Global Sovereigns: Best entry point in a decade?
Global Sovereigns: Best entry point in a decade?
Vikram Aggarwal discusses the remarkable rebound in sovereign bond yields, opportunities and risks in the asset class and macro outlook.
We went more than a decade in which yields in sovereign bonds were lower and lower. In developed markets (DM) such as Germany and Japan, government bond yields were negative and simply not investable.
That has changed in the last 18 months, and sovereigns are once again an income generating asset class. It’s possible to have a portfolio of high-quality government bonds with yields in the mid- to high single digits. We see a strong rationale for investors to allocate to sovereigns and, in particular, to an actively managed, unconstrained global sovereign bond strategy. Sovereign bonds are the largest part of the fixed income universe and the most liquid, so there are, in our view, significant opportunities in this universe of 166 countries, including DM, emerging markets (EM) and frontier markets.
That has changed in the last 18 months, and sovereigns are once again an income generating asset class. It’s possible to have a portfolio of high-quality government bonds with yields in the mid- to high single digits. We see a strong rationale for investors to allocate to sovereigns and, in particular, to an actively managed, unconstrained global sovereign bond strategy. Sovereign bonds are the largest part of the fixed income universe and the most liquid, so there are, in our view, significant opportunities in this universe of 166 countries, including DM, emerging markets (EM) and frontier markets.
Soft landing?
Our approach is to start by formulating a global macro-economic outlook, whilst identifying key economic or market trends. We then identify countries with improving or deteriorating outlooks and begin to construct a portfolio that’s optimised to deliver attractive risk-adjusted returns.
Our macro view is that market participants will shift their focus from concerns over high inflation to concerns over low growth. With the US Federal Reserve pausing its rate-hiking cycle in June, at the same time as “hard’’ economic data was outperforming expectations in DM economies, market participants have placed a higher probability on a “soft’’ economic landing in the US. We believe this optimism is misplaced and see a “hard’’ landing scenario as most likely. We also believe that historically tight monetary conditions have increased the propensity for additional financial accidents such as those we saw at Credit Suisse and Silicon Valley Bank.
Our macro view is that market participants will shift their focus from concerns over high inflation to concerns over low growth. With the US Federal Reserve pausing its rate-hiking cycle in June, at the same time as “hard’’ economic data was outperforming expectations in DM economies, market participants have placed a higher probability on a “soft’’ economic landing in the US. We believe this optimism is misplaced and see a “hard’’ landing scenario as most likely. We also believe that historically tight monetary conditions have increased the propensity for additional financial accidents such as those we saw at Credit Suisse and Silicon Valley Bank.
China risks
It’s also important to note the risks related to the weakness in the Chinese economy, which has seen stagnating industrial production and very low or negative inflation. We expect the policy response from Chinese authorities to be focused on stabilising rather than stimulating the economy, and prioritising consumption over investment. We believe this has profound implications for the rest of the world, especially exporting EM economies and the Eurozone, which have relied on demand from investment spending in China to drive their domestic economic growth for several decades.
We think credit spreads are overly tight, reflecting excessive market optimism, and we think it makes sense to reduce credit spread exposure. Owning a mixture of high-quality DM and EM local-currency sovereign bonds is sensible, we believe.
In the interest rates space, in DM, our preference would be for duration exposure via US, UK and Swedish government bonds. These are economies where we would expect to see slowdowns and signs of disinflation, and central banks may not be able to raise rates as much as the market expects. The UK and Sweden also have extremely weak housing markets. Likewise, in EM, South Korea is facing a slowdown in credit growth and activity and has an over-leveraged economy.
We think credit spreads are overly tight, reflecting excessive market optimism, and we think it makes sense to reduce credit spread exposure. Owning a mixture of high-quality DM and EM local-currency sovereign bonds is sensible, we believe.
In the interest rates space, in DM, our preference would be for duration exposure via US, UK and Swedish government bonds. These are economies where we would expect to see slowdowns and signs of disinflation, and central banks may not be able to raise rates as much as the market expects. The UK and Sweden also have extremely weak housing markets. Likewise, in EM, South Korea is facing a slowdown in credit growth and activity and has an over-leveraged economy.
Rates and FX
We are more positive on the rates outlook in Latin America, including Brazil, where the central banks moved quickly to address inflation.
Looking at sovereign spreads, it is mostly about selectivity. After a lot of pessimism had been priced in 2022, in the more recent months of 2023 we have seen a recovery in many of the idiosyncratic investment cases such as Ukraine, Egypt, Nigeria, El Salvador, Mozambique and Pakistan.
In FX, 2023 so far has been about carry and real yields. Several EM currencies such as the Brazilian real and Colombian peso, offer today meaningfully positive real yields to investors. In the developed markets, the Japanese yen could offer investors upside if a normalization of monetary policy were to start in Japan. Concerns over prospects for economic growth and still relatively modest real yields instead make us more bearish on the outlook for the euro and British pound.
While we are somewhat cautious about the outlook for global economic growth, we think this environment is ideal for investors and active fund managers in the wide and deep market of global sovereign bonds.
Looking at sovereign spreads, it is mostly about selectivity. After a lot of pessimism had been priced in 2022, in the more recent months of 2023 we have seen a recovery in many of the idiosyncratic investment cases such as Ukraine, Egypt, Nigeria, El Salvador, Mozambique and Pakistan.
In FX, 2023 so far has been about carry and real yields. Several EM currencies such as the Brazilian real and Colombian peso, offer today meaningfully positive real yields to investors. In the developed markets, the Japanese yen could offer investors upside if a normalization of monetary policy were to start in Japan. Concerns over prospects for economic growth and still relatively modest real yields instead make us more bearish on the outlook for the euro and British pound.
While we are somewhat cautious about the outlook for global economic growth, we think this environment is ideal for investors and active fund managers in the wide and deep market of global sovereign bonds.
The value of active minds – independent thinking
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