The lack of volatility in recent times – and subsequent underperformance of defensive strategies – has led some market participants to suggest that a more relaxed approach can be taken to bond market risk. This is not our view.
Developed market central bank tightening is happening, ending an almost-decade-long period of ultra-easy accommodative policies. The Federal Reserve will step up the unwinding of its balance sheet and potentially deliver more than three interest rate hikes. In addition, it is possible central banks in Canada, Sweden, and the UK raise rates – while the ECB is reducing the pace of its bond buying to €30bn per month.
This synchronised move tighter, together with stronger global growth, is likely to drive core bond yields higher. We have prepared for a rising rate environment by moving the overall duration level of our T. Rowe Price Dynamic Global Bond Fund close to zero.
We are closely monitoring inflation because we believe that there is potential for price pressures to start rising modestly as a result of stronger global growth, higher oil prices, as well as tight labour markets in several developed countries. There are also signs that inflation has reached a bottom in emerging markets, with the exception of some isolated situations such as Mexico.
Given that consensus inflation expectations still remain subdued, even a tentative rise could catch markets off guard and lead to a repricing in core bond markets that pushes yields higher.
Meaningful political risks persist, too. Although the Trump administration has delivered tax reform, significant uncertainty still surrounds the US president’s ability to deliver on many of his campaign promises. Direct fiscal stimulus in the form of infrastructure spending has been delayed, while the US government continues to pursue trade protection measures that could have negative ramifications for the global economy if implemented.
In Europe, concerns over populist, anti-EU forces have receded, but the Italian general election in March has the potential to reignite them. In addition, noise surrounding the UK’s exit from the European Union is likely to continue through the rest of the year. In emerging markets, several large countries face election risk this year – including Mexico, Brazil, Russia and Malaysia.
The combination of risks present in the market has already resulted in a major spike in volatility in early February. We expect further volatility throughout the rest of the year.
The uncertainty dominating the market environment should provide a tailwind for our strategy, as we seek to identify sectors and individual securities that are mispriced as a result of temporary market dislocations.
Arif Husain, portfolio manager of the T. Rowe Price Dynamic Global Bond Fund