Last month’s “risk-on” trend continued through February, in spite of concerns over the Coronavirus beginning to translate into lockdowns (in the UK and Germany), curfews (in, inter alia, France). A major source of support for financial markets has been the fiscal and monetary stimulus, which is, of course, nothing new, but which is now having a material impact on the economic and inflation cycles. Indeed, our proprietary models indicate that nearly all regions – led by the United States, which appears to be well ahead of the other G4 countries – are in the recovery stage of their economic cycles. ISM surveys are pointing to further growth ahead, amidst lower political risk, a rampant vaccine programme and further stimulus. While lagging the US, Europe can also expect stronger-than-expected GDP in Q4 2020, thanks also to an accelerating vaccine pace and fiscal/monetary policies. The inflation cycle, although seeing a less buoyant bounce, is still experiencing an upward trend, with the US already creeping into the inflation phase while others (Europe and Japan) trudge into reflationary territory. Mirroring this positive view is the non-negligible decline in political risk following an extremely turbulent January, which saw the inauguration of Joe Biden as the 46th president of the United States. In spite of the extremely violent context of political transition, the new administration is now in place, with a friendly House of Representatives, and a Senate with a slightly favourable tilt. This not only ends three months of uncertainty marred by violence and threats but also paves the way to further and much-needed stimulus. Across the Atlantic, Brexit now appears to be weighing less on the macroeconomic context, which is yet again a relief, after five gruelling years of protracted negotiations. Even in Italy, which appeared to be the weakest link in terms of political stability, the Mario Draghi-led government likely to be announced has been widely accepted and celebrated.
Amidst the high level of positivity coming from the aforementioned events and analysis, as bond investors focused on the downside, we were forced to ask ourselves the question, “What can go wrong?”. It is important to note that there are still some events that need to be carefully monitored in the current context. In spite of the vaccines (which do not prevent transmission of COVID), lockdowns continue and the American and European healthcare systems are still under strain. Even though markets have been boosted by positive news and strong fundamentals, it is clear that the compression of spreads and yields (already at record lows) has its limits and will place a cap on returns in fixed income markets. Additionally, at the current level of stretched valuations, these corrections could end up being significant while bouts of volatility could become more frequent. While the reassuring central-bank presence will ensure that the damage will not be lasting, we still feel that adopting a tactical and flexible position alongside our bottom-up research-driven approach will be vital in coping with current conditions.
Positive on Peripherals particularly on Italy
The welcome return of growth and inflation in the US could continue, on the back of the additional fiscal stimulus that is more likely to be voted now that the House of Representatives is firmly in the hands of the Democrats. Joe Biden’s agenda will be focused on additional fiscal stimulus and should hence provide vital and much-needed support. There is little reason to think that the Federal Reserve will not pursue its low-rate policy and bond-purchase programme. Given this, we expect US rates to continue to move upwards. This could lead to an upward movement of a curve that has already steepened on the back of recent Fed policy (involving the toleration of inflation at target levels for a longer period of time). This rise in rates, however, is not only capped by the QE programmes (that include $100 billion/month purchases, with a possible extension in duration), but also by the potential increase in the number of cases and continued social distancing across states. That said, there is more notable technical upward pressure on rates due to the large excess supply than at any other time in the past 10 years. However, as long as the FED maintains its asset purchase programme, a massive sell-off seems unlikely. In summary, given the context, we are holding a slightly negative view on US rates, while tactically managing our short positions. Furthermore, we do take note of the improvement in macro and inflation picture, that could lead to a rise in the long end of the US curve. The short end should also fairly well anchored thanks to the Federal Reserve’s actions. As a result, we are partial towards a steepening strategy, particularly on the 5-30 year segments. We also hold a positive stance in US inflation-linked bonds, on the back of a more supportive inflation cycle and favourable break-even carry.
On the other hand, other rates on the dollar bloc offer opportunities, as we hold a positive view (on a currency-hedged basis) on Australia, on the back of an accommodative central bank deploying QE and whose rates are at slightly more attractive levels than other core markets’. Our previously positive exposure to New Zealand rates has been reduced to negative, on the back of some positive economic data, some tapering of monetary support (in the form of scalebacks in central bank asset purchases) and a less attractive carry.
In Europe, the aforementioned lockdowns and curfews are certainly weighing on the issue but, overall, cyclical indicators, both on economic activity and inflation, are supportive. In spite of the budgetary cycle being less supportive of core European countries, monetary support – driven by the Asset Purchase Program and the increased and extended Pandemic Emergency Purchase Program – remains strongly positive. This will continue to be a driving force for technicals throughout 2021, as net flows for Euro sovereigns will remain negative and as EU issuance will also lighten funding pressure on sovereigns. In this context, we continue to hold a underweight position on core Eurozone markets.
The peripheral sovereign markets continue to be supported by fiscal and monetary policies, and by the strong presence of the European recovery fund, with its sizeable grants for non-core markets. Supply could turn supportive from Q2 onwards and in relative terms versus core, while flow dynamics are also improving for non-core countries. Positioning remains a negative driver, as investors are still mostly long on peripheral markets. After tactically reducing our Italy exposure on expectations of Renzi leaving the government coalition, we moved back overweight on the back of the widening in Italian spreads in second half of January and the increased probability of the formation of a new government. We view Italy in a more favourable manner, as former ECB president Mario Draghi accepted President Mattarella's offer of appointment as prime minister designate, with the opportunity to form a government. The formation of a Draghi-led government with a large majority should improve chances of the effective use of the recovery fund and a stronger economic recovery. We have increased our exposure on Italy against Spain and Portugal, keeping our overall non-core overweight stable.
Given the strong performance of Euro linkers on the back of the spike in January Euro inflation numbers we are taking profit on our long Euro linker exposure and increasing back US BEI exposure. While in the Euro-area, the upturn in inflation should be more limited for the remainder of H1 following the January spike, we expect a more marked upturn in US inflation during H1. Given more supportive US inflation cycle, break-even inflation carry for US BEI trades relative to Euro BEI that will become more favourable, valuations, US stimulus package, relative vaccine related dynamics,… we switch our Euro-linker exposure towards the US.
Developed Market Currencies: Neutral the USD
Our proprietary framework continues to point towards a negative view on the US dollar, on the back of rising twin deficits. The Fed’s rate cuts, QE programme and dovish stance also point to a weaker dollar. However, with the improvement in growth and potential rise in economic activity, the Fed is likely to be more patient in the short term and not immediately add more stimulus. In this mixed context, there could be a respite for the dollar, following a period of weakness, thereby justifying our neutral stance.
Our short position in the AUD is tactical and we believe that the central bank (RBA) will keep its accommodative stance throughout the coming quarter. Trade relations with China are quite difficult at the moment, and this is a risk, as China is an important trade partner, as well as a good hedge versus other high-beta currencies in any risk-off sentiment period. Finally, we are maintaining our long NOK/short SEK. The Norges Bank has adopted a hawkish stance, on the back of better inflation prints, and this is paving the way to a potential rate rise. On the other hand, the Swedish central bank has chosen quite a different approach, having extended and increased its QE programme in December, become more verbal about the strength of the Krona and really cautious about the impact on inflation.
Credit: Favouring European markets and overweight convertibles
Although ample central bank liquidity remains the primary driver of credit markets, corporate results for Q4 2020 in the US further cemented market optimism, with nearly 80% of US companies reporting better figures than expected. Valuations remain challenging across credit markets, with spreads, which continued their downward progress last month, now at extremely low levels. Yields are also at pre-crisis lows across all credit asset classes. This leaves the market vulnerable to bouts of volatility and periods of drawdown. Through our in-house, bottom-up analysis of issuers, we continue to target highly liquid assets of high-quality companies with strong internal credit ratings and low leverage, as balance-sheet repair will represent a major challenge for corporates in 2021. Demand for spread products will stay strong, while supply will remain negative on a net basis, favouring compression trades, especially in the High Yield segment. The default rate could peak in Q1 2021 and decrease thereafter as progressive herd immunity is achieved through vaccination programmes. This will, in turn, support more cyclically exposed sectors.
Euro IG: While maintaining our favourable view on the European credit investment-grade asset class, we continue to closely monitor idiosyncratic risks and exercise a high level of selectivity. Balance sheets are on the mend while downgrades and rating drifts are bottoming, with rating agencies in wait-and-see mode. The ECB’s direct and increased purchases are providing an important backstop and, as a result, technicals are receiving strong support. Valuations remain a source of concern; however, within the asset class and non-financials appear stretched . We have a preference for financials now.
European HY: The asset class should be supported by a relatively attractive carry in a low-yield environment, and supply is not an issue, as companies are relying more on bank loans than on capital markets. However, performance has already been quite strong, and yields and spreads have compressed significantly, taking them close to pre-crisis levels. We still like the compression trade but we are at the lower band of the range trading and only specific stories offer good value. We are looking to add US HY names on an opportunistic basis in order to take advantage of the expected stimulus from the new government.
Finally, we think € Convertibles should benefit from positive dynamics such as the coordinated action from the EU Next Generation Recovery Fund, positive surprises/better visibility from quarterly results, less political noise than in the US and some China economic recovery.
EMD: Positive on emerging currencies
The medium term case for EMD is supported by relative valuations in the HY segment, bottoming of fundamentals, and abundant global liquidity. However, health risks are still elevated around the discoveries of new and more contagious virus variants in South Africa and the UK that have forced re-introduction of tightening measures globally. For the moment, risky markets are looking through the adverse impact on first quarter growth of any mobility constraints as the focus remains on the recovery of activity over the full year. Commodity prices traditionally exhibit high correlation with global demand recoveries and should perform well in 2021 which in turn should benefit EM commodity exporters. We note that we are particularly constructive on Oil that has moved to a persistent supply deficit on the back of clearing of inventories, lower US production and OPEC support. We expect that in the medium term, US Dollar weakness is anchored by the sizeable twin deficits the US have accumulated and by the near doubling of the Fed's balance sheet in 2020. Strong or stable commodity prices and a weak US Dollar have traditionally been supportive for EM credit and EM currency performance as the majority of EM countries are commodity exporters. Uncertainty around the de-rating of the EM universe and the resolution of specific liquidity and solvency issues in some EM remain, but these are going to be addressed on a case by case basis.
This month, our Global Macro Score is closer to neutral, owing to our negative view on US duration. EMFX remains the preferred asset class, although we are diversifying funding into our low-yielding G10 currencies. Terms of trade improvement, lower positioning than at end-2020 and inflows should all support EMFX. For EM rates, as a resurgence in headline inflation has caused central banks to revert to a more hawkish stance, we remain negative, with a preference for high-yielders, where we expect spread compression vs the US. EM corporates are benefiting from lower issuance needs and a valuation pick-up versus US credit. Sovereigns are supported by flows, but positioning is heavy and funding needs remain high, as fiscal balances will see limited improvement this year.
With global reflation gradually firming up, we expect EMFX to be supported. EM central bank will now gradually look at hikes, although their acting remains unlikely before the pandemic is seen to decline globally. The long ends of the curves remain dislocated and we still see value in them, vs short end rates that will increasingly price hikes. Having committed to low underemployment and core PCE averaging more than 2%, we don't see the Fed starting an early QE tapering. No more than a third of foreign flows have yet come back to the asset class since March and we expect them to normalize gradually.