FIXED INCOME IN 2015: And the Oscar goes to

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1 FOR PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY FIXED INCOME IN 15: And the Oscar goes to JANUARY 15 Always make the audience suffer as much as possible. Alfred Hitchcock From great rotation to disinflation, the momentous bond bull market defied expectations again in. For consensus underweight fixed income positions, the sudden collapse in oil prices in H compounded the pain. With many yields now at record lows, what will take the spotlight in 15? STEPHEN COHEN Chief Investment Strategist, Fixed Income and ishares International ``Central bank divergence, our main theme of, took time to surface but is now a core driver for the year ahead. ``The corporate landscape is gradually shifting towards heightened event risk. ``Emerging markets will remain buffeted by the crosswinds of energy prices, political risk and US rates. ``The hunt for yield will be as intense as ever. ``More volatility and less market liquidity look set to present further challenges. Fed and BoE at the Edge of Tomorrow The US economy is showing signs of sustainable growth with an improving labour market. Most importantly, wage inflation the missing ingredient of the recovery looks to finally be here. Pressures on the Fed to raise rates will mount in 15. The US economy is showing signs of sustainable growth with an improving labour market. Unemployment is rapidly approaching economists estimations of the natural rate of unemployment; short-term (less than six months) unemployment has already fallen below such estimations. The ratio of vacancies-to-hiring is now well above pre-crisis levels, implying far less slack in the labour market. Most importantly, this should bring with it wage increases the missing ingredient of the recovery so far. Expect the Fed to raise rates mid-15 and the yield curve to flatten further, with global disinflation limiting the rise in long-end yields. Arguments for being long the USD are strong: the US remains the fastest-growing region and energy independence is in sight. Long USD is, however, the world s number one consensus. Expect volatility and bumps along the road. The BoE had long been in pole position as the first central bank to raise rates. However, a drop in inflation and a cooling housing market has given the Bank pause despite a strong growth picture. Political risk will rise as we head towards the May general election. The potential for no clear winner and the prospect of a possible EU referendum add uncertainty. Market expectations for UK tightening have been pushed back sharply, something that could reverse if the Fed hikes. We expect gilt yields to move higher, but this move will again be limited by the global growth picture. GBP can strengthen (except versus the USD), but weak structural issues (read: twin deficits) and politics are key risks to sterling. 1 Bloomberg, uary 15. SCOTT THIEL Deputy Chief Investment Officer of Fundamental Fixed Income MICHAEL KRAUTZBERGER Head of European Fixed Income SERGIO TRIGO PAZ Head of Emerging Markets Fixed Income

2 UNWINDING CORNER EASING CORNER Fed (Federal Reserve) BoE (Bank of England) ECB (European Central Bank) BoJ (Bank of Japan) PBoC (People's Bank of China) Planning the exit Planning a plan Draghi delivers again Another bazooka PBoC cuts rates... more to come? ECB and BoJ join The Imitation Game For much of, focus was on the growing camp of central banks in easing mode. Actions by the BoJ and PBOC in Q heaped pressure on the ECB to do more, compounding eurozone disinflation and a falling oil price. The ECB has laid out two conditions for further easing: (i) A further decline in inflation expectations (ii) Current measures being insufficient to meet its trn balance sheet goal. As to (i), inflation has turned negative bringing future expectations down further. In fact, medium- to long-term inflation expectations now price in a lot of pessimism possibly too much. Meanwhile, the combination of ABS, covered bonds and TLTROs looks unlikely to be enough to meet (ii). The ECB will deliver sovereign QE as we head through Q1 15, possibly as early as the first meeting in uary. As always, the devil will be in the detail: size, assets to buy and risk sharing. The heightened anticipation is increasingly priced in, limiting the upside of QE-sensitive European fixed income assets. Alongside such policy measures, greater political risk in the eurozone is rearing its head again as a factor in 15 as the unfolding Greek situation demonstrates. For peripheral eurozone bond markets, ECB QE and political risk means greater volatility in 15 even if the overall path for Italian and Spanish spreads to Germany remains gradually tighter. Better value is to be had in the laggards: Portugal (which could be helped by expectations of a ratings upgrade) and Slovenia. Bunds at ECB-inspired record low yields could find themselves in an asymmetric position post an ECB announcement: either vulnerable to a rebound in inflation expectations following a sovereign QE announcement, or sensitive to a pick-up in cyclical European data given current low expectations. As the JGB market s history shows, at these yield levels, things can get volatile. In Japan, the second round of the bazooka now sees the BoJ buying 9% of gross JGB issuance. Such duration extension will keep long-end JGBs firmly anchored and the long-end of the yield curve flattening as the JPY continues to weaken. Saving Mr Banks in Europe Our positive view on European financial credit panned out in, driven by the deleveraging of the banking system. Such positivity has further to run but may slow in 15. Financial corporates should be supported for another year but best value is to be had in subordinated debt, mainly in the core. AT1s struggled in 1 and face more supply pressure as banks look to meet loss absorption and leverage targets. However, yields of 5 9% in a world of 5bp-yielding 1-year bunds make this a place for carry in 15. As banks step away, capital markets step in: fixed income investors will have opportunities to provide capital to borrowers historically funded by banks, such as midmarket corporate loans or residential mortgages. Hunger Games : the search for yield If the downward pressure on global yields from the disinflation in Japan, China and Europe wasn t enough, sub-$5 oil is a game changer. If energy and commodity prices remain at these levels, the impact on fixed income as an asset class is profound. As showed, in a disinflationary world, shocks like oil affect everything from inflation breakevens to official institution flows. Low global yields are now a fact of life, presenting a huge challenge as investors income needs continue to grow. In the past few months, the yield drive has been concentrated in higher quality paper, while parts of high yield and emerging market fixed income have struggled. The question for 15 is: how this will feed through to those parts of the market that have underperformed? 1 Bloomberg, uary 15.

3 GLOBAL TREASURY YIELD 5 1 Sep Apr Nov Jun 5 7 Aug 8 Mar 1 Oct 11 May 1 Global treasury yield Source: Bloomberg, Barclays, LGTRYW Index is used as a measure of Global Treasury Yield, 9 uary 15 Dec For yield seekers, emerging markets will be a key area of opportunities and risks, as divergence is likely to be the norm. was the year of elections, 15 will be the year of reforms. Greater idiosyncratic opportunities at the sovereign and corporate level will be a key theme for the year as reform and governance take centre stage. Many countries are seeing huge adjustments to fiscal and current account deficits, which might put pressure on credit ratings in key economies. As in recent months, FX remains the shock absorber for EM macro and balance sheets, and a key driver for asset allocation. Energyimporting versus energy-exporting country differentiation will continue with much of Asia the main beneficiaries in the former. In the latter, the sell-off in energy exporters is now creating valuation opportunities in parts of EM where balance sheets remain strong. In local markets think India lowering inflation could enable further rate cuts, especially if (and it s a big if) FX volatility can be contained. In fact, India is a microcosm for the drivers in EM: current account rebalancing, oil impact, inflation frameworks and reform tests. Alongside sovereign bond markets, local rates markets that are satellites of the G7 central banks are starting to benefit from the rally in developed market rates. For broad local EMD, FX weakness remains challenging, though for European investors euro weakness provides a buffer to total returns. Hard currency EMD performed well for much of but has been affected by oil prices in recent months. Going forward, it may be a beneficiary of global institutional flows as investors seek both yield and USD assets outside their home markets but without taking on local currency risk. Low supply forecasts for next year also add support given recent widening in spreads. Contagion across EM from exposure to energy-producing sovereigns and a reversal of the US duration tailwind is the main risk to spreads. Credit: shaken but Unbroken Last year we highlighted an important shift for credit: the rise of event risk as companies shift from focusing on bondholders to focusing on shareholders. Share buybacks and M&A continue to rise, and in the US the releveraging cycle has begun. For credit investors, this means an environment where events or accounting readjustments drive greater idiosyncratic volatility, especially in the new liquidity paradigm (see The Force Awakens ). As we saw in, re-leveraging issuance from well-rated companies can create post-supply opportunities. In Europe, the later cycle and ECB policy have driven IG yields to very low levels (1% absolute yields 1 ) but solid balance sheets and lack of alternatives should keep prices supported. As with subordinated financials, the increase in corporate hybrid issuance is also creating opportunities for yield. High yield seems set up for a better year than it had in. Cooling retail flows and sharply-wider spreads (especially in the US) have improved valuations at the start of 15. Expect balance sheet expansion at both the ECB and BoJ to keep the world flush with central bank liquidity and prolong the credit cycle with sub % default rates. However, recent events have reminded investors that HY is not a one-way bet. Defaults can happen: see Phones u. The underperformance of the US HY market in recent months has been driven by its relative exposure to energy names. Such experiences show the greater dispersion across both sectors and ratings that investors can expect going forward. The economic divergence, underperformance and absolute yield levels now on offer in the US could see global yield buyers re-allocate from European towards US HY, but oil stabilisation is key. IG, HY AND EMD YIELD Sep 1 Jun 1 US high yield EUR Investment Grade Mar US investment grade $ Emerging markets debt Dec Source: Bloomberg, Barclays, JP Morgan, the following indices are used: LF98YW Index used for US High Yield, LU1YW Index used for US Investment Grade, LECPYW Index used for EUR Investment Grade and JPGCSOYD Index used for $ EM Debt, 9 uary 15 1 Bloomberg, uary 15. Moody s, uary 15.

4 Volatility and illiquidity: The Force Awakens EXPECT MORE VOLATILITY The combination of diverging monetary policy and (dis)inflationary shocks has re-awakened investors to the potential for a return of volatility. The Fed s withdrawal of liquidity may be offset to some degree by the ECB and the BoJ, but not all liquidity is created equal. Liquidity will find its way from some places to others, having significant impact on EM and adding to cross-market volatility. Did the Q volatility spike provide a trailer for 15 s release? We think so ? As volatility strikes back, market moves will be exacerbated by the new reality of constrained bond market liquidity. Dealers continue to face regulatory pressures and balance sheet constraints that have reduced inventory levels and lowered risk appetite. A market like European corporate credit could face additional liquidity challenges should the ECB decide to engage in corporate QE. As highlighted, in this new paradigm, generating returns is as much about how and when to exit as what to enter Source: Bloomberg, as at 1 uary MOVE index 15

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