What the managers expect: bonds, property and wealth preservation

BONDS

Jenna Barnard, co-head of strategic fixed income at Janus Henderson Investors 

We've seen huge amounts of industry disruption, which is causing problems for certain corporate bonds. Technology is a huge source of disruption and we see that most obviously in the retail sector. But we also see, for example, the beer industry in the US being disrupted by the rise of cannabis as an alternative and small craft brewers. So, it feels that we are being squeezed out of many industries that we would have invested in historically, because they are becoming too unpredictable and there is a lack of top-line growth. So that disruption, divergence and being really strict about who we lend money to is key – and it is getting more difficult.

By far the biggest risk in 2018 to all bond asset classes will be wage inflation. If we see signs that low unemployment in the UK, US, Germany and Japan results in wage inflation, then central banks are back in play and we'll have much faster interest rate hikes. But so far we don't see this.

We think the bigger opportunities for us are in government bonds, for example in Australia, which is a very interesting and divergent economy.

In the US the economy looks quite late-cycle, so we are looking for buying opportunities in government bonds and credit markets. We are going to maintain discipline and keep reducing the riskier credit in portfolios.

Paul Read, head of fixed interest, and Julien Eberhardt, fund manager, at Invesco Perpetual

Following strong performance we will start 2018 with many areas of the European bond market looking expensive, and it is difficult to see bond markets repeating the kind of performance we have seen in 2017. 

But a number of the factors that helped drive returns in 2017 remain in place. The demand for income remains very high and the European Central Bank (ECB) is still a dominant force in European credit markets. Although it is tapering its asset purchases, it is doing so very gradually and any hike in European interest rates still looks some way off. 

Companies have been able to take advantage of low yields by refinancing debt on more attractive terms, so there is little pressure on default rates. This mixed backdrop of positive fundamentals but expensive valuations leads us towards a more balanced investment outlook. It is difficult to see a scenario in which yields move meaningfully lower, so income is likely to be the main component of return in 2018.

Our strategy is to seek out relatively safe sources of income while staying defensive overall. Periods of market strength provide the opportunity to reduce exposure and wait for better levels at which to add.

>We are still finding opportunities among US corporate bonds. The expectation that the Federal Reserve (Fed) will continue hiking in 2018 is to some extent already priced into the US Treasury market

But there are still parts of the market where we are finding opportunities and others we avoid. Generally we stay away from parts of the market that are being manipulated, such as peripheral European sovereigns and bonds purchased through the ECB's Corporate Sector Purchase Programme. The price of bonds often better reflects the underlying risk of the investment in areas including subordinated financials, corporate hybrids and selective parts of the high-yield market.

The bailout and rescues of the past year have removed weaker banks, leaving a stronger financial sector overall. Tighter monetary policy and steeper yield curves should, all else being equal, also support the sector. However, from a valuation perspective the outlook for the sector, like much of the corporate bond market, has become more balanced. Additional Tier 1 and contingent capital yields have fallen significantly in 2017, so the standout valuation opportunity versus the high-yield sector has diminished. There are still some opportunities, but we need to ensure that we are being rewarded for taking the risk.

We are still finding opportunities among US corporate bonds. The expectation that the Federal Reserve (Fed) will continue hiking in 2018 is to some extent already priced into the US Treasury market. Compared to German Bunds, US Treasuries also offer between 160 and 240 basis points of extra yield across the curve. But the two markets are interdependent. The 10-year Treasury tends to pull the 10-year Bund higher, while the Bund anchors the Treasury. As this tussle plays out in 2018, we think the likelihood is for higher Bund yields. Higher rates feed straight through to banks' bottom lines, so this should be supportive of our exposure to European subordinated financials.

Ariel Bezalel, head of strategy, fixed income, and manager of Jupiter Strategic Bond Fund (GB00B544HM32)

The past year has seen the first significant global pick-up in economic activity since the financial crisis began. Although economic data in the US has been mixed, the Fed has deemed it strong enough to take steps to reduce its massively inflated balance sheet, bloated by years of crisis-era monetary stimulus. The Fed also plans to stick with slowly raising interest rates, marking its confidence that inflation, which was stagnant for so many years, is set to return.

The unwinding of the biggest monetary policy experiment in history in conjunction with raising interest rates at this late stage in the economic cycle signals a significant risk for global bond investors. It is this stimulus that has been the key driver of risk assets since the financial crisis.

This year we witnessed some striking warning signs of potential asset bubbles created by such loose policy. European high-yield credit traded in line with US Treasuries for the first time in history, Argentina sold oversubscribed 100-year bonds – despite being a serial defaulter – and, in what is usually a sign of a slowdown, the US yield curve flattened despite improving gross domestic product (GDP) growth, raising questions about whether the yield curve is also distorted.

With the Fed and other central banks around the world now seeking to remove liquidity, and valuations across most risk assets such as corporate bonds and equities at record highs, 2018 could be a challenging and volatile year. At such record high valuations, risk assets look vulnerable as the Fed tries to tighten policy.

>The unwinding of the biggest monetary policy experiment in history in conjunction with raising interest rates at this late stage in the economic cycle signals a significant risk for global bond investors

The Fed has justified its decision to start normalising interest rates by arguing that weak inflation is temporary. However, we expect that downward pressure on inflation will continue to haunt the global economy. Long-term trends such as ageing populations, an overly indebted world and the disruption brought about by technology are all likely to suppress economic growth and inflation for longer than many people expect. These long-term structural issues are likely to keep a lid on bond yields for some time to come.

The US is also showing a number of signs of late-cycle behaviour in corporate bond markets. Delinquencies have risen on credit card debt, auto loan financing has deteriorated and there has been a massive deterioration in the quality of borrowing agreements from US high-yield bond issuers, which represents a big shift in power from the creditor to the debtor. Approximately three-quarters of leveraged loans in the US have been issued with very little covenant protection.

In light of the risks caution is a sensible approach – we have increased the quality of bonds in our portfolios and reduced high-yield exposure. But although we favour high-quality, developed market government bonds, such as US treasuries, we see a few bright spots in emerging market debt.

For example, India is one of the few countries where we favour adding more risk. Government and corporate bond yields are attractive, and despite short-term currency weakness, we expect the rupee to strengthen again as economic activity picks up, following further reforms and as Indian interest rates drift lower. We have also put money to work in bonds that act as cash proxies, where we believe there is a reasonable possibility of better returns without putting the capital invested at undue risk.

COMMERCIAL PROPERTY

Ainslie McLennan, co-manager of Henderson UK Property PAIF (GB00BP46GG64)

The consensus view is that the London office market should see some capital declines, starting in 2018 and flowing through to 2019. The currency benefit of a weaker pound for overseas investors has meant that there is still quite a bit of investment activity in that part of the market, particularly for trophy-style assets. But we expect this to taper off and there to be a shift down in the capital values of West End and central London offices, which vindicates our reduction of the portfolio's weighting to these.

We have implemented a lot of work on portfolio asset management, such as refurbishment work or renegotiating existing leases, to help protect capital values and the fund's occupancy rate. I think 2018 will be about trying to capture as much of that as possible by actively managing the portfolio.  

Some of the most compelling opportunities in the market are within alternatives. This sector has been one of the most traded areas over the past year, but we bought into the sector early enough and at favourable yields, so have enjoyed some of the performance from these assets. Examples of alternatives include care homes, private healthcare, leisure facilities such as gyms, hotels, cinemas and restaurants, and data centres, which are very good income providers. This part of the market is a good place to have an overweight position. The fund's alternative assets in the main have very long leases. And approximately one-third have leases with either inflation-linked increases or fixed increases.

Overall, the UK commercial property market looks relatively stable, and it has been a good year in terms of returns and delivering on income. The risks overall are more at the macroeconomic level, based on the wider economic and political backdrop. We have been positioning the fund to protect investors from any potential fallout as we go through the process of extracting the UK from the European Union (EU), making sure that its income is as steady as possible.

Making sure that rental income is still coming to the fund and managing the vacancy rate will continue to be a huge focus over the next 12 months.

Will Fulton, manager of UK Commercial Property Trust (UKCM)

UK real estate has performed more strongly in 2017 than most analysts and commentators were expecting at the start of the year, recording a total return of over 8 per cent to the end of October. The capital losses seen immediately after the referendum in 2016 have been reversed – capital values are now ahead of where they were before the vote.

UK real estate is at a mature stage of the cycle and the elevated double-digit returns achieved over 2013 to 2015 are unlikely to be repeated in the year ahead. But supply continues to be relatively muted, albeit with pockets of oversupply in some markets such as parts of the central London office market and poorer retail locations.

Demand is holding up well across the market, despite the ongoing uncertainty that is holding back some occupier decision-making. Returns will mainly be driven by the secure, steady income component that is derived from occupiers continuing to pay their rent, and also by the ability of real estate managers to manufacture additional income by increasing rents while meeting tenants' needs.

Next year returns will be lower than earlier in the cycle, but remain compelling on a relative basis. The profile of returns is unlikely to be significantly different to this year, with assets linked to the manufacturing and distribution sectors continuing to benefit from the tailwinds related to the weaker currency and the ongoing structural changes in the way that we shop.

We continue to favour the industrial/distribution sector, although the pricing for good new investment here is now very competitive – our focus remains on resilient income with positive fundamentals. We also think best-in-class retail that offers an experience that can't be purchased over the internet will do well.

We remain cautious on central London offices and expect this sector to continue to underperform. It is more expensive than most of the other segments of the market, and remains most vulnerable to any post-referendum fall-out if the trading arrangements for doing business cross-border are not as favourable as at present. 

Overall, income is expected to be the main driver of returns in 2018. Despite the mature stage of the cycle, UK real estate continues to generate an elevated yield.

WEALTH PRESERVATION

Luke Newman, co-manager of Henderson UK Absolute Return (GB00B5KKCX12)

The breakdown in correlation we've seen between share prices and bond markets will provide a great opportunity, particularly on the short side of the portfolio. We are identifying companies that have prioritised margins and cash flow – which are noble aims – but at the detriment of investing back in their own businesses. Where top-line growth has been disappointing, we are seeing savage de-ratings in share prices. So we will perhaps have a bit of a tilt towards the core short side, where we are seeing some exciting opportunities, for example in areas such as US consumer staples.

There is a lot of poor news, but we don’t ignore the winners. Where we can find companies and franchises that are delivering top-line growth − ahead of expectations, their end markets and economies – we back those businesses in a significant way.

And there is a focus on the supply side of industries and sectors, which is proving very fruitful. Where we find companies that are being disintermediated by new digital players, we are finding some great opportunities to go short. Equally, where we can find and identify industries such as cements, aggregates or bulk annuities, we are seeing an improvement in pricing discipline driven by an exit of established players from those industries. Fewer players and more disciplined pricing hopefully mean better returns for shareholders.

Shrenick Shah, co-manager of JPM Global Macro Opportunities Fund (GB00B4WKYF80)

In 2017 you have had four regions driving global growth – the US, Europe, Japan and China – something we have not had for a long time. This has allowed us to take a bit of extra risk, and for 2018 we expect more of the same with these four regions contributing to growth. We continue to be more optimistic than we were, in part due to three new factors.

Business investment across the globe from the private sector is picking up nicely, which should feed through to the growth numbers in the first half of 2018. Private sector confidence is high both among businesses and consumers. Also, the cost of borrowing and foreign exchange volatility are low, and stock markets are high, which should stimulate economic activity.

When you have a conventional upswing in global growth, an external shock or financial conditions such as central banks tightening can derail this. In the US, you would expect labourforce growth to increase slightly and we hope to see a continued improvement in productivity growth. If this doesn't happen the Fed may tighten quicker than expected.

>We are expecting relatively good news on the US economy to be priced into markets. This should create a nice environment for being long the US dollar, and short lower-yielding currencies such as the euro and Canadian dollar

Inflation could rear its head more strongly than expected and that would be a risk to asset markets next year. The Fed may also move more quickly because the supply-side of the economy – workforce growth and productivity – may not respond very well, so we may not get positive supply-side dynamics.

We are running relatively moderate levels of risk. We wish to capture the stronger global growth dynamic so, for example, our exposure to the financials and materials sectors are explicit plays on this. We also have a significant position in tech stocks, driven in part by our widespread tech adoption theme.

We are short relatively expensive bond proxies – shares of US utilities and staples companies. If government bond yields go higher, as we would expect in an environment of strong growth and tightening monetary policy, staples and utilities are likely to underperform.

We are expecting relatively good news on the US economy to be priced into markets. This should create a nice environment for being long the US dollar, and short lower-yielding currencies such as the euro and Canadian dollar.

We are long US volatility via futures listed on major US exchanges. If there is a move lower in risk markets like equities this strategy should cushion the portfolio from drawdown.

But we are optimistic – we expect strategies tied to stronger global growth to perform well. However, central bank tightening may cause disruption later in the year.