15 Jan 2018
Despite an upbeat picture for the US economy and tax reform, US dollar weakness has extended into the start of the 2018. One reason for this persistent weakness has been flattening yield curves in the US. A flatter yield curve has raised questions over the real underlying health of the US economy and therefore the outlook for the dollar. Lacklustre real wage growth and soft inflation have also raised doubts over how many rate rises the Federal Reserve will deliver in the coming year, weakening arguments for a stronger dollar based on positive or higher rate differentials between the US and other economies. The strength of economic data elsewhere will have also contributed to dollar weakness. Eurozone data has been particularly strong, with the region’s manufacturing PMI reaching a multi-decade high in December.
While we do not expect a material appreciation in the dollar across 2018, we still expect it to strengthen across the year. The currency has been testing its lows from the past two years, but the strong economic backdrop should mean it avoids any further depreciation, especially after 2017’s meaningful correction. At the same time, currencies like the euro remain vulnerable to political risks, with Italian elections due to be held before May this year and ongoing uncertainty around Brexit and the makeup of a governing coalition in Germany.
We took profits on our holding in Asian investment grade bonds, with the asset class having outperformed our expectations over 2017. Strong performance over the year has eroded some of the defensiveness of the asset class, and we rotated capital into US investment grade bonds. Income investors can currently earn a yield of around 3.3%, which is a reasonably attractive level compared to the last five years - although investors should remember that yield is not guaranteed and returns will fluctuate in line with the market.
High yield bonds delivered strong total returns over 2017, as spreads (or the difference in yields between government bonds and high yield bonds) continued to compress. There is a limit to how much further this can go on for however, with spreads now at or close to all-time lows.
Loans look more attractive from a valuation perspective, and offer protection against higher interest rates, a key risk for 2018. While our base case is for a modest rise in inflation, there are risks from tighter labour markets pushing up wages and core inflation. Alternatively, stronger growth could lead to higher commodity prices, pushing up headline inflation in a more typical overheating of the economy.
We took profits on our position in financial equities over the month, with the sector having performed strongly over the past three months. The outlook remains strong for the sector, but we decided to take profits and allocate capital to a new position in MLPs (Master Limited Partnerships). These are a type of US company which operate oil infrastructure like pipelines. Despite the fundamental improvement in the supply and demand of oil in 2017, several MLP vehicles performed poorly over the year. They now offer an attractive yield of around 7.5%, and, through their conservative valuations, a way to play an improvement in sentiment towards oil markets. Investors should remember that this level of yield is not guaranteed and returns will fluctuate in line with the market.
We still maintain a positive view on financials overall, maintaining our holdings in financial debt and financial equity. Using futures to access the opportunity allowed us to easily increase and decrease our exposure in the short term, improving the tactical flexibility of our income portfolios overall.
| Dec 12 - Dec 13 | Dec 13 - Dec 14 | Dec 14 - Dec 15 | Dec 15 - Dec 16 | Dec 16 - Dec 17 | |
|---|---|---|---|---|---|
| Asian investment grade bonds | -6.5 | 4.3 | -1.9 | 0.7 | 1.4 |
| US investment grade bonds | -5.8 | 3.2 | -4.7 | 2.0 | 2.5 |
| Global high yield bonds | 8.0 | -0.1 | -4.2 | 14.8 | 10.2 |
| Alerian MLP ETF | 11.5 | -1.5 | -31.2 | 4.6 | -14.4 |
Source: Thomson Reuters, Datastream, 31 December 2017. Indices: Asian investment grade: ICE BofAML Asian Dollar Investment Grade Index, US investment grade: ICE BofAML US Corporate Constrained Index, Global high yield: ICE BofAML Global High Yield Index. All Performance shown in USD.
Eugene Philalithis is a Portfolio Manager at Fidelity Multi Asset, managing a number of balanced and multi asset funds for retail and institutional investors.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. The value of investments and the income from them can go down as well as up and investors may not get back the amount invested. Investments in overseas markets, changes in currency exchange rates may affect the value of an investment. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuer's ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between different government issuers as well as between different corporate issuers. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the fund investing in them. Investments in small and emerging markets can be more volatile than other more developed markets.