Government bonds: Tactically short on the front end of the US curve
The activity cycle remained stable, following a sharp expansion phase in G4 countries, while momentum continues to stall. This is true for the US, where, in spite of the recent strong ISM prints that helped to temporarily boost the indicator slightly higher, the economic cycle appears to be running out of steam and probabilities of a downturn are greater. Europe also mirrors this situation, with all sub-indicators pointing towards lower momentum and a weaker activity cycle. The UK remains the laggard, with a continued deceleration in recent months. Meanwhile, the inflation cycle has extended its recent strengthening, with the US and euro zone once again leading the way. 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. In the current context, the implemented monetary policy in the US is deemed appropriate, while the market continues to expect one hike between December and January, with another possible in the 1st quarter of 2019. In Europe, our monetary policy gauge indicates that the ECB should continue to normalize its monetary policy, though a first rate hike is not expected before summer 2019. In the UK, we continue to see the contrast of a tightening monetary policy in the face of a growth slowdown.
In the face of these trends, central banks are going to have to navigate between sturdy inflation and a weaker activity cycle as they slowly continue to tighten policy. This is likely to turn into a very tricky balancing act as markets (which are already exhibiting stretched valuations) come to terms with the less-than-ideal scenario of lower accommodation at the peak of the activity cycle. In this context, however, several geopolitical triggers are likely to impact markets as the approval of the Italian budget, an agreement for an orderly and “soft” Brexit and the eventual resolution of the US-China conflict over trade deficits could be supportive of fixed income assets, which have recently suffered.
Tactical shorts on the US front end, Neutral German curves
US treasury yields moved up sharply in the first half of October, breaking multi-year highs on the back of better inflation data, a strong labour market and a well-oriented confidence sentiment. Mid-month, however, risk-off movements in the market led to a sharp decline in yields and a certain level of volatility on the curves. Going forward, the Fed remains committed to following the hiking-cycle path on the back of a potentially robust macro and inflation outlook, thereby putting some upward pressure on the short end of the US curve. The long end, however, should continue to be vulnerable to the geopolitical context and sharp corrections. In the euro zone, although core bonds tend to move in sympathy with the US treasury, the risk of a rise is limited. Indeed, the economy is showing signs of further deceleration while the inflation upside should remain contained in the short term At the same time, Italian event risk, a Brexit deal and supportive flow dynamics should, for now, also help temper the upward risk on German rates.
Preference for EUR linkers
The performance of the linkers asset class was weak last month, primarily as a result of the downturn in the crude oil price. Furthermore, risky assets also suffered and drove the change in rates in the breakeven models. The euro zone continues to be our favourite market, but we are less positive on the US. Valuations remain interesting in the US and expectations on inflation continue to be supportive. However, in terms of carry, it is rather negative, as is the momentum model (once again driven by oil and risk appetite). In the euro zone, on the other hand, the carry is positive while our BEI model is less negative. Furthermore, the inflation cycle is clearly supportive and core inflation – supported by components such as wages and capacity utilisation – should continue to rise, thereby validating our positive view. UK and Swedish linkers markets are clearly negative now (less supportive cycle, with negative carry).
Neutral peripherals, Negative on Italy
We benefited from our underweight position in Italian bonds, which was established in January this year. In October, the European Commission rejected the Italian budget proposal, deeming it unfit in terms of deficit limits. Italy is now expected to submit a revised budget plan and further negotiations are expected. While we expect some form of agreement, given that it is in neither party’s best interests to encourage a stand-off, we feel that this will continue to add uncertainty on Italian debt (which is now becoming the subject of downgrades from rating agencies). As the Northern League gains more ground in the polls, thereby anchoring the government’s populist agenda, we have retained some of our underweight positions on Italian sovereign bonds, preferring Spain or Portugal, where, so far, contagion remains contained.
Credit: Law carry and high valuation in Europe
European Investment Grade credit markets have become more popular, not only thanks to ECB support, but also because of their critical size and the good fundamental backdrop. While headwinds such as the Turkish crisis, EM turmoil and tariffs are likely to spill over and challenge the Euro Investment Grade markets, fundamental factors are still supportive as leverage is declining in spite of some negative earnings surprises in the Q3 results. The bank stress test results published by the ECB on November 2nd delivered no big surprises and confirmed the robustness of Spanish banks. Investors have drastically reduced their positioning and supply will be more moderate in Q4 as the reporting season will close the door on primary markets. With the recent widening of spreads in the asset class, a more attractive carry-to-risk has led us to maintaining our preference for Investment Grade vs. High Yield. High Yield faces plenty of idiosyncratic risks and a callable option exercise has been repriced as some issuers post stretched liquidity.
US credit market exhibiting lower risks
With the backdrop of a rebound in the economy over the second quarter and supportive company results, the asset class could be temporarily well supported thanks to its domestic economic power. In this context, we are maintain a selective view on US credit and avoiding some secular sector challenges. Hedging costs have risen, reducing the value of dollar markets for European investors. High Yield continues to post attractive carry and we prefer this segment to the US IG market, where leverage is peaking and valuations are stretched.
Emerging Debt: positive, despite trade-war risks
We remain moderately constructive on emerging hard currency debt, as the asset class is benefiting from a supportive reform momentum and energy exporters. We nevertheless now hold asset class protection as a hedge against headline and trade war risks.
We are more defensively positioned in emerging local currency debt as local bond market valuations are not excessively attractive. EM currency valuations, on the other hand, are attractive from a longer-term perspective but we shall remain cautious in the short term given the elevated risks from higher US Treasuries, a stronger US Dollar, and trade wars.
The Hard currency Emerging Debt segment ( EMD HC) remained under pressure (-2.2%) from elevated US-China trade-war risks and the oil-price correction (-8.8%), and despite declining idiosyncratic risks. In Brazil, Jair Bolsonaro’s convincing 1st round presidential election victory removed the risk of a binary election outcome for the 2nd round and drove an aggressive rally across Brazilian assets. In Argentina, the authorities managed to gain some credibility by stabilizing the currency and discouraging further USD demand. In Turkey, the September inflation print was much higher than expected (at 24.5%) but the CBRT did not have to hike rates as the geopolitical risk premium continued to decline with the release of Pastor Branson. Ukraine and the IMF agreed on a 14-month, $3.9bn programme extension. EM spreads widened by 31bps and US Treasury yields rose by 7bps, which resulted in negative spread (-1.7%) and treasury (-0.5%) index returns. IG (-2.3%) slightly underperformed HY (-2%), with Lebanon (3.0%) and Brazil (2%) posting the highest, and Sri Lanka (-7.3%) and Venezuela (-6.3%) the lowest, returns.
With a yield of 6.8%, EMD HC compares well to Fixed income alternatives especially now that some of the idiosyncratic and global asset class risks – elections in Brazil, external vulnerabilities in Argentina and Turkey, US-China trade tensions, the absence of growth recovery outside the US – seem to be well-priced. The medium-term case for EMD remains supported by the resumption of the synchronised global growth recovery and the very attractive asset class valuations. On a one-year horizon, we expect EMD HC to return around 4.7%, on an assumption of 10Y US Treasury yields rising to 3.75% and EM spreads tightening to 330bps.
The largest detractors of performance were the UWs in Lebanon (where a cabinet formation now appears imminent) and low-beta credits like China or CEE, as well as the OWs in Ecuador (oil correction) and Venezuela (PDVSA) on news that the government was investigating the set-up a new oil champion with a clean balance sheet. The fund took profit in Brazilian local bonds and long-end Turkey USD bonds, reduced half its long Brazil CDS position and added to Mongolia, Oman and Ukraine via attractively priced new deals. The fund's absolute (-21bps to 5.56yrs) and relative (+2bps to -0.91yrs) duration positions did not change materially during the month.
We are still constructive on commodity exporters like Angola, Ecuador, Kazakhstan, Nigeria, Petrobras (Brazil), and Pemex (Mexico) given our positive outlook on the oil price.
We are also maintaining exposure to specific idiosyncratic re-rating stories (high-yielders with positive reform momentum) like Argentina, Ukraine and Egypt, which now appear even more attractive relative to the lower repayment risks.
Our underweights (UW) further include US treasury-sensitive credits with tight valuations such as Panama, Peru, Chile, China, Uruguay and the Philippines. We also hold an underweight in Russia, which is vulnerable to further US or EU sanctions, geopolitical risks, dependence on commodity exports and limited value versus IG peers and index.
The Local currency Emerging Debt segment (EMD LC) underperformed again (-1.96%) on the back of weak EMFX (-1.9%) and duration (-0.6%), and a positive carry (0.5%) contribution. EM remained under pressure from hawkish US rhetoric on trade with China although recoveries extended in idiosyncratic stories like Argentina, Brazil and Turkey. The ARS rallied 12.7% after the BCRA set up a new currency regime and implemented aggressive quantitative tightening. The TRY rallied 7.2% after Pastor Branson was released and the trade deficit showed continuous improvement. In Brazil, right-wing Bolsonaro’s convincing victory in the 1st round of the presidential elections against the left-wing Haddad prompted an aggressive rally in the BRL (7.5%) and in Brazilian rates (4.7%). Mexico underperformed (MXN -7.7%, rates -3.8%) after the incoming president decided to interrupt the construction of the Mexico City airport, perceived as a business-unfriendly move. CEE EMFX were put under stress by the Italian budget and the Euro correction (-2.6%). The top LC bond index performers were Argentina and Brazil, with Mexico and South Africa at the bottom.
We believe that, with a yield of 6.8%, EMD LC compares well to FI alternatives, especially now that some of the idiosyncratic and global asset class risks – elections in Brazil, external vulnerabilities in Argentina and Turkey, US-China trade tensions, the absence of growth recovery outside the US – seem to be well-priced. The medium-term case for EMD remains supported by the resumption of the synchronised global growth recovery and the attractive asset class valuations. On a one-year horizon, we expect EMD LC to return around 8%, as the prospect of an EMFX rebounding (2.0%) from current distressed levels has now increased.
Currencies: Tactically positive on USD
Based on investor positioning, trade and capital flows and PPP, the overall framework is negative for the US dollar. The twin deficits exhibited by the US should keep the greenback under pressure vs. major currencies. However, the currency should receive some support from the Fed, which is likely to continue hiking rates. Short-term factors also remain supportive of the USD (fiscal plan, budget, cash repatriation). Finally, in the current context of geopolitical risk, the dollar is an interesting safe-haven asset to hold.
The Norges Bank made a dovish hike in September, highlighting the fact that global tensions could be a risk for the economy. As our scoring remains very positive for the currency, we have maintained our long position on the NOK, which is also supported by a relatively strong economy with an expanding activity cycle.
Though rate differentials remain penalizing, the Yen – based on our long-term framework – appears attractive. In the current environment of geopolitical uncertainty and the heavy dose of event risk present, the Yen remains an attractive safe haven and a diversifying asset. Nevertheless, flows are preventing a large appreciation of the currency as the Japanese are buying US bonds.
Specifically, we remain overweight on high-yielders supported by high real rates and constructive disinflation dynamics (Indonesia, India, Peru, South Africa). We are underweight lower-yielding local rates markets in Asia (Thailand and Malaysia) and CEE (Czech Rep., Hungary, Poland). Our duration position did not change during the month amidst tighter global financial conditions and no space for EM central bank easing. We closed our defensive positions in the EM currency space and are now overweight the ARS, IDR, INR and TRY, resulting in an overall US Dollar short position of 8% on an expected near-term decline in China-US trade risks.