Strategic Fixed Income outlook 2017: keep liquid, sensible; look for opportunities, but don’t force it

John Pattullo, Co-Head of Strategic Fixed Income at Henderson Global Investors, discusses how the markets were affected by major political events in 2016 and the lessons learned. As he looks forward to 2017, John shares his views on what themes are likely to dominate the markets given a volatile backdrop and where he looks to find good investment opportunities.

What lessons have you learned from 2016?
2016 has been an interesting year and we have learnt two main lessons. Firstly, that these days no one can predict the outcome of a poll! More interestingly and related to this, was the monetary1 and fiscal2 responses to the two big events — Brexit and the US presidential election. Brexit produced a monetary policy response, as the Bank of England cut interest rates; and while sterling fell sharply, sterling bonds benefited as yields fell and prices rose. In the US, with the election of Donald Trump the opposite was proposed — a fiscal response; the US dollar rose sharply while the bond markets witnessed a sell-off as yields rose. These two events have, however, taught us that we will have opportunities to exploit in the upcoming elections in Europe in 2017.

The second lesson was on ‘liquidity’. In the last year we have significantly increased our holdings of US investment grade3 corporate bonds. Following the surprise election of Trump, in order to protect the portfolios, we took steps to reduce duration (interest rate sensitivity) and were able to sell roughly US$400m of bonds in just two days in the US investment grade market. The transactions were done in an efficient way due to the sheer size and liquidity of this market. That could not have been possible in our traditional hunting ground, the sterling corporate bond market, which is relatively small in size. Thus the need to be in liquid, sensible names that we can easily trade, became ever more apparent. We found that having more pools of liquidity available to us — in US dollar, euro or sterling; government, investment grade, or high yield4 bonds, and loans — proved beneficial at a critical time.

What are the key themes likely to shape the markets in which you invest in 2017?
In recent weeks, prior to the US presidential election, equity markets were experiencing a small ‘reflation’ rally, as economic data seemed to suggest a return of modest growth and inflation in some parts of the world. We have spoken about this in our videos and articles; but the election of Trump pushed the theme far and wide, with more investors rushing to switch from defensive/expensive stocks into cyclical stocks such as financials, while bond markets sold off.

We believe there is a possibility that the reflation theme might fade by the middle of next year. This is because we are not convinced, and nor are the strategists that we speak to, that Donald Trump can invigorate the US economy meaningfully to justify the very large price moves that we have seen in both the equity and bond markets. We may go back to the deflationary5, secular stagnation6 themes that were prevalent in the bond markets; or secular stagnation with an extra dose of ‘stagflation’7, potentially, next year.

The other big theme is politics, in particular the French and German elections. These could turn out to be big events, and are thus a big focal point for the team. While there could be obvious threats to the European project, we foresee opportunities arising for investment, based on our experience this year in trading some of the election risks and the strategies around them. In fact, there are always things to be doing in the markets and that is what makes them so interesting.