Improving activity and better inflation data continue to emanate from the Eurozone, reinforcing our conviction to hold an underweight duration to core EU rates, where valuations are stretched and the asset class is still quite expensive. We have chosen to express this through the belly of the EUR curve (namely the 5-year portion), instead of the 30-year portion, as we had done previously. Furthermore, reinvestments made by the ECB would also support a flatter EUR curve.
The recent political tensions in Italy have had some (although limited) spillover effects on peripheral sovereign bonds, where yields have recently widened. In this context, we have benefited from our underweight position in Italian bonds, which was established in January this year.
We are constructive on the Euro Credit Market. European assets have become more popular thanks to the continued support of the ECB (until the end of 2018 at least). Good Q2 earnings publications will certainly lead to an improvement in risk appetite, while the bottom-up selection is key. Fundamentally, IG Corporates are in good shape. This positioning, combined with more attractive levels of yield, is supporting European credit market recovery. If the high-yield market is facing some idiosyncratic risks, with a substantially higher default rate (rising from 1.8% to 2.5% till the end of 2018, according to S&P), it is largely anticipated by a risk premium widening of 100 bps since the beginning of the year.
We still have a positive stance towards hard currency debt, with a supportive reform momentum and supportive energy exporters. However, we have bought asset class protection to hedge against headline and trade-war risks. The case for emerging market debt remains supported by the general recovery in global growth and elevated oil levels, valuations and technicals. Asset class valuations have now turned attractive on both absolute and relative basis versus US credit.
We have reduced our exposure to headline risks in the emerging debt hard currency strategy and now have a more balanced positioning, with positive convictions in emerging market names and a negative stance via basked-to-single-name CDS.
We believe that, with a yield of 6.6%, the emerging debt in local currency is an attractive investment in a global fixed income context, with the risks of monetary tightening in core markets and deleveraging in China offset by strong fundamentals, global growth and trade recovery, constructive commodity outlook, and – among high yielders – a benign inflation outlook.
Specifically, we remain positive on select high-yielders that are supported by high real rates and constructive disinflation dynamics (Brazil, Peru, Russia). We are negative on lower-yielding local rates markets in Asia (Thailand and Malaysia) and CEE (Poland, Hungary and Romania). Our duration position did not change materially during the month and we retain a neutral bias on emerging market duration amidst emerging market central bank policy hikes induced by tighter global financial conditions.
The overall framework is negative for the US dollar. We currently have a short position on the USD and aim to manage the exposure in a tactical manner as the trade remains vulnerable to central bank communications.
We have maintained our long position on the NOK, which is also supported by a relatively strong economy in which the activity cycle is expanding.
In the current environment of geopolitical uncertainty and the heavy dose of event risks, the JPY remains an attractive safe haven and a diversifying asset. Our long position on the currency has been particularly beneficial in this context.