Government bonds: Tactically short on the front end of the US curve

The activity-cycle now appears to be stalling; at the same time, we expect some moderate deceleration, both in the US and the euro zone. Though we do not see a sharp momentum, it is important to note that, in both regions, the probability of moving into downturn has increased considerably. This is true of 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 downturn are greater. Europe also mirrors this situation, as all sub-indicators point towards lower momentum and a weaker activity cycle. The UK remains the laggard, with a continued deceleration in recent months. Meanwhile, the inflation cycle extended its recent strengthening in the euro zone, 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 monetary policy implemented in the US is deemed appropriate, while the market continues to expect one hike between December and January, with another possible in 1Q 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 remain wary of a policy mistake as we continue to see the contrast of tightening monetary policy in the face of a growth slowdown.

In the face of these trends, the omnipresent geopolitical risks are playing an increasingly important role with regard to the markets. Even though Theresa May survived the no-confidence motion, the Brexit question remains as uncertain as ever, as the UK continues to weigh up its choice of options, which include: a hard Brexit (a scenario whose probability has significantly risen), the current deal that has been agreed on, a new referendum or even fresh general elections. Resolution appears to be closer in the budget tussle between Italy and the European Commission as both parties continue to work on the agreement. On the other hand, trade wars continue to weigh on markets, with both the US and China still at loggerheads over the various tariffs and duties that each country has so far unilaterally applied. The uncertainty and volatility that these events will add are likely to weigh significantly on fixed income markets in the short term, and could also start affecting fundamentals in the longer run. It will hence be vital to monitor the events surrounding these issues all the closer as they could be triggers to future market movements.

Tactical shorts on US front end, Neutral German curves
US treasury yields moved sharply downwards in November, as the aforementioned geopolitical risks and lower oil prices weighed on the curve. Going forward, the Fed remains committed to following the path of a hiking cycle 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 remain vulnerable to the geopolitical context and sharp corrections. In the euro zone, though 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 still weak last month, primarily as a result of the downturn in crude oil prices and some lower momentum in the inflation cycle, and also because risky assets, which also suffered, drove the change in rates in the breakeven models. The Euro area continues to be our favourite market, but we are more cautious on the overall linker market. 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. We are neutral on US breakevens and negative on other global linker markets.

Neutral peripherals, Negative on Italy
Italian bonds suffered considerably over 2018 but November saw some respite, with yields moving sharply lower on the back of thawing tensions between the Italian government and the European Commission. However, we are keeping a prudent stance on Italy, given the still-important fiscal, economic (see recent negative growth momentum) and flow challenges. Furthermore, the compromise of the current government is obviously not finding favour with the populists, and the far-right, anti-European party (the Northern League) is gaining ground in the polls. While we expect some form of agreement to take place, given that it is in neither party’s interest to encourage a stand-off, we feel that the fiscal reality check in 2019 could bring new tensions with the EC to the forefront. (We continue to hold some of our underweight positions on Italian sovereign bonds, preferring Spain or Portugal where, so far, contagion has remained contained.

 

 

Credit: Slightly Positive on Euro Investment Grade credit

In an environment of trade-war intensification, economic slowdown and rising political risks in Europe, we are more cautious on risky assets and prefer Investment Grade (IG) to High Yield (HY). Earnings projections will be reviewed to the downside, as we expect an economic deceleration both in the US and in the euro zone, due to fallen angel risk and a higher default rate. In Europe, this rate is expected to rise gradually from 1.6% to 2.5%. Moreover, uncertainties regarding Italy and Brexit will continue to weigh on issuers, particularly smaller companies and tier-2 banks. In a new era of less central bank support, supply/demand is less favourable than in the past. On the IG side, net supply is expected to be positive next year but investors have reduced their positioning to pre-CSPP levels, which is more neutral. On the HY side, outflows still dominated, as yield tourists retraced and tail risks increased. With the recent widening of IG spreads to 160bp (the pre-CSPP level), IG appears more attractive, while HY widening is less pronounced, with spreads widening to 500bp (still below the level of 560bp of March 2016). We maintain our preference for IG over HY.

 

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

We remain moderately constructive on emerging hard currency debt, as the asset class now explicitly benefits from attractive absolute and relative valuations. We nevertheless still maintain asset class protection as a hedge against headline risks of around 0.8yr of spread duration.

 

We are more defensively positioned in emerging local currency debt, with a neutral EMFX versus our US Dollar position, as EMFX valuations do not appear attractive, apart from exceptions in higher yielders like ARS, TRY and IDR, and due to headwinds to Chinese growth and global trade. 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 on US monetary policy for 2019.

Hard currency

EMD HCs (-0.4%) remained under pressure from elevated US-China trade tensions and the extension of the oil price correction (-22.2%). The suffering experienced by global oil exporters (Nigeria, Gabon, Bahrain) spilled over into other African issuers regardless of their commodity exposure (Cameroon, Ghana, Kenya). The announcement of investor-friendly restructuring in Mozambique helped Zambia recover on a view that bonds had already priced in default risks. Ukraine remained under pressure on poor technicals after the sovereign issue in October and on escalating tensions with Russia. Argentina also extended its underperformance due to the elevated risk aversion, despite the pronounced absence of negative fundamental news. Costa Rica rallied on the approval of fiscal reform aimed at reversing the primary deficit. The 60bp EM spread-widening and 14bp US Treasury-yield decline resulted in negative spread (-1.5%) and a positive index returns of +1.1%. IG (0.0%) outperformed HY (-0.9%), with Mozambique (12.0%) and Zambia (10.0%) posting the highest, and Venezuela (-6.8%) and Nigeria (-4.2%) the lowest, returns.

With a yield of 7.1%, EMD HC compares well with 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, and the absence of growth recovery outside the US – seem to be receding. 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 6%, on an assumption of 10Y US Treasury yields rising to 3.5% and EM spreads tightening to 350bps.

The largest detractors of performance were the overweights in Ukraine (Eurobond supply and escalation of tensions with Russia) and Argentina as well as the overweights in oil exporters (Ghana, Kazakhstan, Nigeria) and the underweights in IG, lower-beta credits in Asia and CEE. The overweights in distressed Mozambique and Zambia added to performance, as did the UWs in Lebanon and Oman. We added exposure to lower-beta Belarus and Montenegro and exited our long protection positions in China and South Africa. The fund's absolute (-22bps to 5.35 years) and relative (-13bps to -1.04 years) 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 oil prices. 

We have also maintained 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 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 the index. 

Local currency

EMD LC delivered a healthy 2.8% return coming from duration (+1.2%) followed by FX (1.1%) and carry (0.5%). Rates, globally, were supported by worries that US growth had peaked and by a 20% fall in the oil price, as inventory build-up triggered a massive unwinding of hedge fund positions.

In turn, USD weakness was triggered by Fed chairman Powell revising his previous hawkish comments to a more neutral tone. High betas performed best: TRY +7%, ZAR +6%, IDR +6%, while, on the rate side, Indonesia and South Africa delivered 4%, followed by the Philippines and Hungary (+2%).

In Latam, idiosyncratic risks dominated. After rallying 6% since August, the ARS sold off 4%, underlying the fact that political risks remain unresolved. Also, the BRL gave back 4% of the post-election rally amid profit-taking and a lack of direction regarding pension reform. While the MXN was flat, Mbonos kept underperforming under the weight of heavy positioning and persistent worries about President Lopez Obrador that further affirmed his populist bias.

We believe that, with a yield of 7.7%, Emerging debt in local currencies (EMD LC) compares well with 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, and 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 synchronized 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 (roughly 2.0%) from current distressed levels has now increased.

The risk added in October in the FX and rates of high-yielders has paid off, led by Indonesia, Turkey and India. The long-held duration overweight in Peru also paid off. However, we did not expect low-yielders to rally massively following oil and US Treasuries, and our underweight detracted to performance in Thailand, Hungary and the Czech Republic. During the month, we increased the USD short position by up to 10% before scaling it back to 5%. We increased the fund's absolute duration by 0.46yr, to 5yrs, by adding duration mostly in high-yielders’ long-end bonds. The fund's relative duration also increased by 0.48yr and is now flat to benchmark.

 

Currencies: Neutral position on USD

Developed Markets

The overall framework, based on investor positioning, trade and capital flows and PPP, is negative for the USD. The twin deficits exhibited by the US should keep the  greenback under pressure vs. other major currencies. Furthermore, the trade wars between the US and China are 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. In this context, we prefer to have a neutral position on the USD.

The Norges Bank made a dovish hike in September, highlighting the fact that global tensions could be a risk to the economy. As our scoring on the currency remains very positive, 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 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 Yen remains an attractive safe haven and a diversifying asset. Nevertheless, flows are preventing any large appreciation of the currency, as the Japanese are buying US bonds.

Emerging markets

The LC strategy is now neutral on EMFX, with overweights in higher yielders like ARS, IDR, and TRY, as well as the CNH, on expectations of near-term trade-war de-escalation, and underweights in Asian FX like 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). During the month, we covered the 0.5yr underweight in our duration position (on shifts of Fed policy market pricing) by adding exposure to higher-yielding markets like Indonesia and South Africa.

Monthly Strategic Insight

Mehr dazu

Fixed
Income
News

Read all articles