Australian government bond yields have moved meaningfully since the US election, but what was missed by many is that they had already moved higher prior to it.
Initially, this movement was driven by a subtle but meaningful change in stance by central banks globally.
Unconventional policy including quantitative easing and the general buying programs that had manipulated bond yields lower over the past few years, in an attempt to stimulate investment at both the corporate and private level, are now being reassessed.
The efficacy of these programs and their ability to assist economic growth started to be questioned by the G20, as well as International Monetary Fund throughout 2016.
What followed was that many central bankers and governments started to talk about the need to move away from easier and easier monetary policy and think more about fiscal policy.
Then came the US election – Donald Trump’s win and his focus on pro-growth policies has given markets the confidence to think that the tide has finally turned.
This in turn has seen equities sharply higher in the last couple of months of 2016 and bond prices lower (yields higher).
For equities this pushed the S&P/ASX 200 from marginally negative for the year to up almost 8 per cent, whereas 10-year bond yields ended the year basically unchanged.
So where to now?
Trump policy, if enacted smoothly, could add 50-75 basis points to growth in the US and would therefore lift growth in 2017 to 2.25-2.50 per cent, this is good but not stellar.
Global growth should improve marginally, but as Trump’s policies are squarely focused on the US, the benefit for local markets comes more from having a weaker local currency (vs the USD) to help with export competitiveness, although global trade policy changes by Trump could whittle this benefit away.
Additionally, not all of the new administration’s policies are positive for economic growth; trade and immigration are the obvious ones, yet markets have ignored these presently.
In Australia, the growth story remains sound – in the third quarter of 2016 growth was negative, but we will see a turnaround in the December quarter.
Growth will end 2016 below trend again but considering we are transitioning from the largest mining capex boom in our history, this growth is acceptable.
The pleasing part is that growth in the services sector remains on track and, after increasing our resources capacity, demand is solid and pricing has recovered after a very soft period in 2015, as a result we will see an improvement in growth in 2017, albeit still below trend.
In the US, bond yields have already factored in hikes by the Federal Reserve.
Already, the strong rally in the US dollar is going to provide a headwind on activity for the US economy and will also impact on profitability for the US-owned multinationals.
Inflation is the other key for the direction of government bond yields.
For the past five years, longer in places like Japan, deflation has been a concern for central banks globally.
In Australia, this has been one of the major drivers that have pushed the cash rate to a record low of 1.50 per cent.
With commodity prices rising, oil in particular, and unemployment declining in many countries, this concern has eased somewhat, or at least there is some comfort that the strong deflationary forces are subsiding.
That said, inflationary pressures in Australia are still relatively benign as we will have reasonable slack in the labour market throughout 2017 with unemployment at around 5.6 per cent.
Wages growth will remain at the lowest levels in decades around 2 per cent, a far cry from the 10-year average of 3.4 per cent.
With business investment languishing, employment growth and, therefore, wages remaining somewhat contained in the medium-term, inflation will not be a driver for the Reserve Bank of Australia (RBA) to tighten policy over 2017.
Over the past few months, Australian government bond yields have moved higher across the yield curve and we suspect that volatility in rates will continue throughout 2017, as it will for other asset classes as well.
The headwinds globally haven’t just disappeared with a new government forming in the US.
Global issues like demographics, low productivity, a lack of business investment and government indebtedness remain.
On a regional level, Italy’s banking issues, China’s growing private debt and high savings rates, as well as the impacts of Brexit, all still exist and are still going to affect markets. For these reasons, along with benign inflation and below trend growth in Australia and quantitative easing still the vogue in Japan, UK and Europe, we don’t expect bond yields to rise significantly in 2017.
Therefore, with active duration management, sector rotation and stock selection benefits within the fixed income asset class, we expect bond returns to be positive during 2017.
The benefit of owning bonds is critical to a balanced portfolio and that holds true now more than ever.
If the ‘Goldilocks’ scenario proposed by Trump fails to materialise, then owning government bonds will be a critical offset to the negative capital gains that will occur if markets reassess all the positives that have overcome markets recently.
Anthony Kirkham is head of investment management (Australia and New Zealand) at Western Asset, and portfolio manager of the Legg Mason Western Asset Australian Bond Trust.
