The activity cycle remains firmly in ‘downturn’ mode, with every country in the G10 region now in either ‘downturn’ or ‘recession’ territory. Macroeconomic data from the US has seen declines over the past months and is now fully in the downturn stage, confirming the signal provided by our in-house models (since the beginning of the year) of recession was on the rise. In the euro zone, the business cycle has also taken a sharp hit and the probability of downturn is now above 50%. The UK the economy doesn’t appear to be turning for the better while still in a recessionary phase amidst Brexit uncertainty.The US inflation cycle has dipped below average into disinflation territory and more importantly, the euro zone, at its peak in recent months, appears to have turned a corner, also declining somewhat. Unsurprisingly, in these conditions, central banks across the globe have continued to maintain their dovish stance, to the delight of investors, particularly in the US, where the Federal Reserve has already delivered 2 rate cuts this year, with a possible 3rd rate cut before the end of the year. The ECB has already delivered a rate cut as well as an open-ended QE program, with Mario Draghi bowing out by doing “whatever he could”.  

Neutral on US & Core European Rates 

The Fed has now delivered its second rate cut since July, pointing towards downside risks in the global economy while forward indicators are falling short of expectations. However, with significant weakness baked into the curve, good news on the trade war front could push yields up temporarily. In this context the market may be at risk of experiencing some profit-taking. In this context, we have adopted a neutral stance towards US rates. The ECB has delivered on their promises by announcing a package of measures: a cut of the deposit rate to -0.5%, announcing a 2- tier system, extending forward guidance, restarting the quantitative easing program and finally lengthening maturities on TLTRO to 3 years. Furthermore, economic data in the euro zone remain fairly weak, led by Germany (with composite PMI now below 50), while headline inflation also decelerated further in September. However, given tight valuations, more challenging investor positioning and flow dynamics, we are comfortable holding a neutral position to core euro zone rates.

Positive view on Peripheral Sovereigns 

Non-core markets have continued to receive support from the ECB’s monetary policy. At the September meeting, Mario Draghi formally announced the return of the open-ended QE, to the tune of 20 billion worth of bond buying a month. He also insisted on the need for countries to implement fiscal support in order to avert recession in the euro zone, as he is passing on the torch to Christine Lagarde. Flow dynamics linked to new purchases and reinvestments should continue to underpin non-core markets, compressing risk premiums. Furthermore, the political risk that had weighed on Italy over the past months has retreated as the 5 star movement was able to agree to an alliance with PD (a more mainstream party), resulting in a less resulting in a less Euro-sceptical government and more market-friendly economic plans – a major hurdle in the past. In the context of lower political risk and increased ECB accommodation, we hold a positive stance on peripheral sovereign rates (Portugal, Spain and Italy).

Developed Market Currencies: Long position on USD

The Fed cut its rates and adopted an outright dovish stance, which points to a weaker dollar. However, with other central banks also aggressively easing their monetary policies, currencies like the EUR are likely to see short term declines vs the USD. Furthermore, macro-economic weakness also is relative as the rest of the world does seem to be decelerating at a faster pace. In this context, we prefer to have a long position on the greenback and we continue to tactically manage the position.

Our scoring remains positive on the Norwegian Krone and we have therefore maintained our long position on the currency. Furthermore, the currency is also supported by a relatively strong economy, where the business cycle - though in downturn territory- is unlikely to fall into recession and economic surprises should be positive. The Swedish Krona on the other hand continues to suffer significant losses as poor macro-economic data has cast doubt over the central banks probable rate hike. The currency is also vulnerable to trade wars as exports account for a material portion of the country’s output.


Credit: Increase exposure to European Investment Grade 

We maintain our favourable view on the European credit investment grade asset class, though we continue to monitor the situation in the context of a weaker European economy and rising idiosyncratic risk. Company fundamentals are not deteriorating as expected, as they are pursuing deleveraging and maintaining good operating margins. The credit quality on High Grade names appears healthy, with more upgrades than downgrades, unlike High Yield. European credit seems to be the only opportunity in a context of negative-yield sovereign bonds and therefore has enjoyed strong inflows. In the current context of the economic slowdown and the uncertainties regarding trade wars, Brexit and other geo-political risks, the ECB has decided to adopt an accommodative stance, cut rates and restart QE, all of which will have a positive impact on Investment Grade corporate bonds. With the current purchase programme, net supply will be negative, supporting the corporate bond cash market and containing any widening in spreads, which further reinforces the case for Eur. IG credit. 

US High Yield and Emerging High Quality Credits offer interesting opportunities 

We have a preference for US High Yield to European High Yield. At 450 bps, the asset class offers some value considering the average credit quality, and especially vs. its European peers. While the US recession is not currently our central scenario, US GDP growth is decelerating slightly under 2% for next year though financial conditions remain supportive and the Federal Reserve has promised to do more to sustain the current economic cycle. The European economy is more fragile, and the high-yield market more limited, as BB bonds have already reached their tightest level over the last 12 months and profit warnings are rising in the lower credit quality profile. So, selectivity is key as dispersion is rising and downgrade activity outpacing upgrades, with some sectors facing structural challenges and the default rate expected to continue to modestly rise towards 3.5% in the next 6 months.



Emerging Markets: Moderately constructive

We remain cautiously constructive on EMD HC as the asset class continues to explicitly benefit from the aggressively dovish Fed and ECB stance and from the stable outlook for commodities despite that the US-China trade relationship is unpredictable and would not likely be resolved in the near term. The imposition of EU trade tariffs in the autumn and Brexit also pose clear risks to the extension of the risky asset rally. Absolute asset class valuations are not as attractive as the start of the year although there are pockets of value in select EM credits, especially in B and BB rated credits, where we are concentrating exposures, and in relative terms – versus US credit – as the percentage of negative yielding fixed income securities has increased to 2016 highs (30% of the Bloomberg Global Aggregate index is now negative-yielding, with 90% yielding less than 3%).

In EMD LC we are keeping our positive duration stance in high yielders, under the premise that the easing signaled by the Fed and ECB will provide space for EM central bank to cut more than anticipated. We also added to lower-yielding local markets, favouring China as a hedge against trade-war escalation and global recession risk.

Our baseline scenario for 2019 is growth remaining weak but stabilising into positive territory in 2020, which favours duration over FX, and, among currencies, the countries that took advantage of the slowdown to compress internal demand and improve external balances. 


Hard currency 

EMD HC posted a small negative return (-0.5%) driven by the 17bps US Treasury widening (to 1.66%) and by the partial recovery in EM HY on subsiding trade war risks and confirmation of the dovish DM and EM central bank trends. In reversal of last month's dynamics, negative Treasury returns (-1.1%) were somewhat offset by positive Spread returns (+0.7%). Risk sentiment was supported by the Fed's extension of its easing cycle with another 25bps cut, the postponement of US tariffs on Chinese goods, the stable oil prices despite their material intra-month volatility around the attack on the Saudi oil facility, and by the recovery in Argentina and some reform focussed EM HY credits like Ecuador and Ukraine which sold off excessively last month. HY (+0.4%) out-performed IG (-1.2%) with Argentina (+16.1%) and Zambia (6.7%) posting the highest and Venezuela (-33.6%) and Tajikistan (-3.0%) the lowest returns. 

With a yield of 5.2%, EMD HC valuations are less compelling in absolute terms than at the start of 2019 although they still offer value in relative terms to a growing universe of negative yielding global FI (at 30% by the end of September). The EM HY to IG spread is still attractive as are the EM single and double B rating categories versus their US HY counterparts. The medium term case for EMD remains supported by the benign US Treasury and stable Commodities outlook. Global growth and trade stabilization can support the next leg of EM spread compression but and global data continues to soften and trade war risks persist. On a one year horizon, we expect EMD HC to return around 6%, on an assumption of 10Y US Treasury yields at 1.35% and EM spreads at 350bps.

We retain an overweight in HY versus IG, although we have scaled down that position materially since the end of July by additions to IG-rated Chile, Colombia, Indonesia, Panama and Romania, and reduced exposure to energy exporters like Bahrain, Nigeria and Oman.

In the HY space, we remain exposed to idiosyncratic stories like Egypt, Ghana and Ukraine as these continue to offer value relative to the balance of risks, and to attractively priced energy exporters like Angola, Bahrain and Ecuador. We retain exposure to Argentina as the bonds have already declined more than 45% over the month and are now trading below expected recovery values of around 60-70 cents on the US Dollar. In the IG space, we now hold large positions in Qatar, Colombia, Indonesia, Panama and Romania but remain underexposed to the most expensive parts of the IG universe like China, Malaysia, the Philippines and Peru. 

We retain underweights in Lebanon, Russia and Saudi Arabia as we feel we are not adequately compensated for sanctions or political risks in these credits. In Brazil, Mexico and Turkey, we hold overweights in attractively priced quasi-sovereigns and corporate bonds versus underweights in sovereign bonds. We also retain a tactical 15% CDX.EM asset class protection position on elevated trade-war risks. 

Local currency 

EMD LC returned 0.96% with all components contributing positively (duration: 0.86%, carry:0.46%, FX: 0.11%). Local duration outperformed core duration by 20 bps. US and German yields widened by 17 bps on the back of a truce in the US-China trade dispute and somewhat constructive activity data. DM CBs delivered further easing - the ECB - a 10 bps policy rate cut and resumption of asset purchases; and the Fed - an additional 25 bps cut - but both actions were perceived as indecisive by the market. EMFX rebounded till mid-month before retracing. Most currency pairs ended flat vs the USD. HUF underperformed (-2%) on the back of the ECB resuming quantitative easing. RUB outperformed (+3%) on the back of bond inflows along with TRY that benefitted from inflation gapping lower and locals reducing FX deposits. Turkish government bond yields compressed by 250 bps while other markets were flat. Czech duration underperformed (30 bps wider) in sympathy with Bunds, suffering in addition from the resilience of domestic data. 

We believe that with a yield of 5.2%, EMD LC compares well to FI alternatives especially as we are now expecting a respite from US-China trade tensions and US growth exceptionalism and in an environment of broad-based global monetary policy accommodation. On a one year horizon, we expect EMD LC to return around 5.7%, assuming a conservative -1% EMFX and +1.5% duration returns. EMFX are unlikely to outperform in a global growth slowdown although external rebalancing is taking place in most EM and EM central banks have managed to deliver hiking cycles to maintain attractive FI risk premiums versus DM in 2018 that have not been unwound. 

In EMD LC, we prefer to retain exposure to EM rates versus EM currencies and prefer bond markets that offer high-risk premiums versus US Treasuries, which happen to be represented by a wide range of low-yielding and high-yielding local markets. The EMD LC strategy is very long duration in low-yielders like China, Czech Republic, Malaysia and Poland, and high yielders like Indonesia, Mexico and South Africa; moderately long duration in high-yielders like Brazil, Peru, Russia and the Dominican Republic, and close to flat the rest of the EMD LC local bond markets. 

The LC strategy is short EMFX overall and only holds small currency positions in frontier markets like Dominican Republic Peso (DOP), Kazakhstan Tenge (KZT) and Ukrainian Hryvnia (UAH) where we also like local bonds. The LC strategy is short Latin America FX such as the Colombian Peso (COP), Mexican Peso (MXN), Peruvian Sol (PEN) and Asian FX such as the Chinese Yuan (CNH), Indonesian Rupiah (IDR), Indian Rupee (INR), Philippine Peso (PHP), and Thai Baht (THB), and flat CEEMEA FX with the exception of the Ruble (RUB). We are less positive on EMFX given the global slowdown and EMFX’s growth sensitivity, as well as the strong positive US Dollar momentum in negative global market environments. 

In terms of preference, we prefer LC Rates followed by HC sovereign credit (especially the IG or UST-sensitive parts of the universe), and are negative EMFX.