We believe global monetary policy will remain a primary focus of investors in 2016 driven by a continuation of the Federal Reserve’s recently launched rate hiking cycle.
In the U.S., the focus will turn to the pace of rate hikes in 2016, while in Canada and Japan investors will be on the lookout for signs of whether further stimulative measures are needed to combat slow growth and/or low inflation. The European Central Bank remains committed to easing measures given modest growth and inflation, but its approach to policy intervention in 2016 will likely be modest compared to recent years that have seen the introduction of negative interest rates and quantitative easing.
Credit spreads have widened in response to lower commodity prices and the Fed’s tightening cycle, resulting in attractive opportunities for investors. While segments of the investment-grade corporate bond market are most attractive in the U.S. and Europe, we see opportunities in the preferred share market in Canada for long-term investors. The high-yield market presents pockets of opportunity, but remains appropriate only for investors comfortable with high levels of volatility and credit risk.
Central bank rate (%)
*1-yr base lending rate for working capital, PBoC
Source - RBC Investment Strategy Committee, RBC Capital Markets, Global Portfolio Advisory Committee (GPAC), Consensus Economics
Sovereign yield curves
Source - Bloomberg
- Fed uncertainty remains as markets now turn the focus toward the pace of rate increases following the December rate hike. The Fed isn’t expected to raise rates again at the January meeting, with markets seeing March as the next realistic option. However, we think June is more likely—with officials wanting time to assess the incoming data in order to justify the next move—before commencing a “more normal” pace.
- Treasuries pulled off a surprise upset over corporates in 2015, returning +0.84% to the investment-grade market’s -0.68%. But don’t expect a repeat performance in 2016. We see still-favorable fundamentals and a solid economic backdrop, supporting a return to relatively tighter credit spreads. This tightening should be sufficient to offset modestly higher Treasury yields, with performance led by the less interest-rate-sensitive “BBB” corporate sector.
- Cracks in the high-yield credit market have captured headlines in recent weeks amidst some high-profile fund closures and ongoing commodity-related stress elsewhere. We believe the fund liquidations were isolated events due to highly-speculative holdings, while we see low likelihood of commodity-related stress spreading to other sectors, where we expect positive coupon-like returns outside of energy.
10-year rate (%)
*Eurozone utilizes German bunds.
Source - RBC Investment Strategy Committee, RBC Capital Markets, GPAC
- 2016 began with heightened expectations for an interest rate cut from the Bank of Canada (BoC). This follows a December that included the release of data that revealed slower growth, continued oil price weakness, and the BoC having lowered the “effective lower bound” of interest rates to -0.50% from 0.25%. Investors concerned about another rate cut should consider locking in the rates on their cash balances by purchasing GICs.
- The preferred share market reached new lows in mid-December before rebounding by the end of the month. Tax-loss selling and a fall in 5-year government of Canada yields were the key drivers of the price declines. Looking forward, we continue to recommend investors focus on issues trading at significant discount to par and offering attractive long-term spreads.
- Credit spreads have been weak across all sectors, but most notably in the high-yield energy space. We view the recent pullback as an opportunity to add higher-quality credits to portfolios, but remain cautious on high-yield and energy names.
Continental Europe & U.K.
- We expect core country eurozone yields to remain at low levels given muted levels of inflation and growth. Peripheral countries should be the largest beneficiaries of the European Central Bank’s decision to push the deposit rate further into negative territory concurrent with tweaks to its quantitative easing program. However, political uncertainty could provide bumps in the road.
- The U.K. economy is improving, but inflation remains stubbornly low. Inflation expectations for the next three years remain low with the odds of an interest rate hike in the next six months diminished. The Gilt market continues to trade between U.S. Treasuries and German Bunds, a pattern that is unlikely to end in the short term.
- European credit spreads widened in anticipation of a rate hike by the Federal Reserve and remained elevated post the 25-basis-point increase. Wider spreads present an opportunity for investors in investment-grade corporates, particularly among BBB-rated consumer services and financial issuers. We remain comfortable increasing duration exposure up to 10 years in Europe (within the context of an average portfolio duration nearer five years) in light of the low growth and inflation environment that is expected to persist through the medium term.
Credit market stress remains concentrated in energy sector
Source - RBC Wealth Management, Bloomberg, Barclays
The high-yield energy sector has breached the 10% distressed yield level indicating rising default risks; stress elsewhere remains contained.