After the relative calm of 2017, fixed income investors were confronted with a more complex constellation of factors to manage in 2018, most notably a return to monetary normalisation after an unprecedented decade of ultra‑loose policy.
The gradual reduction in the U.S. Federal Reserve’s balance sheet combined with the explicit raising of policy rates in the U.S., U.K. and Canada, weighed on markets throughout 2018. Political uncertainty in Europe and the U.K, as well as trade tensions between the U.S. and China, further unsettled markets at various points during the year.
Another key theme for 2018 was the return of volatility. After hitting decade‑low levels of 10% at the beginning of the year, the VIX equity volatility index soared before settling into a higher range throughout 2018, while interest rate volatility also spiked from historically low levels. As is often the case during periods of rising volatility, investor risk appetite fell, causing credit spreads to broadly widen and safe haven investments such as the U.S. Dollar to rally. The combined effect of widening credit spreads, a stronger Dollar, modestly higher U.S. interest rates and growth moderation outside the U.S., produced a largely negative total return across the major sectors of the bond market during 2018.
Interest rates began the year close to multi‑decade lows in most non‑U.S. markets. Ex‑U.S global government bonds closed the year three basis points higher to yield around 1%. In the U.S., a late cycle flattening of the yield curve in response to central bank tightening, caused the U.S. 10‑year Treasury yield to jump 80 basis points during the year before ending 30 basis points higher at 2.8% after a fourth quarter rally. In response to falling market inflation expectations and a general risk‑off sentiment, the U.S. Inflation‑Linked Bonds market saw the 10‑year break‑even dropping from over 2% to close the year at 1.65%.
During 2018, relatively strong U.S. growth and a large positive interest rate differential between the U.S. and other major developed economies contributed to an average 4.5% appreciation of the Dollar versus other G10 currencies.
Credit markets faced a challenging environment in 2018. The combination of rich valuations at the start of the year, coupled with rising equity volatility and the withdrawal of liquidity by central banks, pressured credit spreads to widen as the year progressed. U.S. credit, both investment grade and high yield, underperformed cash. Emerging market assets also came under pressure from the global slowdown, liquidity tightening, trade tensions, and other factors.
As it was for other asset classes, 2018 provided a challenging environment for active management in fixed income markets. However, tactical decisions made by ADIA in early 2018 to reduce exposure to Credit and overweight the U.S. Dollar benefitted performance during the year.
The Fixed Income & Treasury Department made significant progress in 2018 to prepare for the launch of a single pool, or portfolio, into which all its existing pools will be combined. This provides a framework that will eventually enable the Department to manage all of its assets actively across market segments. In addition to reducing complexity, we expect this to increase net revenues without compromising strategic asset allocation or liquidity provisions.
During 2019, as part of its transition toward increased active management, the Department plans to add a number of new positions, mostly within investment and research‑focused roles.
From a market perspective, valuations in 2019 will likely continue to gravitate towards historical norms. This may include wider spreads, higher yields and modestly higher volatility as markets assume a greater role once again in determining appropriate risk premiums.
Fading fiscal stimulus and ongoing Federal Reserve monetary tightening are expected to result in a narrowing of the growth gap between the U.S. and other developed economies, and a gradual convergence in policy rates. Central banks in the Euro Area, Sweden and Norway are all candidates for rate rises, while tapering of asset purchases in Japan is likely to continue. As a result, 10‑year bond yields in these markets may edge closer to those in the U.S.
In Europe, the outlook for government debt will be shaped, to some extent, by the European Central Bank’s (ECB) decision to end the bond‑buying programme it began in 2015. As the ECB’s purchases helped depress yields, the absence of such a large buyer could be expected to exert some upward pressure, although this may be hindered by the ECB’s reinvestment of its proceeds from maturing debt that it already owns. Investors will also pay close attention to European Parliament elections in May, where Eurosceptic candidates are predicted to perform strongly.
After experiencing considerable volatility last year, emerging markets may begin to look attractive if conditions stabilise in 2019. Political events will likely remain in focus, with closely watched elections due in Argentina and India.
Meanwhile, credit markets may come under growing pressure in 2019 against an increasingly complex geopolitical backdrop. There are also concerns that valuations remain too high given deteriorating fundamentals and liquidity conditions.