Government bonds: Steepening strategy on US
The business cycle remains firmly in a “downturn” phase, with every country in the G10 region now in either “downturn” or “recession” territory. While over the past few months, the US outlook has appeared to be holding firm, some cracks have started to appear in the macroeconomic outlook. In the Eurozone, the business cycle has continued to lose some momentum, while in the UK the economy is still in a recessionary phase, though a slight improvement has been observed. Inflation appears to be deteriorating across most regions as many countries are entering the cooling phase of the cycle. The Eurozone is the one area that appears to be offering any resistance, as it is the only region to remain in the inflation phase. The debt cycle has seen a slight dip (into negative territory), taking our framework from “deleveraging” to “repair”. This is indicative of a relatively weaker scenario as nearly all countries have posted less supportive credit conditions. 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 markets are already pricing at least three rate cuts before year end. The ECB, on the other hand, has now ruled out a rate hike before summer 2020, alongside its TLTRO program. Monetary easing is also being driven by emerging markets. The PBOC appears ready to play its part in supporting the Chinese economy: the governor has stepped up his dovish rhetoric by indicating that the central bank has “tremendous scope” to act on the monetary front. Furthermore, some countries (India, Indonesia) have already implemented rate cuts over the past months, with more likely to follow.
Overall, the combination of lower growth, weaker business cycle, softer inflation and extremely supportive central banks is positive for Fixed Income markets and spread products in particular. However, after five months of falling rates (with an acceleration to the downside and tightening spreads), valuations are looking less appealing. Furthermore, event risks have not subsided with continued anxiety over Brexit in the UK, where hardliners are favourites to win the premiership race. Trade wars are also fuelling uncertainty on several fronts after President Trump issued warnings to Mexico, while raising tariffs on India, and as negotiations with China continue to struggle. The month of May saw a resurgence of risk-off sentiment as US treasuries plunged below 2.1% (10-year yields). However, yet again, Central Banks across the globe appear poised to support economies and markets with their accommodative stance and further monetary easing. The fact that a significant number of CBs are switching to a dovish stance at the same time (both in developed and emerging markets) is likely to provide enough support to temporarily soften the uncertainties clouding today’s environment.
Neutral on German yield curve
US unemployment levels are still at historic lows and financial conditions appear to have stabilized. Valuations on German rates are still stretched. However, the Fed continues to maintain a patient and flexible approach, while pointing towards downside risks in the global economy. With macro-economic data deteriorating and forward indicators falling short of expectations, it is increasingly likely that Jerome Powell will announce a rate cut in the third quarter of 2019. We believe that this would push short/mid-term rates upwards in the US, thereby steepening the overall curve. The ECB has been particularly hesitant regarding the strength of the region’s economies and has now taken the rate hike off the table until the summer of 2020. Furthermore, the macro-economic outlook in the Eurozone doesn’t appear to be improving, though inflation seems to be holding up. Considering the above-mentioned risks to the market (trade wars, Italy, Brexit), German rates are likely to benefit from their safe haven status. In this environment, in spite of the fact that they are very expensive, we remain neutral on German rates curves.
Positive view on Spain and Portugal, Neutral on Italy
Non-core markets have continued to receive support from the ECB’s monetary policy. The adjusted forward guidance and details of the TLTRO announced at the June meeting, together with Draghi’s speech at Sintra, where he hinted at a potential strong easing package, should continue to underpin non-core markets. Draghi stated that, “in the coming weeks, the Governing Council will deliberate how our instruments can be adapted commensurate to the severity of the risk to price stability”. Technical factors (Carry/RD) and the supply outlook also remain supportive, while investors’ positioning has become more mixed. We have therefore maintained our overweight on Spain and Portugal. In Italy, our overall prudent stance still remains a core conviction. However, taking into account the recent considerations, which include the retracement of the tussle between the European Commission and the Italian government over the deficit, we feel that the rally in Italian rates might still have some legs and spread tightening should be helped along with the ECB’s dovish stance. In this context, we prefer to tactically move neutral towards Italian sovereigns.
We are positive on European Investment Grade credit, thanks to central bank support and relatively healthy fundamentals in this low-yield environment. The ECB and FED recognized, during their last statement, that further accommodation was needed, taking into account the downside risks to the global economy. The easing bias would act as ‘insurance’ against further economic deterioration. If the Federal Reserve has headroom by cutting rates, the European Central Bank needs to be more ingenious in this tool kit. The resumption of the Asset Purchase Programme, including private corporate debt, is on the table. As a result, on the technical front, investor flows are continuous, as the search for yield intensifies, reinforcing the case of Euro IG as the asset class of choice within the credit markets! As the economic cycle is deteriorating and idiosyncratic is rising, we are focusing on quality, preferring IG to HY. Dispersion is increasing, with CCC names suffering and BB names very expensive, retrieving their level of May 2018, as the domino effect of quantitative easing is enforced.
US Investment Grade credit continued to attract little interest from a European perspective, as hedging is costly and fundamentals have continued to deteriorate. Q2 results publications will highlight some sector vulnerabilities, pushing certainly leverages to their highest level. Non-financial corporates face challenges, notably on the environmental front: electric vehicles for the automobile industry, e-commerce for retail and digital transition for media. Higher employee and raw material costs are weighing on margins. With the global outlook weakening, default rates are likely to trend slightly up and idiosyncratic risk could materialize. Taking into account the carry-to-risk element, and relative to other asset classes, we continue to prefer emerging markets over US credit. With the Fed turning more dovish, the dollar expected to weaken somewhat and China about to rely on further fiscal and monetary easing, sentiment around Emerging Debt is more positive.
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 the unpredictable nature of the US-China trade relationship and the unlikelihood of it being resolved in the near term. Brexit and the imposition of EU trade tariffs in the autumn also pose clear risks to the extension of the risky asset rally. Absolute asset-class valuations are not as attractive as at the start of the year, although there are pockets of value in select EM credits, especially in B-rated 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 (27% of the Bloomberg Global Aggregate index is now negative-yielding, and 90% is yielding less than 3%).
In EMD LC, we are keeping our positive duration stance in high-yielders, on the premise that the easing signalled by the Fed and ECB will provide space for EM central banks to cut more than anticipated. We also reduced our duration underweight (UW) in low-yielding countries overall, favouring China as a hedge against trade-war escalation and global recession risk.
Our baseline scenario for 2019 is: growth remaining weak but stabilizing into positive territory in 2019 (which favours duration over FX), and, among currencies, the countries that took advantage of the slowdown compressing internal demand and improving external balances.
EMD HC (+3.4%) delivered the highest monthly return since mid-2016, as both Spread (+2.4%) and Treasury returns (+1.0%) rallied on expectations of a US-China trade-war de-escalation and on the Fed and ECB strengthening their accommodative stance. Risky and risk-free assets rallied in tandem with EM spreads tightening by 32bps to 346bps, the S&P rebounding 6.9%, and the 10Y US Treasury yield declining by 12bps to 2.0%. Oil (3.2%) recovered further from its May correction as geopolitical uncertainty around the US-Iran relationship re-surfaced. Argentina extended its May recovery, with inflation and growth data pointing to stablization. Turkish assets rallied after the decisive opposition win of the Istanbul local election re-run. HY (+2.6%) marginally outperformed IG (1.9%), with Mozambique (15.7%) and Argentina (10.4%) posting the highest, and Belize (+0.4%) and Lithuania (+0.8%) the lowest, returns.
With a yield of 5.5%, EMD HC valuations are less compelling in absolute terms than at the end of 2018, and as EM risk premiums have already largely priced in the US-China trade tension de-escalation while still offering value in relative terms to a growing universe of negative-yielding global FI. 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 Commodities outlook. Global growth and trade stabilization could support the next leg of the EM spread compression but global data continues to soften. On a one-year horizon, we expect EMD HC to return around 6.5%, on an assumption of 10Y US Treasury yields at 2% and EM spreads at 355bps.
We outperformed the benchmark index by 45bps, on a net basis. The largest contributors to performance were the overweights (OWs) in Argentina, Ukraine and SSA (Sub-Saharan Africa), with the risky asset recovery from the May correction supported by the rebound in oil and the dovish global central bank stance. The UWs in Asia credits like China and Malaysia also added to performance, with trade-war uncertainty remaining elevated until month-end.
Although we are still constructive on commodity exporters like Angola, Ecuador, Kazakhstan, Petrobras (Brazil) and Pemex (Mexico), as we expect oil prices to remain stable at around $60-70, we scaled down our OWs in 2Q after the very strong start to the year.
We also maintain exposure to specific idiosyncratic re-rating stories (high-yielders with positive reform momentum) like Argentina, Ukraine and Egypt, which appear attractive relative to the balance of macro-economic and political risks.
We took some profits in Mbonos and added back exposure to Ecuador and Ukraine in June. We added to our absolute (+83bps to 7.89yrs) and relative duration positions (+0.56bps to +0.76yrs), as close to twenty DM and EM central banks are now expected to ease and US Treasuries have priced in more rate cuts.
In June, EMD LC returned 5.5%, the most since June 2016, with the return roughly equally split between FX (2.7%) and duration (2.4%), next to a 0.43% carry contribution. Local markets outperformed US Treasuries by 26bps in yield terms, led by Brazil (-80bps), Indonesia (-62bps), Mexico (-55bps) and Russia (-40bps). Distressed local markets like Argentina (-480bps) and Turkey (-320bps) staged a spectacular comeback. The FOMC delivered on market expectations, strongly signalling a July cut, as did the ECB, with a number of EM central banks confirming the view that, in an environment of synchronized global growth slowdown, central bank stimulus is considered necessary. China and the US returned to the negotiation table on trade, signalling a respite in tensions at the G20 summit.
We believe that, with a yield of 5.7%, 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% in 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.
We outperformed the index by 23bps, on a net basis. Performance was helped most by duration OWs in Indonesia, Czech Republic, Brazil, Russia and South Africa, along with the OW in CZK. The biggest detractors were the UWs in Thailand and Turkey – both FX and rates – and, to a lesser extent, by the UW in PHP and the UW duration position in Chile.
We materially reduced our USD position from 10% to -4%, reflecting a view that cyclical FX pairs have troughed, while keeping duration constant vs the benchmark. We have added to our absolute duration 6.09yrs (+0.15yrs), while the relative duration position at +0.7yrs has not changed.
Our overall view is negative for the US dollar, based on investor positioning, trade and capital flows and PPP. The twin deficits exhibited by the US should keep the greenback under pressure vs. major currencies. Should the macroeconomic data continue to weaken, and the Fed cut its rates and adopt an outright dovish stance, the US dollar is likely to decline. However, with other CBs – including the ECB – also aggressively easing their monetary policies, currencies like the Euro are likely to see short-term declines vs the USD. In this context, we prefer to have a neutral position on the greenback and 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, which 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. Finally, the central bank could continue along its hiking path, which would boost the currency further.
Rate differentials remain detrimental and our long-term view also points towards a decline in the overall score for the Yen. However, in the current environment, which is marked by geopolitical uncertainty and a heavy dose of event risk, the Yen remains an attractive safe haven and a diversification tool. We therefore continue to manage the currency tactically, with a neutral stance at present.
The prevailing Goldilocks scenario for risky assets helped lift EMFX. Low-yielding FX pairs in CEE (CZK 4%, PLN 3%) and Latam (CLP 4% and COP 5%) outperformed, being more sensitive to US rates. The Argentine Peso rallied by 6%, supported by growth and inflation stabilization that should help president Macri’s reelection in October.