Short duration bias on the US short-term part

The US economy is less exposed to the UK and thus should be less impacted by the Brexit issue. The US activity cycle – dragged down by the ISM manufacturing and low capacity utilization – is, nevertheless, decelerating (GDP growth: 1.1% this year and 2% next year). However, inflation is recovering from the bottom, thanks to the housing component and the stabilization of oil.

In this context, the Federal Reserve is in an uncomfortable position, with diverging signs from the economic and inflation front and the economic impact of the Brexit, which needs to be assessed. The markets remain sceptical about the FED’s ability to embark on a sustained path of policy normalization and will probably have to remain in “wait-and-see” mode. US rates, nevertheless, are still expensive territory (2Y at 0.67%, 10Y at 1.53%), certainly at the front end. We are keeping our short duration bias on the US 2Y.

US remains our preferred linker market

We are keeping a large overweight bias on the linker asset class, principally via the US (+0.25 CTMD) and, to a lesser extent, via EMU linkers. Our strong conviction on US linkers is driven by inflation dynamics, valuations, monetary policy and the BEI carry.

The US & EU areas are in a reflation phase. Despite signs of firming wage inflation, this still needs to translate into core PCE, meaning the FED should stay on hold for the moment. In Europe, headline data remain low but base effects should be positive in H2 2016, as oil is stabilizing, and should help inflation pursue its increase. Global central banks should also keep a dovish bias, with the Brexit added to the equation.

Defensive on Euro non-core countries overall

We further reduced our overweight on non-core European countries, taking a neutral positioning overall on peripherals. We reduced our exposure via Italy as political risk seems to be turning negative (constitutional referendum) and banking risk remains highly tangible. The high proportion of non-performing loans in banks’ balance sheets points to the need for a recapitalization (around €25/30bn for the whole sector). At the same time, a political solution could possibly be found in Spain, even if parliament remains fragmented after the elections. The formation of a right-wing minority government seems possible. Also, economically, Spain continues to stand out relative to Italy. Growth dynamics remain better (GDP growth: 2.8% in 2016 and 2.5% in 2017 vs. 1.4% then 1.3% in Italy), also highlighted by recent PMI data (55.7 for Spain versus 52.6 for Italy).

We therefore increased our exposure to Spain (+0.1 CTMD) relative to Italy (-0.1 CTMD), driven by the evolving political dynamics and concerns about the Italian banking sector.

We also reduced our exposure to Ireland (-0.1 CTMD) relative to France. Valuations are less attractive while the Brexit referendum could also penalize Ireland on a relative basis. Ireland has a large relative economic exposure to the UK (export exposure to the UK in % GDP: 7%, FDI: 9%). Also, on Portugal, we are maintaining our defensive bias, as fiscal dynamics remain challenging, while liquidity dynamics remain poor. Important for Portugal will be DBRS’s assessment of the country’s solvency.

Overall, non-core countries continue to be strongly supported by both the monetary policy stance of the ECB and negative flow dynamics. In July, negative cashflows will be at, respectively, € -28bn. and € -19 bn. for Italy and Spain  (driven by important redemptions and coupon payments). The key for peripherals will be the political developments (referendum in Italy, formation of a government in Spain) and the resolution of the banking issue in Italy.

Core Euro countries: limited value at the front end

The ECB’s very accommodative monetary policy is very supportive of core European yields. PSPP is driving sovereign yields further downwards, with more than 50% of the European bond market trading in negative territory, principally in core countries.

Following the negative outcome of the Brexit referendum, core yields decreased even more (GER 10Y at -0.05%, FR 10Y at 0.19%). In this context, our framework continues to point to the relative expensiveness of the core markets. Yields could nevertheless fall even further downwards over the summer as negative flow dynamics will be very supportive, certainly when adjusted for PSPP. At the front end, we are nevertheless keeping a tactical short duration bias via the German 2-year part as, with a yield of -0.67%, there remains but limited value.

Since the beginning of the year, emerging market currencies have remained well oriented (BRL +17.8% vs. EUR, MYR +6.5% vs. EUR, ZAR +5.2% vs. EUR) while the British Pound (GBP, -13.5%) has unseated the Mexican Peso (MXN, -8%) as this year’s worst performer vs. EUR. The GBP was massively sold after the Brexit referendum.

Neutral stance on most G10 currencies following the Brexit referendum

Despite its safe-haven status, we are sticking to our neutral position on the US Dollar vs Euro, as our framework is more negative than it was last month. The long-term indicators in particular (trade & capital flows, purchasing power parity) are pointing towards an overvaluation of the USD.

We still do not have a strong conviction on the GBP. The Brexit uncertainty is pulling the currency downwards, in a one-way market.

After a sharp depreciation, some value indicators are turning positive (PPP, rates differential). The GBP could, however, remain under pressure  in the coming weeks, as a consequence of the economic and monetary implications of the referendum.

The EUR still remains undervalued vs. all major G10 currencies and has kept a positive grade in our framework, thanks to its purchasing power parity. Short positions on the EUR are not an overcrowded trade anymore, bringing the market positioning from short to neutral. However, in an uncertain post-Brexit economic environment, we are distancing ourselves from from the EUR and GBP.

The Canadian Dollar (CAD) is close to its fair valuation – according to its PPP – while tactical indicators are supportive and oil is stabilizing. Consequently, we remain neutral on CAD.

Forex fundamentals are supporting a lower CHF while Switzerland’s business cycle, which may have hit a bottom, is showing signs of rebound. Even if the CHF were to benefit from the risk-off environment, we would stay neutral, as the SNB has repeatedly expressed its determination to contain strong appreciation.

Positive on the JPY & NOK vs. Negative NZD & AUD

Long-term and tactical indicators (PPP, trade flows) still point towards further JPY appreciation, as risk-off persists and markets remain sceptical about policies designed to further weaken the JPY.

Our framework is strongly positive on the NOK. Cyclical & forex frameworks are pointing towards a re-appreciation of the krona, especially since oil has formed a bottom. Conversely, we remain neutral on the SEK, even if long-term drivers are positive, as the inflation outlook is not offering signs of policy normalization.

NZD and AUD appear overvalued and long-term drivers suggest more downside for the AUD than for the NZD. The Australian activity cycle could support a FX appreciation while FX fundamental drivers (PPP, current account) remain negative.

Emerging market FX: Overweight Latin America FX vs. Underweight Asian FX

Emerging market currencies are still highly sensitive to external risks and global growth. The Brexit outcome should introduce some volatility in the emerging markets in the second half of the year. We shall expect a better environment for EM only when EM growth firmly recovers.

Overall, EMFX valuations are attractive and external risks (commodities, Fed policy and China) continue to subside.

We are keeping our overweight on the Argentinian peso (ARS), which is being  supported by structural reforms and central bank easing, and on the Brazilian real (BRL) following the appointment of a new government willing to implement fiscal reforms.

On the other hand, we are maintaining our structural underweight on Asian forex.

Due to the liberalization of its capital account and its slower growth, the Chinese Yuan (CNY) is experiencing a medium-term depreciation. The Thai baht is also entrenched in a depreciation stance amidst an accommodative monetary policy and deteriorating fundamentals.

The Thai baht also depreciated because of the accomodative monetary policy and the deterioration in fundamentals.