What Should Europe’s Bond Investors Be Watching in 2018?
This year may be remembered for its low volatility and the strong performance of nearly all asset classes across almost all geographic markets. But 2018 may follow a different playbook. Compressed bond yields and tight credit spreads present challenges—and volatility could make a comeback as monetary policy turns and political controversies resurface.
What should European fixed-income investors watch out for? Six factors look likely to have most IMPACT on bond portfolios.
Inflation. US inflation could surprise on the upside if growth accelerates as oil prices stabilize, labor market slack narrows and wage inflation pressure builds—and it could be further stoked by fiscal stimulus. Sustained inflation shocks could force a more aggressive rate-hiking response from the US Federal Reserve (Fed) than markets currently expect. Inflationary pressures in Europe are more muted, but stronger-than-expected regional growth and, consequently, an improved inflationary outlook might see the European Central Bank (ECB) slowing its quantitative easing (QE) program faster than markets are pricing in.
As developed-world bond yields come under pressure from stronger inflation and rising rates, some emerging-market (EM) debt could rally as falling inflation allows local central banks to ease. Keep an eye on Mexico where inflation is set to drift lower throughout 2018.
Monetary policy. With the global recovery strengthening, central banks across the developed world will press ahead with monetary policy tightening. Four more rate hikes are on the cards in the US in 2018 and we expect the Bank of England to raise rates at least once more next year. The ECB isn’t likely to hike before 2019, but QE tapering will exert upward pressure on euro-area bond yields. The shift towards less bond-friendly policy will likely be gradual—but markets could be caught off guard if big inflation or growth surprises see policy quickly turn less accommodative.
Populism. Concerns about globalization, immigration and austerity will continue to drive support for populist politicians with unpredictable policy agendas that could trigger market unease. Potential hot spots include Italy, where the anti-globalization, Eurosceptic Five-Star Movement may gain ground as general elections in May approach. Spain is vulnerable given uncertainties associated with Catalonia’s bid for greater independence. In Germany, Chancellor Angela Merkel is still struggling to form a workable coalition government. Continued stalemate could force fresh polls—with a risk that the populist right-wing Alternative für Deutschland might rock the boat.
Latin America has a busy election schedule in 2018. Polls in Colombia in May, in Mexico in July and in Brazil in October could all spark political tensions that might drive up political risk premiums on these countries’ sovereign bonds.