Government bonds: Small tactical shorts on US front end

The activity-cycle now appears to be taking a breather, with some moderate deceleration expected in both in the US and the Eurozone. In both regions, the probability of moving into downturn has increased considerably and confidence in future economic releases is cracking. This is true of the US, where, in spite of the recent strong ISM prints that helped to temporarily propel 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 to lower momentum and a weaker activity cycle. The UK has now seen a very sharp deceleration that has confirmed the slowdown witnessed in recent months, and has clearly entered the recession stage of the cycle. Meanwhile, the inflation cycle appears to have reached a peak, extending its recent strengthening in the Eurozone, though the US index was off its highs, with housing declining significantly. All in all, the inflation picture is exhibiting an upward trend across developed markets, with the UK remaining a stubborn exception. In the current context, the implemented monetary policy in the US is deemed appropriate, with the Federal Reserve implementing a rate hike in December. Chairman Powell did, however, emphasize that the central bank would be “flexible” going forward, which in fact represents a material shift, as did his prior communication. In Europe, the ECB has ended its quantitative easing programme, ending the decade-long G4 central bank balance-sheet expansion era. Regarding the ECB, we do not expect a first rate hike before summer 2019. In the UK, we remain wary of policy mistakes, continuing to see the contrast between a tightening monetary policy and a slowdown in growth.

The investor concerns that led to a rather turbulent Q4 in 2018 are likely to carry over into 2019. Indeed, there are plenty of political risks present with very uncertain outcomes. The Brexit situation remains unresolved. There does not seem to be an end in sight to the US government shutdown, with president Trump continuing to hold out in the absence of funding for the border wall. While trade negotiations between the US and China have reopened, the road ahead appears fairly bumpy, with both sides still far from reaching an agreement. Finally, geopolitical risks are also in the background, as the conflict in Syria and sanctions against Iran continue to weigh on markets. These risks were already somewhat present in 2018. However, this year, bond markets will face these issues without the crucial support of central banks. The absence of the massive bond-buying programmes that fixed income investors have grown used to over the past decade is likely to add further challenges and volatility.

Small tactical shorts on US front end, Neutral German curves

December saw a continuation of the fall in treasury yields, the 10-year rapidly plunging to 2.6% (from 3%), as a risk-off wave gripped markets and equities sank significantly. Going forward, the Fed has shown some hesitation regarding the strength of the US economy and is likely to be more flexible regarding its hiking cycle. All the same, we believe that the current levels of growth and inflation are likely to lead to somewhat increase short-term rates. The long end, however, should remain vulnerable to the geopolitical context and sharp corrections. In the Eurozone, though, core bonds usually tend to move in sympathy with US treasuries. At the same time, the Brexit deal and lower growth levels, for now, will help temper the upward risk on German rates. The important start-of-year Euro sovereign issuance has also been met by high investor demand.

Neutral on Global Linkers

Linker performance was again weak last month, primarily as a result of the downturn in crude oil prices and lower momentum in the inflation cycle. Furthermore, risky assets, whose suffering continued, drove the change in rates in the breakeven models. Overall, we are maintaining a defensive stance – primarily driven by the carry – on the market (negative the US, the Eurozone and the UK). The break-even model – driven by oil prices and risk aversion – increased its negative stance. Valuations are, however, slightly more attractive. In terms of the inflation cycle, the US appears to be less strong than in the past. Overall, we hold a neutral view on Linkers and a negative stance on the UK and Sweden.

Neutral peripherals

Fair-value indicators continue to point to the expensiveness of core markets. Cyclical indicators are neutral. Monetary policy remains supportive: the ECB is reducing QE and, although it has removed its QE easing bias, gradualism remains the motto, as core inflation dynamics remain contained while growth is moderating. Sentiment indicators – driven by investors’ positioning – remain supportive. Supply/demand dynamics are neutral for core countries. The supply picture at the start of 2019 is mixed but seems to have been easily absorbed by the market. In this context, we hold an underweight allocation to certain core yields such as France and Austria. Non-core markets continue to be supported by the ECB. The carry/ roll-down remains supportive. We have maintained a prudent stance on Italy, where we remain close to neutral. Event risk on Italy will be driven by success of supply, upcoming rating reviews and politics. We have a favourable view on Spanish and Portuguese debt, which present attractive valuations and relatively low political risk, and which should benefit more, in relative terms, from the ECB’s reinvestment policy.

 

 

Credit: Slightly Positive on Euro Investment Grade credit

In an environment of trade-war intensification, economic slowdown and rising political risks, we are more cautious on risky assets and prefer IG over HY in Europe. Earnings projections will be reviewed to the downside as we expect an economic deceleration both in the US and in the Eurozone involving fallen angel risk and a higher default rate. In Europe, the deceleration is expected to rise gradually, from 1.6% to 2.5%, while, in the US, it should stabilise at around 2.5%. Uncertainties regarding Italy and Brexit will also continue to weigh on issuers, particularly smaller companies and tier-2 banks. In a new era of more subdued central bank support, supply/demand is less favourable than in the past. On the IG side, net supply is expected to be positive this year but investors have reduced their positioning to the more neutral pre-CSPP levels. On the HY front, outflows still dominated, as yield tourists retraced, and tail risks increased. With the recent widening of IG spreads to the 160bp level, i.e., back to pre-CSPP levels, IG appears more attractive, while the widening in HY is less pronounced, with spreads widening to 51bps; still below the level of 560bps in March 2016. Credit is more attractive today than in the past but demand is key! We maintain our preference for IG over HY in Europe. 

 

Emerging Debt: Moderately constructive on expectations of near-term trade-war de-escalation

We are more constructive on emerging hard-currency debt in early 2019, as the asset class is now explicitly benefiting from attractive absolute and relative valuations after the sharp correction in December, and given our near-term expectations of a more dovish Fed, weaker US Dollar, respite in US-China trade tensions, and an oil rebound. Nevertheless, we still maintain asset-class protection as a hedge against headline risks and weaker global growth of a 0.7-yr or so spread duration. 

The EMFX position, although positive, is still close to neutral, as we added risk in BRL and COP but took profits in IDR and TRY in January. We have neutralized the local bond duration over the past month, adding to select higher yielders like Indonesia and South Africa, in acknowledgement of a sufficient LC spread cushion and shifting market expectations vis-à-vis US monetary policy for 2019.

Hard currency

EMD HCs (+1.35%) posted a positive return, in a classic risk-off, illiquid end-of-year market, with US Treasuries rallying and EM risk premiums rising in the midst of a US equity (-9.2%) and oil (-8.4%) market correction and in the absence of any meaningful resolution on the US-China trade tensions post-the G20 meeting between US and Chinese policymakers. Argentina and Ukraine extended their underperformance due to elevated risk aversion, market positioning and illiquidity, and despite the pronounced absence of unexpected fundamental news. Turkish assets extended their recovery on slowing inflation and a faster-than-expected adjustment of the country's current-account deficit. Lebanese policymakers came close but still failed to form a government, although this did not prevent a material rally in Lebanese assets. EM spreads widened by 20bps and US Treasury yields declined by 30bps, resulting in a negative spread (-0.95%) and positive treasury index (+2.32%)  return. IG (1.65%) outperformed HY (1.04%), with Turkey (5.0%) and Lebanon (3.6%) posting the highest, and Oman (-4.0%) and Argentina (-3.8%) the lowest, returns.

With a yield of 6.9%, EMD HC compares well with FI alternatives, especially since risk premiums in higher yielders increased dramatically in 2018, better reflecting the main risks to the asset class from US-China trade tensions and US growth exceptionalism. The medium-term case for EMD also remains supported by the more benign US Treasury outlook post-the 4Q18 14% US equity and 35% oil price corrections that raised the probability of slower US growth and tampered inflation. On a one-year horizon, we expect EMD HC to return around 6%, on an assumption of 10Y US Treasury yields rising to 3.25% and EM spreads tightening to 375bps.

The largest detractors to performance were the overweights (OWs) in Angola, Argentina, Ecuador and Ukraine as well as the underweights (UWs) in IG and the lower-beta credits in Asia and CEE after the material US Treasury rally. The OWs in distressed Mozambique and Zambia marginally detracted from performance, as did the UW in Lebanon (where policymakers came close to forming a government). We took profits from an Indonesian quasi-sovereign Inalum and exited our long protection positions in Argentina. Our absolute (+3bps to 5.38yrs) and relative (-13bps to -1.18yrs)  duration positions did not change materially during the month.

We are still constructive on commodity exporters like Angola, Ecuador, Kazakhstan, Nigeria, Brazil (Petrobras), and Mexico (Pemex), given our positive outlook on the oil price. 

We also maintain 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 but we will be looking for opportunities to cover some of these UWs given the more dovish Fed stance. 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. 

Local currency

EMD LCs continued to rally in December, albeit at a slower pace, returning 1.3% from duration (0.8%) and carry (0.5%). DXY lost 1% but mostly against safe havens. EMFX was flat overall, with some high-betas battered and Euro proxies rallying. The ZAR was most affected by the bout of top-down-driven risk aversion (-3.6%) and the RUB was also affected by the extra fall in the oil price (-8.4%), along with speculation about Democrats taking more aggressive aim at Russia. Being the underperformer last month, the MXN rallied (3%), amidst a show of goodwill from President-elect AMLO. The global growth scare – that contributed both to the equity sell-off and the continuing fall in the oil price – also explains why EM rates outperformed EMFX so markedly for the second consecutive month.  Only Mexico (-53bps) and Brazil (-40bps) outperformed US Treasuries (-30bps). Yields widened only  a marginal 5bps in Indonesia and Chile. Duration was well supported in Brazil, where inflation remains subdued and President Bolsonaro’s prudent approach is,  so far, bolstering local sentiment.

We believe that, with a yield of 6.4%, EMD LC compares well with FI alternatives, especially as we are now expecting a respite from US-China trade tensions and US growth exceptionalism. The medium-term case for EMD also remains supported by the more benign US Treasury outlook post-the 4Q18 14% US equity and 35% oil price corrections, which have raised the probability of slower US growth and tampered inflation. On a one-year horizon, we expect EMD LC to return around 5%, with only a marginal detraction from EMFX (-1.0%), given the slightly weaker global outlook.

 

Currencies: Neutral position on USD

Developed Markets

The overall framework 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. The trade wars between the US and China are also likely to have a negative effect on the greenback. However, the currency should receive some support from the Fed, which is likely to continue hiking rates. Moreover, short-term factors (fiscal plan, budget, cash repatriation) remain supportive of the USD dollar. In this context, we prefer to have a neutral position on the USD.

Norges Bank made a dovish hike in September, although highlighting global tensions could be risky for the economy. As our scoring remains very positive for the currency, we maintained our long position on the NOK, a currency also supported by a relatively strong economy and expanding activity cycle. 

Though rate differentials remain penalizing, the JPY – based on our long-term framework – appears attractive. In the current environment of geopolitical uncertainty and the heavy dose of event risk present, the JPY remains an attractive safe haven and a diversifying asset. Nevertheless, flows are preventing any major currency appreciation, with the Japanese buying US bonds.

Emerging markets

Performance was helped by the trades we undertook to protect our strategy from the surge of risk aversion and volatility – the short in ZAR and long in JPY that,  globally,  were respectively the worst- and the best-performing currencies. Performance was hurt by the widening spread between lower-yielding curves (where we are UW on Thailand and on Hungary) and higher-yielders, where we are OW on Indonesia. The OW in the TRY also detracted from performance.

During the month, we completely neutralised our US Dollar exposure in anticipation of headwinds to EMFX performance. Our absolute duration increased by 0.10Y to 5.10Y, while the relative duration was flat against benchmark.

Our strategy is now small OW EMFX with OWs in higher-yielders like the ARS, BRL, COP and CNH, on expectations of a near-term, trade-war de-escalation, and UWs in Asian FX like the INR, PHP and THB, on deteriorating fundamentals. 

We are underweight lower-yielding local rates markets in Asia (Thailand and Malaysia) and CEE (Czech, Hungary, Poland).

Monthly Strategic Insight

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