For bond investors, crossing the Atlantic makes sense

Diverging business cycles, diverging yields

“Given our current environment of elevated macro uncertainty, investors should still consider fixed income as an asset class. Look across the Atlantic, where the US bond market stands out both relative to other developed market bonds and in absolute terms.”

“If we look past the near-term economic uncertainty, we see that the structural drivers behind low rates are still very much in place. Medium term, now is therefore not the time to dismiss bonds as an asset class. What’s more, the hurdle for positive return surprises has been lowered – especially in the US.”

  • Yield gap at multi-decade highs
  • Eye-catching investment opportunity in US fixed income: The yield difference between US and Europe is at decade highs
  • Even from an absolute perspective, we see no reason to dismiss the US bond market: Longer term, demographics, high savings and low potential growth will keep a lid on rates.

Last summer, a subtle but significant shift took place in investors’ outlook: reflation hopes began to take hold and global yields began to rise. Unsurprisingly, analysts are now calling for rates to rise in 2017. Is it time for bond investors to run for the hills?

The answer isn’t obvious. Keep in mind that in 10 out of the last 10 years, shorter US bond yields ended the year below analysts’ forecasts. Given our current environment of elevated macro uncertainty, investors should still consider fixed income as an asset class—and this is all about choosing the right markets. Look across the Atlantic, where the US bond market stands out both relative to other developed market bonds and in absolute terms.

A bit of background: the spread between US and European interest rates has been growing ever since the Great Financial Crisis. Measured in terms of 10-year government bond yields, it now stands at the highest level since 1989. Back then, the US was still in in the aftermath of former Fed chair Volckers’ inflation-fighting agenda, with  inflation rates at 4,8%. Today the picture is fundamentally different, as the global economy has barely left its post-Lehman deflation fears behind and inflation stands at a relatively benign 1,6%.

Some of this widening interest rate gap can be explained by a stronger recovery in the US relative to Europe. As the US business cycle becomes stronger relative to other countries, the gap widens—but this economic divergence does not, in fact, tell the whole story. In particular, the most recent spread widening was by-and-large sparked by hopes for rising growth combined with a moderate inflation pick-up. Nevertheless, whether such a rosy reflation forecast materialises or not, the US stands out as an attractive investment opportunity in the fixed income space.

The relative case for US bonds: Bull and bear scenarios

Let’s start with the negative scenario. Markets have generally turned a blind eye to the contradictory elements of Trumponomics, expecting simultaneous higher growth, more protectionism and tighter monetary conditions. If rosy reflation turns out to be wishful thinking and the positives are largely off-set by the negatives, demand for safe haven bonds should rise. With US fixed income offering a significant yield pick-up and therefore price discount relative to other developed markets, a higher return potential strongly favours this region.

In a positive scenario, expectations for higher real growth and higher inflation would turn into reality. Still, this would make the relative attractiveness of US fixed income all but obsolete. Having a trade surplus vis-à-vis the US, Europe would most likely gain significantly from higher US demand. This would lift European growth above trend levels and put a huge question mark behind the ECB’s current monetary stance. On the other side of the Atlantic, rising inflation expectations and a narrowing unemployment gap have already caused markets to discount a steady rate hiking path. In stark contrast, no significant ECB tightening is expected over the coming two years. In other words, even a rosy economic outcome might imply less downside in the US than in European bond markets.

Trump’s protectionist agenda might be a wild card. If the bark is not worse than the bite, inward-looking trade policies would only allow for minor growth spill-overs if at all, leaving the rest of the world largely sidelined. Still, European rates could increase under such circumstances, as protectionism in essence is inflationary – and in Europe there seem more upsides in inflation expectations compared to the US. More protectionism would also imply a weaker global economic picture sooner or later, increasing the demand for safe haven assets over time. In the longer term, this limits downside in developed market bonds and actually underpins the attractiveness of US bonds.

The final analysis: don’t give up on US bonds

Leaving aside the relative attractiveness of US bonds, what about their overall return potential? The structural bull market in bonds has been driven by lower potential growth combined with higher savings, resulting in steadily falling yields. But this trend was reversed in the summer of 2016, as reflation hopes caused yields to rise. The downside risks in fixed income assets spawned from this changing sentiment should not be ignored. That said, the underlying structural drivers behind low rates are unlikely to change anytime soon. Many of the proposed policy changes in the US come at the price of lower growth elsewhere – at best a zero sum game. Trump’s tax cuts could very well result in higher savings, as the benefits are traditionally tilted towards the wealthier part of the population with the highest saving rates. Moreover, demographics have also played an important role in higher savings rates. The long-term trend of ageing populations won’t change with varying political majorities—it’s unlikely Trump can make America younger again. If we look past the near-term economic uncertainty, we see that the structural drivers behind low rates are still very much in place. Medium term, now is therefore not the time to dismiss bonds as an asset class. What’s more, the hurdle for positive return surprises has been lowered – especially in the US.

About Nordea Asset Management

Nordea Asset Management (NAM, AuM 214.5 bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 317 bn EUR*). NAM offers European and global investors exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies.

Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Sao Paulo, Singapore, Stockholm, Vienna and Zurich. Nordea’s local presence goes hand in hand with the objective of being accessible and offering the best service to clients.

Nordea’s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients.  NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products.

 *Source: Nordea Investment Funds, S.A., 30.09.2016

Nordea Asset Management is the functional name of the asset management business conducted by the legal entities Nordea Investment Funds S.A., Nordea Funds Ltd and Nordea Investment Management AB (“the Legal Entities”) and their branches, subsidiaries and affiliated companies. This document is intended to provide the reader with information on Nordea’s specific capabilities. This document (or any views or opinions expressed in this document) does not amount to an investment advice nor does it constitute a recommendation to invest in any financial product, investment structure or instrument, to enter into or unwind any transaction or to participate in any particular trading strategy. This document is not an offer to buy or sell, or a solicitation of an offer to buy or sell any security or instruments or to participate to any such trading strategy. Any such offering may be made only by an Offering Memorandum, or any similar contractual arrangement. Consequently, the information contained herein will be superseded in its entirety by such Offering Memorandum or contractual arrangement in its final form. Any investment decision should therefore only be based on the final legal documentation, without limitation and if applicable, Offering Memorandum, contractual arrangement, any relevant prospectus and the latest key investor information document (where applicable) relating to the investment. The appropriateness of an investment or strategy will depend on an investor’s full circumstances and objectives. Nordea Investment Management recommends that investors independently evaluate particular investments and strategies as well as encourages investors to seek the advice of independent financial advisors when deemed relevant by the investor. Any products, securities, instruments or strategies discussed in this document may not be suitable for all investors. This document contains information which has been taken from a number of sources. While the information herein is considered to be correct, no representation or warranty can be given on the ultimate accuracy or completeness of such information and investors may use further sources to form a well-informed investment decision. Prospective investors or counterparties should discuss with their professional tax, legal, accounting and other adviser(s) with regards to the potential effect of any investment that they may enter into, including the possible risks and benefits of such investment. Prospective investors or counterparties should also fully understand the potential investment and ascertain that they have made an independent assessment of the appropriateness of such potential investment, based solely on their own intentions and ambitions. Investments in derivative and foreign exchange related transactions may be subject to significant fluctuations which may affect the value of an investment. Investments in Emerging Markets involve a higher element of risk. The value of the investment can greatly fluctuate and cannot be ensured. Published and created by the Legal Entities adherent to Nordea Asset Management. The Legal Entities are duly licensed and supervised by the Financial Supervisory Authority in Sweden, Finland and Luxembourg respectively. The Legal Entities’ branches, subsidiaries and affiliated companies are duly licensed as well as regulated by their local financial supervisory authority in their respective country of domiciliation. Source (unless otherwise stated): Nordea Investment Fund, S.A. Unless otherwise stated, all views expressed are those of the Legal Entities adherent to Nordea Asset Management and any of the Legal Entities’ branches, subsidiaries and affiliated companies. This document is furnished on a confidential basis and may not be reproduced or circulated without prior permission and must not be passed to private investors or any investors not covered by relevant regulation. This document contains information only intended for professional investors and eligible investors and is not intended for general publication. Reference to companies or other investments mentioned within this document should not be construed as a recommendation to the investor to buy or sell the same, but is included for the purpose of illustration. The level of tax benefits and liabilities will depend on individual circumstances and may be subject to change in the future. © The Legal Entities adherent to Nordea Asset Management and any of the Legal Entities’ branches, subsidiaries and/or affiliated companies.

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