Stephanie Flanders: Bond prices have met their enemy

Last year will be remembered for its political upsets. For investors, it will probably also go down as the year when global deflation fears came to an end, long-term interest rates finally started to rise and central banks stopped being the only game in town.

Politics and policy will dominate the headlines again this year but, for the investment world, it is likely the real economy will continue to be the most important factor. Voters decided against business as usual in 2016 and, increasingly, investors are expecting a change as well.

Yield curves are going to steepen – not just because of the end of global deflation fears but because even places that still need a lot of support from monetary policy (the eurozone and Japan) have come to the conclusion that, when it comes to pushing down long-term interest rates, you can have too much of a good thing.

Donald Trump’s victory in the US election accelerated the rise in yields as investors bet his polices would lead to higher growth and inflation – both of which are the enemy of bond prices.

The recent increase in yields seems to be driven almost equally by higher growth and inflation expectations, which has not always been the case during other periods of rising yields.

No fun for fixed income

Optimists about the global economy could be forgiven for predicting more losses for investors in government bonds as inflation expectations rise further. Investors should not expect capital gains on bond holdings to compensate for low interest rates in the future, as they have in the past. Even if investors avoid further losses in coming quarters, the long-run outlook for returns on core fixed income remains poor.

Eight years into a slow recovery marked by low productivity and weak investment, increased US public spending to support long-term potential growth could be positive for the global economy. In general, though, the kind of policies Trump has suggested spending money on are not really those economists would say are likely to give the highest economic return.

On a global basis, it is fair to say this extra stimulus from the US will be happening in the part of the developed world that needs it least. The risk is that any short-term boost to growth will come with a shortening of the economic cycle, rather than an increase in US potential growth, and therefore bring the date of the next US – and global – recession somewhat closer.

While the implications of Trump’s election victory for the various emerging market countries are not clear cut, some could well benefit from a more reflationary environment in the US.

China’s long-term imbalances have not been resolved and remain a downside risk for emerging market economies as a group. But growth seems to be stabilising for the time being, with Brazil and Russia now both past the worst of their recessions.

Indeed, compared with Europe, the prospects for emerging market economies look positively calm. Europe continues to battle with many potential political minefields. The concern is that political volatility and reduced faith in monetary policy stimulus will make for a risky cocktail at a time when the moderate stimulus provided by fiscal policy over the past two years might well come to an end.

Brexit uncertainty

The other major source of uncertainty for Europe will be the UK, which has promised to start the formal Article 50 process for leaving the EU by the spring. Consensus forecasts for the UK are for 2 per cent growth in 2016, up from 1.5 per cent immediately after the referendum. But most are expecting the recovery to slow sharply as higher inflation squeezes consumers’ real incomes.

Overall, the upside risks to global growth and inflation in the short term are probably higher than they have been for several years, and there is a good chance forecasters will be revising up their 2017 forecasts for a change. But the medium-term risks to the global economy and financial markets seem both higher and more various than they were a year ago. The best advice for ordinary investors is to stay well diversified and keep a close eye on the US.

Stephanie Flanders is chief market strategist for Europe at J.P. Morgan Asset Management