2017, we think Draghi will have to announce his next tapering in September 2017, and whilst this will underpin risk free rates we must also recognise the numerous political events in Europe in 2017, and this serves to make us more cautious on Europe for 2017. Those political events could pass by like Renzi’s without a blip, but at these ultra-low yields, it is not worth the risk in our opinion.

On the flip side of the risk spectrum we have credit markets, thank goodness, because rates will struggle to deliver positive returns without a suitably negative catalyst. A rising rate environment is not uncommon, nor is it the toughest part of the cycle to manage through, we save that title for the end of the cycle, which as we know, can sometimes end in material losses. The ‘end of cycle phase’ is nearest in the US where the cycle is more mature compared to Europe or the UK, but with Trump at the helm we think the US cycle extends by at least a year or two, giving us a greater degree of confidence for US credit. This becomes our safe trade for 2017, with returns predicted in $ terms of around 6% for high yield. In Sterling, which we favour over Euro, we already have a ‘Brexit buffer’ priced in and we are one small step removed from European political events in 2017. We forecast that investment grade bonds should come close to earning their yield as rises in gilt yields are offset by modest spread compression. In £ high yield, the starting yield of 5.22% is nearly 200bp higher than the € index, which we think more than compensates the Brexit risk over European political risk. Overall we expect that HY will more or less earn its yield in 2017. In ABS, we expect a year similar to 2016, that is driven by stable fundamentals and an absence of duration. Investment grade bonds, similar to those we hold in the Monument Bond Fund (we use this example to move away from the largely AAA rated bias of the index) should return around 3%, whereas in high yield ABS we predict an impressive 6%.

Finally this leaves me to cover our most favoured sub-sectors. There are two that stand out, but both come with warning of higher volatility, which we would see as suitable for blended portfolios. The banking sub-sector of Additional Tier 1 securities should benefit from more favourable regulation and transparency, as well as generally improving fundamentals from a fixed income standpoint. A well selected portfolio of AT1 securities should return around 7-8% in 2017. Our second top pick is European CLOs. This is a way to gain access to the European secured high yield loan sector, which is floating rate and also generally better secured than high yield bonds. For example BB rated CLO tranches currently yield Libor plus 650 basis points, which even without any capital gain is a very good return for the risk.

I hope that these predictions provide some useful insight, at least for now anyway. Entering the year we remain long credit risk, comforted by Trump extending the US cycle, but generally short dated and with minimal interest rate risk. We hope that as risk free yields drift higher that we can add more rates exposure and hopefully have some opportunity for capital gain thereafter. However for now, this stage of the cycle dictates that we wait for curves to price in future inflation and rate hikes before we make that move.

Once again though I would stress the benefit of active management, even if markets did not move as much or how people expected in 2016, usually that is not the case and it is good practice and a valuable source of information to learn how markets react after each event. 2017 has the potential to provide at least as many if not more surprises than 2016, so we must be on our guard and take advantages of opportunities should they arise. Not reaching out for too much risk now will certainly make that possible should it occur in 2017.

Finally that just leaves me the chance to thank everyone for reading our blog and for the many questions it triggers.

We wish a Merry Christmas to all, and hope that “this time next year, we could be millionaires….”

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