04 JUN

2018

Fixed Income , Asset Class

Activity-cycle trend still intact across G4 countries

Global Context

The robust activity-cycle trend remained intact over the month across most G4 countries, with the expansion stage remaining well-anchored. In the US, economic momentum remained strong, thanks to very positive ISMs (Manufacturing and Services) and labour market prints. The recent fiscal reform package (which included tax cuts) is likely to further boost GDP growth in 2018. In the Eurozone, economic activity remains in the expansionary phase, with consumer confidence still elevated, though the momentum appears to have stabilized after a long period of strength. Growth is pointing upwards in most countries in the G10. However, the decline in UK activity (for three consecutive months now) remains a cause for concern. With weak retail sales and housing prices on the decline, we expect this trend to continue.

The inflation cycle extended its gradual strengthening, with the US and the Eurozone once again leading the way, while Japan and the UK presented a mixed bag. In the US, the inflation trend improved significantly, with all indicators (producers, wages, and expectations) up. In the Eurozone, inflation dynamics are expected to improve through several sub-indicators (in particular, wages). We are already seeing an improvement in the expectations component, which is now contributing positively. On the other hand, in the UK, the inflation cycle appears to be decelerating, with an ever-decreasing housing component. However, all in all, the inflation picture is exhibiting an upward trend across developed markets, with most countries in the inflation or reflation phase of the cycle.  

Europe seems to be the only region resisting on the debt-cycle front, while the slowdown in US credit creation continues, weakened by low loan demand due to US policy uncertainties, higher leverage and a higher bond supply. Weakness is spreading amongst G4 countries as Japan and the UK have joined in the decline, though at a slower pace. This is an important factor to be taken into account, as the debt cycle is a leading indicator of activity cycles. Hence while we do not foresee any immediate declines or necessary cause for alarm at this juncture, this indicator does call for a cautious stance, especially since weakness is spreading amongst the G4.

Regarding the monetary cycle, the US outlook remains positive, with one hike operated in March and three more scheduled for 2018. At the latest FOMC, new chairman Powell provided a balanced rhetoric, reiterating his commitment to raise rates in a gradual manner. While he did take note of the rise in inflation, he also indicated a willingness to let inflation move above 2% without immediately reacting with a rate hike. In Europe, while our monetary policy gauge indicates that the ECB is on the verge of normalizing its monetary policy, the recent meeting of the central bank yielded a rather dovish stance from Mario Draghi. Meanwhile, the BOE has been forced to adopt a more dovish stance in the wake of declining activity and falling housing prices, and has postponed a potential rate hike.

A notable result of the fact that the Federal Reserve is now the only central bank to adopt a tightening policy was the significant strengthening of the US dollar, which had previously remained weak in spite of the rise in US rates and stable US economy since the beginning of the year. This, combined with the Trump protectionist rhetoric and geopolitical tensions (especially in the Middle East), has had a negative effect on risk assets, particularly EM debt (both in hard and in local currency). Additionally, tension is building on the political front in Europe as we trudge towards a populist coalition in Italy and idiosyncratic risks build in Argentina and Turkey, which have helped prolong the sell-off in equity markets and short periods of risk-off in FI markets.     


Global rates strategy

Tactical Long US vs. Strategic Short Core Eurozone

In spite of the improving macroeconomic outlook and better inflation numbers in the US that had led us to previously hold a short position on treasuries, we remain wary of the current movements in markets. In spite of the recent up-tick in US rates, the sporadic “risk-off” episodes are likely to lead to increased appetite for safe havens. As president Trump continues to drop bombshells in terms of trade protectionist policies, we believe that treasuries could tactically yield positive performance. Furthermore, the heavy market positioning on US treasuries (underweight/shorts), in spite of the recent decline in yields, leaves investors exposed to sharp corrections. Hence, while over the long run, we continue to be cautious towards the US curve, on a tactical basis we hold a long position to US treasuries. We are particularly focussed on the long end, which is likely to be less affected by the repricing of the market expectations of the Federal Reserve’s actions (a rate hike is widely expected in June 2018). We remain flexible and moderate on this position. In Europe, the continuous rise in the activity cycle and the ECB’s tapering of QE have incited us to hold a short position on the core EUR curve. Improving activity and better inflation data continue to emanate from the Eurozone, reinforcing our conviction to hold an underweight duration to core EU rates, where valuations are stretched and the asset class is still quite expensive.

 

We favour Portugal, Ireland and Spain vs. Italy in our non-core allocation

The recent political tensions in Italy have had some (although limited) spill-over effects on peripheral sovereign bonds, where yields have recently widened. However, the non-core European bond markets continue to be supported by the ECB (and will continue to be over the next 6 months) and flow dynamics are also positive. Peripheral sovereigns also benefited from the reallocation from credit in March while substantial reinvestments should be carried out by the ECB in April. Furthermore, valuations have now turned more attractive across the non-core government bond markets following the recent widening. Despite the reduction in purchases by half from January 2018, purchases and reinvestments remain sizeable in an open-ended programme. In this context, we tactically continue to hold our positive view on Spanish and Portuguese sovereign bonds as they are benefiting from the reduced political risk, strong flows and improved economic dynamics. Regarding Italian elections, the formation of the coalition is in its final stages and very likely to include the populist parties – the Five Star movement and the Northern League. Several propositions in the proposed common manifesto agreement (which includes reduced flat taxes) have been met with concern by the markets and led to a sharp widening of yields. We continue to monitor the situation and await the final agreement in order to take stock of the ever-evolving situation. In the meantime, the maintenance of our very prudent and underweight stance in Italian sovereigns contributed to our outperformance in recent weeks.

 

Exposure to US, Canadian Break-evens, increasing Euro  

US break-evens, which appear particularly attractive, are supported by the positive carry profile. The inflation cycle remains strong, despite somewhat disappointing data more recently (average hourly earnings). Recent geopolitical tensions have put upward pressure on oil prices, which are now hovering around the $70/barrel mark, thereby supporting inflation. Our momentum model is also positive on the asset class. Valuations are also attractive on Canadian linkers, but we are now more cautious on Japanese ones. In the UK, on the other hand, valuations remain expensive. In this context, and in spite of some less favourable inflation data recently, we hold a favourable view on break-evens in the US and Canada. Furthermore, we are positive on Eurozone break-evens. Valuations are attractive as the carry has turned positive. With rising inflation expectations, we have increased our long positions on EU break-evens.