Following a torrid period for riskier assets, that included the first serious correction in stock markets since 2011, world equity indices recorded their strongest monthly gains in four years in October, a move that has continued into the current month. Worries over global growth gradually eased as Chinese stimulus plans and improving emerging market economic data helped alleviate investor concerns.
With main market government bonds generally ceding prior gains, global equities outperformed global bonds by nearly 12% from 29/9 to 4/11. Unsurprisingly, cyclicals led the recovery and the main equity indices and high yield debt, together with emerging market equities, bonds and currencies, all rebounded strongly.
China Cuts Interest Rates
Once again, there was considerable monetary policy commentary but the only central bank to act was China’s PBOC which cut interest rates for the sixth time in twelve months and again lowered the reserve requirement ratio for commercial banks.
Elsewhere, the statement from the US Federal Open Market Committee (FOMC) was far more hawkish than expected, the Bank of Japan held steady, a surprise to many commentators, European Central Bank President Draghi hinted of more stimulus to come, while Bank of England Governor Carney indicated interest rates will rise next year rather than in Q2 2017 as predicted by the futures market.
Recent statements from the FOMC and speeches from key Fed officials clearly signal a preference for a rate hike at the December 16 meeting, a view now effectively priced into financial markets – indeed, the implied probability from interest rate futures, two year treasury yields and the dollar have all surged in recent weeks.
Will Fed Raise Rates Next Month?
Should it begin the interest rate “normalisation” process in December, additional FOMC tightening thereafter is likely to be gradual. In contrast, financial markets are pricing in further stimulus from the ECB and probably more than just extending the timeline for asset purchasers by a quarter. Elsewhere, further stimulus is still probable in Japan while UK interest rates rises are still some way off.
Having produced excellent gains during the prior risk asset sell-off, global bond returns were totally reversed as the JPM Global Aggregate Bond ($) index declined 2.0% between 29/9 and 4/11. Losses within fixed income were principally sustained by US and UK government bonds while Europe and Japan produced positive returns, the former following heightened expectations of further ECB purchases.
How Have Bonds Performed?
Naturally enough, corporate bonds outperformed governments as spreads narrowed. This was particularly true for high yield, especially in the US, which aided by a 6% gain in high yield energy bonds rallied some 4%. As emerging market fears eased so emerging market debt and currencies surged, producing a 4.5% gain for the JP Morgan EMBI Global index between 29/9 and 4/11.
Looking forward, riskier assets are still preferred to government bonds. Investment grade has lagged the recovery elsewhere, although this may partly be due to large M&A announcements and issuance, but spreads remain much wider than at mid-year.
Despite their sizeable rally high yield spreads could tighten further although valuations have moved closer to fair value in a still uncertain climate.
With the US Fed itching to raise rates, and headline CPI expected to soar in the New Year from zero to at least 1.5%, US treasury yields should head higher taking gilts in their wake. Spreads over German bunds have widened out in recent weeks leaving bunds even more overvalued but, with ECB purchases ongoing, “fair value” may be less meaningful and the currency could well take the strain.
Within emerging market debt, quality has performed well and should continue to do so but fundamentals for emerging market corporates remain challenging and a Fed “lift-off” may generate some near term concerns.
