The activity cycle (our in-house long term indicator) continues its negative spiral in 2019, with every country in the G10 region now in either ‘downturn’ or ‘recession’ territory. Specifically, the US appears to be at risk of entering recession, a far cry from the very positive context depicted just a year ago by the Fed. This confirms the signal provided by our in-house models (since the beginning of the year) that the probability of recession is on the rise. In the Eurozone, the business cycle has also taken a sharp hit and the probability of downturn is now above 50%. The UK 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 Eurozone, which was at its peak in recent months, appears to have turned a corner and seen significant declines. Unsurprisingly, under these conditions, central banks across the globe have continued – to the delight of investors – to maintain their dovish stance. However, we might observe a pause in central bank activity after the significantly dovish stance that a great number of central banks have maintained since the beginning of the year. Indeed, the Fed appears to be in “wait-and-see” mode and the ECB already seems to have exhausted its ammunition for the year. Should central banks take a breather, the rate markets could possibly witness a short-term upward tick in yields after the very strong performance of 2019.
Tactical underweight on US & Core European Rates
The Fed has now delivered three rate cuts this year, all the while pointing towards downside risks in the global economy, while forward indicators are falling short of expectations. At the moment, the central bank appears to be on hold, in spite of the political pressure it faces to lower yields. If macro-economic data continue to stabilize, the Fed could maintain rates at current levels. Furthermore, with significant weakness baked into the curves, good news on the trade war front (where, following recent talks, we are seeing movement on “phase one”) could push yields up temporarily. In this context, the market may risk experiencing some profit-taking and we have adopted a tactical underweight stance towards US rates. The Eurozone not only faces tight valuations, but also a central bank that has already done “whatever it takes” and doesn’t seem to have much left in the tank. With the onus now on individual states to implement fiscal reforms, we expect some stabilization in the economy. The spectre of a hard Brexit is now fading fast, and yields could see upward movements. We thus feel comfortable with a short position on German rates. The linkers market has delivered a mixed performance, with US and EUR markets performing well, while the UK was a laggard on the back of the strong rally on the Pound Sterling. We hold a slightly positive view on Euro linkers, which should benefit from ECB easing, attractive valuations and better supply dynamics.
Positive but cautious on Peripheral Sovereigns
Non-core markets have continued to receive support from the ECB’s quantitative easing. 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 in recent months has retreated, as snap elections have temporarily been avoided following the formation of a new government in Italy. In Spain, the Socialist party (PSOE) won the highest number of seats, but still failed to bring in a majority, while the far right made considerable gains. We continue to monitor the situation, as no clear coalition appears to be ready to form a government. Furthermore, from an investor-positioning standpoint, non-core markets appear to be at the end of their multi-year highs and hence caution is further recommended.
Developed Market Currencies: Neutral USD
Our proprietary framework continues to point towards a negative view on the US dollar. The Fed cuts and dovish stance also point to a weaker dollar. However, we do expect that, after the recent actions, central banks are going to take a breather. Since the Fed has already provided 3 cuts and an injection of liquidity into the market, we believe that the pause in dovishness is likely to result in a stable US dollar. In this context, we prefer to have a neutral position on the greenback and we continue to tactically manage the position.
As our scoring remains positive on the Norwegian Krone, we have 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. The Swedish Krona, on the other hand, continues to suffer significant losses, as poor macro-economic data have cast doubts over a probable central bank rate hike. The currency is also vulnerable to trade wars, as exports account for a significant 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 risks. Company fundamentals are not deteriorating as expected, as they are pursuing deleveraging and maintaining good operating margins. Overall, the earnings season has shown beaten estimates for a significant number of companies, though those estimates were very cautious. However, on a year-on year basis, earnings do seem to be lower, indicating that fundamentals might not be as sturdy as expected and valuations are driven more by technical factors.
In the IG portion, the Credit quality on High Grade names appears healthy, with more upgrades than downgrades, as opposed to high yield. As European Credit seems to be the only opportunity in a context of negative-yield sovereign bonds, it 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, 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.
Emerging Markets: Moderately constructive
We remain cautiously constructive on high currency emerging debt as the asset class continues to explicitly benefit from the dovish Fed and ECB stance and from the stable outlook for commodities, despite the unpredictable US-China trade relationship not looking likely to be 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- 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 beyond 2016 highs.
In EMD LC, we are keeping our positive duration stance, under the premise that the easing signalled by the Fed and the ECB will provide space for EM central banks 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 risks.
Our baseline scenario for 2019 is for weak but stabilizing EM and DM growth which favours duration over EMFX. Within EMFX, we favour the currencies of countries that took advantage of the growth slowdown to compress internal demand and improve their external balances.
EMD HC continued recovering (0.3%), on rising expectations of a US-China trade de-escalation and constructive risk sentiment (S&P 500 was up 2.0%). EM spreads tightened by 9bps (to 328bps) and 10Y US Treasuries were stable, around 1.70%, resulting in positive spread and neutral treasury returns. EM domestic political risks rose dramatically around proposed energy subsidy cuts in Ecuador and metro price hikes in Chile – threatening to topple governments in both countries. An adequate policy response stabilized the situation but authorities in both countries had to scale back fiscal consolidation plans for 2020. The Turkish invasion of North-eastern Syria after US troops were ordered to withdraw from the region was resolved within ten days after a ceasefire was agreed on October 18th and the US lifted sanctions against Turkey. None of these events managed to spill over into the other EMs. HY (+0.2%) and IG (0.3%) performed similarly, with Tunisia (+3.0%) and Ukraine (2.9%) posting the highest, and Lebanon (-14%) and Venezuela (-9.4%) the lowest, returns.
With a yield of 5.1%, 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 24% by the end of October). 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 could support the next leg of EM spread compression but global data continue to soften and trade war risks persist. On a one-year horizon, we expect EMD HC to return around 5%, on an assumption of 10Y US Treasury yields at 1.6% and EM spreads at 335bps.
We outperformed the benchmark index by 2bps, on a net basis. The largest contributor to performance was the underweight (UW) in Lebanon, where bond prices collapsed on the back of anti-establishment demonstrations against a political class that never offered solutions to concerns about debt sustainability, growth and corruption. During the month, we reduced our absolute (-10bps to 8.67yrs) and relative (-24bps to +1.26yrs) duration positions after scaling down exposure to IG credits that performed well in 3Q like Colombia, Panama and Romania, and in anticipation of a near-term trade deal.
We retain an overweight in HY versus IG, although we have scaled down that position materially 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, whose bonds have already declined more than 45% on 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 do not anticipate being 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 6% CDX.EM asset class protection position on elevated trade war risks.
EMD LC returned 3% in October, with a strong rebound in FX (+2%). LC duration returned 0.4% with a 10bp spread-tightening vs US Treasuries. The USD sold off on the back of the Fed announcing $60bn/month of T-Bill purchases, while risk sentiment was supported by the US-China talks staying on track. EUR-related currencies led the rebound in EMFX (PLN 5%, HUF 4.5%), supported by resilience in activity and inflation data. Latam high beta also performed well (BRL 3.8%, COP 3%). EMEA high betas underperformed on domestic issues. The ZAR sold off after a budget announcement that showed fiscal deficit peaking only next year, and closed at 0.7%. The TRY sold off after Donald Trump announced the US had allowed Turkey to move troops into Syria, before backtracking and threatening Turkey with sanctions. Ultimately, VP Pence and President Erdogan came to an agreement and Turkish assets recovered.
In the rate space, high yielders performed strongly (Turkey -84bps, Russia and Brazil -55bps, Indonesia -30bps), while low yielders were flat, in line with US Treasuries.
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 EMs, 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 have been presented with a wide range of low-yielding and high-yielding local markets. The EMD LC strategy is (a) a very long duration in low yielders like China, Czech Republic and Malaysia, and in high yielders like Indonesia, Mexico and South Africa; (b) a moderately long duration in high yielders like Peru and the Dominican Republic, and (c) close to flat in the rest of the EMD LC local bond markets.
Growth data globally have stabilized when the market was expecting an acceleration of the slowdown. With a possible truce in the US-China trade war, and favourable valuation, EMFX has rebounded but remains range bound. A break towards the upside will depend on a confirmation of the so-called phase one deal as well as positive surprises in EM growth