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Looking for positives in a negative-yielding world

James Cheo
James Cheo9/27/2019 6:30 AM GMT+08  • 5 min read
Looking for positives in a negative-yielding world
(Sept 30): A focus on negative yield curves masks the fact that there is still value in the markets. You just have to look in different places.
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(Sept 30): A focus on negative yield curves masks the fact that there is still value in the markets. You just have to look in different places.

Too early to worry about inversion

The plunge in bond yields has forced yield curves (the interest rate horizon for similarly rated bonds with different maturity dates) to invert recently. The inversion between the US Treasury 10-year and twoyear bond yield is often seen as an indicator of a possible recession ahead, as it signals that the market believes the central banks in question (the US Federal Reserve, European Central Bank, Bank of Japan and Swiss National Bank have been hawkish of late) are behind the curve, and will need to cut rates quickly to stabilise the economy.

But while the indicator is often a good signal of a recession ahead, it falsely signalled a recession in 1998. In addition, it tends to take 15 to 18 months after a curve inversion before a recession materialises. Lastly, we believe the yield curve would need to remain inverted for several weeks for the signal to be credible. So far, the inversion of the 10-year and two-year yield curve has occurred only briefly for a few days in August.

Yield curve inversion does not equate to recession

Trade and manufacturing are weak around the world, but consumption and services are generally still quite resilient. This is due to relatively strong labour markets, high consumer confidence and the broad downward trend in unemployment.

The good news is most economic indicators outside of manufacturing are holding up, and central banks have promised to stay very accommodative until the global economy is in decisively better shape.

The critical factor to watch is whether manufacturing slows down so much that it leads to significant job losses, and starts to negatively affect consumer confidence and spending. There are no signs this is happening yet and a recession appears unlikely for now.

Trillions of negative-yield bonds cannot disappear overnight

Against a backdrop of slower growth, most central banks will look to lower interest rates, which will entrench the existing stock of negative-yielding bonds. Currently, there is a staggering US$16 trillion ($22 trillion) of bonds trading with negative yield. Already, more than half of the developed-market bonds currently yield less than 1%, with more than a quarter in negative territory. This creates a challenging environment for investors in a negative-yielding world.

Looking further afield for positives

The good news is that even in a world with negative yields, there continues to be attractive carry opportunities for investors if they look further afield, especially in emerging markets (EMs).

A dovish pivot by central banks and a slowing, but still growing, global economy bode well for EM bonds. Muted issuance is a positive. With the current economic cycle stretching out further because of central bank easing, default risks connected to a downturn are also further away.

Global diversification and active management can negate negative yields

Global diversification is the key strategy in navigating the negative rate environment. Investors can boost return potential by diversifying a fixed-income portfolio across segments of the bond and equity markets that offer higher yields than developed-market government bonds, including corporate bonds, EMs and dividend yielding equities.

Earning attractive, positive returns can be challenging when yields on a significant portion of the bond market are negative. A quarter of developed market bonds are negative yielding. Blindly mirroring passive global bonds — with inherent exposure to negative bonds — would erode an investor’s total returns. Therefore, in a world of negative yields, the need for active managers to minimise the impact of negative yields and outperform the broader market is paramount.

Selective carry opportunities in EM bonds

One of the main bond asset classes that still offers positive carry is EM bonds. We have recently upgraded our view on EM debt, where the dovish shift in US policy has provided support to EM bonds. The high-yield portion of the EM debt complex offers attractive spreads. And we believe the recent pullback has opened up selective opportunities for EM debt — especially in Indonesia and India — although we steer clear of countries with high exposure to the USChina trade tensions.

Finding yield with dividend equities

On equities, we want to take some profit on our cyclical positions and rebalance into more defensive dividend-yielding stocks. In fact, one of the primary beneficiaries of a negative-yielding world would be higher-yielding Asian dividend stocks.

From a portfolio perspective, the rationale of rebalancing from high-beta, cyclical equity exposure to lower-volatility dividend stocks has its merits. The relatively lower volatility of dividend stocks stems from the stability of their earnings. Dividend payers tend to be more established companies with solid business models that benefit from more stable cash flows and have less economic sensitivity than more-volatile companies in cyclical industries. From a total returns standpoint, dividends comprise a large portion of performance over the longer term. Having solid dividends can cushion performance during market swings.

Positive carry strategies crucial in negative yield enviroment

Amid sluggish growth and in an environment where central banks are on a rate-cutting path, income strategies are reasserting themselves as the key driver for asset returns. Coupon and dividend income has historically contributed to the bulk of total returns for bonds and dividend stocks. The recent decline in yields may have temporarily elevated the role of capital appreciation in generating returns. We believe positive carry strategies will be crucial in a negative-yielding world.

James Cheo is chief market strategist for Southeast Asia at HSBC Private Banking Important note: Investments in emerging markets may be extremely volatile and subject to sudden fluctuations of varying magnitude due to a wide range of direct and indirect influences. Such characteristics can lead to considerable losses being incurred by those exposed to such markets. This document does not constitute independent investment research. This document has been issued by the Singapore Branch of The Hongkong and Shanghai Banking Corp Ltd.

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