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 favorites to win the premiership race. Trade wars are also fueling 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.
Steepening strategy on US, 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 lower 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
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 offer extra support to non-core markets. Draghi also indicated in the Q&A that the ECB is standing ready to use all instruments in the event of adverse contingencies. Technical factors (Carry/RD) also remain a supportive factor. We believe that the likelihood of the socialist party forming a government (through coalition) in Spain has increased after the elections - as it no longer needs to rely on support from less moderate regional parties. This could potentially contribute to a more stable political outlook. We have therefore maintained our overweight on Spain and Portugal. In Italy, there appears to be a greater probability of fresh general elections following the strong show of the Lega (far right anti-EU party) in the European elections - along with other strong lined parties - while mainstream parties lost votes, changing the current coalition’s balance of power. In spite of the country’s strong performances recently, we continue to keep a prudent stance on Italy for fundamental reasons.
We are constructive on European investment grade credit despite Europe’s weak economy and rising idiosyncratic risk. The earnings season turned out better than expected and deleveraging is continuing. Credit quality on High Grade names appears healthy with more upgrades than downgrades. Spreads have tightened, a move driven by strong inflows into the asset class. Supply is limited and cash is still high considering the strong demand. In light of the US-China trade war, the risk of potential European auto tariffs and strong performances year to date, some profit taking could take place. However, dovish central banks and the low rate environment should limit any widening in spreads. The latest comments from the ECB have also strengthened the case for Euro IG credit: Draghi indicated that the central bank was close to adding stimulus measures, which sent yields towards new lows. This context, combined with the Chinese fiscal stimulus - which would support Europe at a later stage and held avoid a recession - further strengthens our investment thesis on European Credit as an asset class.
US Investment Grade credit continued to attract little interest from a European perspective as hedging is costly and fundamentals have continued to deteriorate. While the earnings season turned out better than expected, leverage is at a 10-year high and cash balances are shrinking for a majority of US companies. However, Asian investors - particularly in Taiwan - remain attracted to US credit markets. The US economy is stable, inflation is below 2% and the Fed is on hold. The US credit cycle has expanded, but non-financial corporates face challenges, notably on the environmental front: electric vehicles for the automobile industry, e-commerce for retail, 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 upwards 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 despite the downside risks. The strength of the dollar and the trade war are major headwinds but China can rely on further fiscal and monetary easing should there be an escalation in the conflict. We are more cautiously selective on emerging markets than over the previous month as idiosyncratic risks are rising.
We are now less constructive on EMD HC after the strong first semestre. While the asset class continues to benefit explicitly from the Fed’s outright dovish stance and the stable outlook for Commodities, the trade relationship between the US and China remains quite unclear. Trade war risk is binary– trade negotiations between the US and China can either be extended or break up - and after the recovery in early June, markets have not fully priced in the re-escalation of tensions. Absolute asset class valuations are not as attractive as they were at the start of the year, although there are pockets of value in selected EM credits, especially in B and BB-rated credits, where we are concentrating exposures.
In EMD LC, we have kept a small short bias in EMFX, amid lackluster growth, the resurgence of trade tensions and the persistent outperformance of the US economy. On the other hand, duration should remain supported as inflation is well-anchored globally and inflows have been subdued since the sell-off last year. We would tend to add duration on retracements.
Returns on the EMD HC (+0.4%) market were marginally positive, but with a marked divergence between the Spread (-2.2%) and Treasury segments (-2.7%) on the back of a resurgence in trade war risks and flight to quality driven re-allocations. EM spreads widened by 34bps to 378bps, or their mid-Jan 2019 level, and 10Y US Treasury yields rallied by 38bps to 2.12%, levels last seen in Sep-17. Oil (-11.4%) also corrected materially on concerns over weaker demand and further downward global growth re-pricing; EM HY oil exporter credits suffered. Argentina recovered some of its April correction as inflation and growth data pointed to a tentative macro-economic recovery; the opposition has failed to unite for the time being and president's Macri's ratings have marginally improved. HY (-0.5%) under-performed IG (1.3%) with Belize (5.3%) and Kuwait (2.7%) posting the highest returns and Zambia (-6.4%) and Lebanon (-4.0%) the weakest.
With a yield of 6%, EMD HC valuations are less compelling than at the end of 2018, after a strong start to the year and as EM risk premiums have already largely priced in the US-China de-escalation in trade tension. The EM HY to IG spread is still attractive, as are the EM single and double B rated segments versus their US HY counterpart. The mid-term case for EMD remains supported by a benign US Treasury and Commodities outlook. Global growth and trade stabilization can support the next leg of EM spread compression, but we are expecting more data to confirm any positive trends. Over a one-year horizon, we expect EMD HC to return around 6.5%, on the assumption of 10Y US Treasury yields at 2.25% and EM spreads at 355bps.
We under-performed the benchmark index by 29bps, on net basis. The largest detractors to performance were the under-weights (UWs) in US Treasury sensitive credits such as Malaysia, Peru, South Africa, and Uruguay and our over-weights (OWs) in HY credits such as Egypt, Ivory Coast and Zambia. The over-weights (OWs) in Argentina and Qatar added to performance, as did our long hedging position on the asset class via CDX.EM and our under-weight (UW) in Lebanon and Sri Lanka. We continued to take profits on oil exporting countries such as Angola, Ecuador and Kazakhstan, and on Caribbean credits like Bermuda and Bahamas in early May. We added to our absolute (+14bps to 7.06yrs) and relative duration positions (+0.13bps to +0.20yrs) as the Fed remained dovish, US Treasuries rallied, and trade war risk re-surfaced.
We are still constructive on commodity exporters such as Angola, Ecuador, Kazakhstan, Petrobras (Brazil), and Pemex (Mexico) as we expect oil prices to remain stable around $60-70; however, we scaled down our over-weights (OWs) after the very strong start to the year.
We have also maintained our 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.
The EMD LC market was stable in April (-0.18%), with the correction in rates offsetting the contribution from carry (0.5%), while FX was near flat (-0.2%). US Treasuries sold off marginally on the back of profit taking, stronger US data, and higher oil prices, that in turn had ripple effects on EM rate markets. Argentina was under pressure (ARS: -6%) but the rest of EM were not affected. Argentine assets came under pressure ahead of uncertain elections in October, and as the protracted recession is not boding well for the re-election of the reform-committed President Macri. The Turkish Lira (-5%) also sold off due to the continued decline of FX reserves and the rise in FX HH deposits, Erdogan's challenge of local election results in Istanbul, and uncertainties over the country’s relationship with the US and NATO. Elsewhere, the US Dollar was stable while MXN (+2%) and RUB (+1.7%) outperformed. Rates sold-off up to 30 bps in Hungary, 20 bps in Indonesia, Colombia and Chile.
We believe that with a yield of 6.0%, EMD LC compares well to FI alternatives as we are now expecting a respite in US-China trade tensions, fading US growth exceptionalism, and more dovish policy stance from the Fed. On a one-year horizon, we expect EMD LC to return around 6%, assuming conservative -1% EMFX and +0.9% duration returns. EMFX are unlikely to outperform amid a global slowdown in economic growth 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. We expect that quantitative tightening will be paused in the US and delayed in Europe which should also support EMD LC.
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. Furthermore, the trade war between the US and China is likely to have a negative effect on the dollar, compounded with declining activity and inflation cycles. 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. In this context, we prefer to have a negative position on the currency.
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. Finally, the central bank could raise rates amidst relatively better forecasts, 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 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.
We underperformed the index by 20 bps, on net basis. The FX UW in TRY and THB detracted most from performance, along with our UW in Polish duration. The main contributors were our UW in COP and CLP, and our OW on duration in the Czech Republic, Peru and Brazil.
We trimmed our short position on the US Dollar by 8% to 10% to reflect the uncertainty stemming from the escalating trade war, especially on commodity markets. We increased duration expecting that core yield would keep trending down and that inflation and imbalances in EM were contained. The absolute duration has increased by 0.3 yrs to 5.94yrs. Our relative duration position is now 0.7 yrs (+0.23 yrs).