The third quarter of 2016 was dominated by Federal Reserve rate hike probabilities and the implications of the Brexit vote. As the quarter progressed, U.S. Federal Reserve officials seemed more eager to hike rates as the trajectory of growth, inflation and employment seemed to strengthen.
At the start of the quarter, while Fed Funds futures indicated a 12% probability of a rate hike in December, by the end of the quarter, markets were pricing in a nearly 60% chance of a December rate hike. The third quarter started on the heels of the Brexit vote, and resulted in expectations that developed markets will keep rates “lower for longer” to support their economies. Low rates may drive investors searching for yield to look at Asia and allow Asian central banks to maintain relatively easy monetary policy to support their own economies. Indeed, over the third quarter, the majority of Asian countries saw rates fall and currencies appreciate versus the U.S. dollar. Asian credit was also strong during the quarter, with spreads tightening significantly in July and staying largely stable in August and September.
As we move into year-end, one major theme continues to be the search for yield in emerging markets driven by historically low yields in developed markets. Currently, around 40% of global developed market government bonds and 60% of Eurozone government bonds trade at negative yields. Investors seeking returns without significantly higher volatility have increasingly looked to Asia.
In credit, we believe the easing bias of central banks will help mitigate the risk of rising defaults and prudent carry strategies, such as Asia high yield, will likely continue to be attractive. Entering at current levels has historically resulted in gains as long as investors have an investment horizon greater than two years. One unintended consequence is the current unusually low level of dispersion— the spread difference between the highest and lowest credit quality by rating or by spread quintile—in credit markets. Regardless of which metric we use to measure this dispersion, we find that investors are not demanding a significantly higher spread for the marginal credit risk. Historically, a low dispersion environment has signaled complacency and lower forward-looking returns. Nevertheless, the easing bias of central banks will mitigate risks of rising defaults.
In interest rates, we believe there will be one rate hike in the U.S. in December, with another 25 – 50 basis points (0.25% – 0.50%) of hikes in 2017. This shallow hiking cycle would still result in relatively low interest rates compared to historical averages. We believe Asian countries will continue to have lower-to-stable rates as most countries have seen moderating inflation with slow growth, providing room for policymakers to continue easing. We believe Indonesia, India and Malaysia all have room for more interest rate cuts, which should support their local currency bond prices.
In currencies, uncertainty around the global recovery will continue to drive volatility and U.S. dollar strength in the short term. Despite Asia’s relatively small trade exposure to the United Kingdom, we believe concerns over the long-term viability of the European Union (EU) and uncertainties surrounding the framework of Brexit will continue to weigh on risk sentiment. Asian currencies will remain volatile, and we expect greater dispersion amongst returns. Higher yielding, high volatility currencies that have experienced the greatest depreciation in the last few years, such as the Indonesian rupiah, Indian rupee and the Malaysian ringgit, will continue to have the greatest likelihood of appreciating over the next year.
An ancient Taoist proverb says, “As things tend to their extremes, they give way to their opposites.” As we think about the considerable global uncertainty we are faced with, it seems that in some areas, we have reached such extremes that we are seeing them give way to their opposites. Central banks are increasingly recognizing the futility of negative interest rates, and explicitly or implicitly passing the baton to governments to do more on the fiscal side. The skein of the EU proved to be too tightly bound, with its unwinding just beginning. The UK has voted to exit the EU, and the political winds which once blew so reliably towards integration are now going in the opposite direction towards disintegration. By staying focused on investing in companies with strong business models, balance sheets and good governance, we believe we are well-positioned to weather this period of uncertainty.
Fixed income investments are subject to additional risks, including, but not limited to, interest rate, credit and inflation risks. Investing in emerging markets involves different and greater risks, as these countries are substantially smaller, less liquid and more volatile than securities markets in more developed markets.
The views and opinions in this commentary were current as of September 30, 2016. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the Fund’s future investment intent.