In the end, things could have been a lot worse for government bonds. Against a backdrop of improving growth at the start of 2018, many forecasters (including us) were expecting a bad year for this asset class. But this was not the case.
Overall, sovereign bonds posted positive performances in 2018. The US index returned +0.8% in USD (BoA ML); a paradox given the significant improvement in the economy and the Fed proceeding with four rate hikes as expected. In Europe, despite the deteriorating growth indicators after the fourth-quarter 2017 peak, the end of the ECB’s quantitative easing programme would suggest that rate normalisation is coming. Nonetheless, the segment returned +1% in EUR (BoA ML index) over the year. So why was everyone caught on the hop?
The move into government bonds could simply be interpreted as a flight to safety in a climate of mistrust of risky assets, given the sources of tension accumulating (Trump, Brexit, US-China trade tensions, oil, etc.). However, a closer reading shows that the fall in monetary expectations was the main factor influencing yields over the period.
Hampered by a considerable increase in supply, oil prices plummeted. This movement had a major impact on the inflation numbers, sending inflation expectations tumbling.
Within the eurozone itself, the picture is pretty clear, with the significant underperformance of Italy over the period (-1.4%) the main factor; and it has to be said that the market rarely rewards the worst performers. The comparison with Spain (+2.6%) and Portugal (+3.1%) is stark. Also catching the eye was the performance of the eurozone’s core countries, led by Germany (+2.3%), which benefited from their safe haven status: the yield on the 10Y Bund was 0.23% at the end of the year.
In short, the bond market swung like a pendulum in 2018, from one extreme to another. After a fleeting economic upturn, the market is now anticipating a sharp slowdown. We will probably see something in between. Our bet as we enter the new year is that the bond market will be relatively calm and asset valuations will reconnect with fundamentals
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