07-2014 Market Perspective In Focus: Fixed Income Fixed Income Outlook Summary This Outlook provides a forward-looking summary of the medium-term views from the Fidelity Fixed Income team. Macro Outlook: Government bonds & rates We expect government bonds to generate flat returns over the coming twelve months. While government bond yields are slightly below our estimates of fair value, we believe the debt overhang and accommodative monetary policy should keep a lid on yields. On a longer horizon (beyond 12 months), we expect the leverage build-up and ageing demographics should act to keep yields contained compared to previous cycles. We expect only a modest rise in US Treasury yields over the coming year, targeting fair value on 10 year US Treasuries at 3.0-3.25% by June 2015. The FOMC hinted at a first rate hike as early as mid-2015 conditional to seeing not just growth improvements but more specifically wage inflation as a precondition towards policy normalisation. The Fed continues to express caution about the improvement seen in the labour market with unemployment rate masking weakness in other areas. On the technical side, the improvement in the budget deficit is reducing the net supply of Treasuries, providing an important offset for weakening demand from US retail investors. We expect flat returns from German Bunds over the coming 12 months, with German government bond yields being broadly range-bound. In contrast, the relentless rally in peripheral government debt begs the question whether bond holders are still compensated for the embedded risk. While trade deficits have rebalanced, the developing deflation story and still elevated debt levels in Mediterranean economies lead us to expect monetary policy to remain. The June policy measures taken by the ECB are likely to remain unchanged for the rest of 2014, which should anchor core and periphery bond yields for longer. We expect 10 year UK Gilt yields to stay range-bound between 2.5-3.0% over the coming twelve months, with flat expectations for Gilt returns. UK economic data continues to surprise to the upside, but the recent fall in inflation suggests spare capacity still exists. While expectations for the first rise in official interest rates have crept forward, a relatively aggressive tightening cycle is already factored into UK bond markets. This should support Gilt valuations in the near term. Investment Grade Credit Investment Grade delivered strong positive returns year-to-date and we expect flat to positive returns from investment grade corporate bonds over the coming twelve months. The fundamental picture for credit is modestly supportive although the credit cycle is clearly maturing. This phenomenon is led by the US, but even there, event risk seems contained, with leverage down from its x1.8 peak in 4Q13 and M&A and LBO activity has not yet surpassed growth in market capitalisation. Overall, we believe the deterioration of fundamentals will play out over a long period of time and is of idiosyncratic nature, i.e. affecting individual issuers, rather than a threat to total returns of the asset class. 1 07-2014 Investment Grade credit spreads are still above historic tights and around historic averages. Therefore against the current backdrop of low yields, valuations remain attractive. While spreads have tightened further across the asset class, credit is not yet overvalued and we may even see the rally go further for as long as QE is on. Indeed, credit spreads continue to be a direct function of liquidity and to a large extent, the deterioration of Investment Grade fundamentals – still modest in Europe - is seen as less of a concern relative to that of higher beta credit. We do however see a risk that if leverage is taken on the presumption that growth will come through, volatility could pick up from its current cyclically depressed levels. The Asset Quality Review of the banking sector due in October 2014 represents a supportive technical factor for financials as politicians and regulators encourage issuers to remain bondholder-friendly. Most banks are well prepared leaving us less cautious on the sector. As recovering financials display accelerating earnings growth and continuing deleveraging, they offset the slowdown in performance out of non-financial credit and provide support for the wider Investment Grade bond category. Ultimately, net negative supply should stay broadly supportive for credit in a low rate environment as investors continue to reach for yield. Emerging Debt EM hard currency debt staged a strong comeback in the second quarter, outperforming its developed market counterparts. Soft EM growth momentum, US tapering, growth concerns in China and geopolitical tensions in Russia/ Ukraine has not deter investors loading up on yield and carry. As global rates stay depressed income will remain a key focus for investors. After such a strong rally, still mired within a weak growth environment, we expect modest single digit positive returns for EMD. Fundamental growth remains sluggish. EM election risk has diminished as many high profile elections are now over (e.g. South Africa and India). Central banks are lowering their hawkish guard (examples: surprise rate cuts in Mexico and Turkey) which puts much needed economic rebalancing and policy credibility at risk. Technicals are positive. Steady inflows on the back of improving sentiment and further easing by ECB as see year to date EM fixed income fund flows at +$4.2 billion. Valuations are highly differentiated between asset and individual security types. When viewed on its own, excluding Asian High Yield, dedicated EM credit continues to look like fair value to modestly rich. When compared to DM (Developed Market) high income counterparts (EHY and US HY) EMD yields continue to remain compelling. The FIL-EMD team prefers idiosyncratic risks (relative value security selection strategies) over deploying broad based market beta strategies. Flows have been concentrated EM hard currency $ sovereigns (high duration sensitivity ~7.1yrs ). Forward looking, investors should look to substitute EM sovereign credit spread with EM corporate spread risk. EM corporates have a better risk / reward profile due to its lower duration sensitivity (~5.2yrs) and more diversified regional allocation. In a depressed growth environment we recommend EM local government rate exposure, however EM FX continues to remain dependant on a pending revaluation of EM Growth fundamentals. Inflation Linked Bonds Inflation remains contained across most continents. There are signs of fundamental inflation pressures in the US via a positive trend in wage growth. We anticipate that this will filter into consumer prices. Meanwhile, the Fed remains accommodative and the base rate will likely not increase until mid to late 2015. In Europe, the threat of deflation has bottomed out. We forecast inflation to remain positive in the next 12 months and forecast the year on year European harmonised core inflation measure to be approximately 0.7% to 0.8% in December 2014. 2 07-2014 We have recently increased our US CPI forecast to 2.6% year on year in December 2014. Recent strong CPI releases have supported breakevens. Although some of the increases are temporary (air fares, hotels), some other core components such as housing and rental cost,are unquestionably accelerating. The trend in PCE, the inflation measure the US Fed focuses on, should mirror the trend in core CPI, maintaining a 40 to 60 bps gap. PCE is currently at 1.5% while core CPI is at 2% year on year. We remain bullish on US inflation funds, especially in the shorter end of the curve. While current valuations are compelling, markets remain too preoccupied with current low inflation levels. From here on, however, we expect inflation-linked bonds to outperform their nominal equivalents. We expect US breakevens to perform in the coming 12 months on better US economic data. In Europe, pessimistic sentiment keeps breakevens low. The mispricing between inflation and breakevens in Europe presents selected opportunities for long positions. Inflation in EM included in Barclays World Government Inflation-Linked 1-to-10 Year Index is running at or close to the upper end of central bank targets. The passthrough of a weak currency into inflation is much higher in EM than in DM, hence any weakness in currencies can manifest itself in a higher CPI measure with little delay. This has been beneficial to carry in an environment of weakness in EM. Mexico is attractive from a fundamental growth perspective. The Mexican economy is showing signs of recovery after a weak Q1 and an unexpected cut in the base interest rate. Core inflation should start reflecting the economic recovery going forward. High Yield High Yield credit has delivered an impressive return year-to-date. If we annualise current returns across all the main high yield markets, we would easily print another double-digit year of performance. Mathematically this is not impossible, but with a large amount of corporate bonds reaching the call price ceiling, price upside is limited. Carry is the main focus for the second half of the year. Broadly, corporate fundamentals are robust but there is a growing divergence among regions. In the US there is more tolerance for aggressive deals including a raft of payment-in-kind notes, dividend deals and CCC issues. Weaker covenants and more aggressive financial policies are not surprising at this stage in the credit cycle. This trend is more acute in the US, Europe is probably around 12-18 months behind. Here corporates remain in defensive mode with the majority of new issuance still for refinancing. Globally, high yield defaults are low and expected to stay this way over the medium term. Financial repression has enabled companies to refinance and push out the maturity wall, suppressing the default cycle. Technicals have been one of the main drivers of the asset class. Flows favour Europe where the ECB’s promise of lower for longer has seen investors reach for high income solutions and Asia which offers a healthy premium. The US has also seen decent flows with the much debated pronounced great rotation away from bonds not materialising. However, any technical weakness could exacerbate downside price movements, especially due to the often illiquid nature of the high yield market. Supply had a weak start to the year but has picked up over the past couple of months; both Europe and Asia are on track for another recordbreaking year of issuance. 3 FIL Limited and its subsidiaries are commonly referred to as Fidelity or Fidelity Worldwide Investment. Fidelity only gives information about its products and services. Any person considering an investment should seek independent advice on the suitability or otherwise of the particular investment. Reference to companies mentioned within this document should not be construed as a recommendation to the investor to buy or sell the same, but is included for the purpose of illustration. Performance of the stock is not a representation of the Fund’s performance. Fidelity, Fidelity Worldwide Investment, the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited. The material is issued by FIL Investment Management (Hong Kong) Limited and it has not been reviewed by the Securities and Futures Commission (“SFC”).