Inflation-linked bonds continue to be a favourite, mainly US ones

The rebound in economic activity that had troughed back in September 2016 continued to firm up in February 2017, further clearing up the uncertainties surrounding the global outlook, with probabilities clearly turning in favour of economic expansion. The US continues to remain the primary driver of this phenomenon, as witnessed by the employment and PMI numbers printed over the course of the month. In the Eurozone, economic momentum continues to build, and the activity cycle has reached a new 4-year high, with all indicators in positive territory. The UK market, on the other hand, continues to slowly experience the pain linked with catching up with the reality of the Brexit. Indeed, economic activity is losing momentum, as exhibited by the falling consumer and economic confidence numbers and higher unemployment.

To add to this generally improved economic outlook in the G4, the rather clear and generalised trend of reflation amongst developed economies appears to be gaining momentum, in line with the scenario we have established over the last few months. In the US, the uptick in inflation has been rather clear, with wage and consumer components contributing substantially. Furthermore, expectation indicators have now turned positive, strengthening the US inflation rebound. In the EU, reflation is now turning more homogeneous amongst sub-indicators, though wages and housing segments remain key drivers of the uptrend. While the recent acceleration is impressive (as our indicator is now above its long-term average), expectations remain low. Though the UK and Japan lag on the economic activity cycle front, higher inflation is very much present, with Britain benefiting from a lower Pound sterling and the Japanese disinflationary trend appearing to have bottomed. Other developed countries are also feeling the inflationary effects of an ultra-low rate policy, with countries like Sweden experiencing reflation.

The combination of expanding economic activity and a certainly improving inflation outlook is increasingly likely to lead to a Central Bank policy normalisation in 2017.  Federal Reserve rhetoric did, indeed, sound hawkish, with Mrs Yellen highlighting the fact that employment and inflation targets were close to their objective, paving the way for the much-awaited rate increase and reinforcing our view of 3 rate hikes in the US this year. The next stage of the normalisation in the US may, furthermore, consist in beginning to reduce the FED’s balance sheet, as actually mentioned in the latest FOMC minutes. The ECB meeting yielded a relatively hawkish tone, in spite of the overall stance remaining expansionary. There are an increasing number of critics of the hyper-accommodative monetary stance, and murmurings abound regarding a possible tapering in the market, along with increasing talk about a move towards fiscal stimulus. Broadly speaking, the reflationary trend is going to be a challenge for central banks, all the more so as excessive accommodative policies are producing undesired effects.

In terms of the debt cycle, fundamentals continue to suggest a new leg of credit boom, as both the business cycle and credit cycle are in expansion phase. In the credit-boom cycle, we expect spreads to tighten marginally and default rates to stabilise.

Global Rates Strategy

Risk-on assets continued to do well in February, while developed-market sovereign bonds saw some respite after a rather gruelling few months. UK and Eurozone govies led the way with strong performances while the core markets outperformed European peripherals. US rates were one of the few asset classes to post a negative performance (albeit nothing really to write home about). New Zealand, Canada and Japan also compiled positive returns. As mentioned earlier, the Eurozone, led by Belgium and the Netherlands, was particularly in good form in February. Even the rather volatile French political landscape could not stop govies from outperforming their Spanish and Italian counterparts. Developed markets were not the sole beneficiaries of that month’s rally as both EM local and hard currency markets delivered a strong positive performance in the wake of the rise in other risk-on assets.

Inflation-linked bonds continue to be a favourite, mainly US ones

The US and the Eurozone are in a reflation phase. Wage and consumer sub-indicators are posting solid numbers while the energy segment should also help push headline inflation higher in the coming months. We continue to believe that there remains a reasonable gap between what has been priced in by the market and current/expected inflation levels. Break-even protection levels are positive in the US, and this, combined with an inflation cycle that continues to point upwards, is keeping us positive on US break-evens, in spite of an apparently neutral momentum indicator. We favour long end break-even positions in the US. In Europe, core inflation is still at very low levels, and the cycle is not as strong as in the US (and driven more by the base effects of oil). Furthermore, in spite of a favourable cycle, CPI estimates are lower than Real CPI and our momentum indicator is neutral. We hence remain neutral on Euro inflation-linked bonds, having taken some profits last month. A source of diversification is our favourable view on Australian break-evens, supported by an inflation cycle that is finally rebounding after having bottomed out. Furthermore, probabilities of reflation are higher than before and the Australian break-even spread with the US is at a 5-year low.

Tactically managing exposure to US rates

The base case scenario continues to point towards rising rates in the US (on the back of better activity and an inflation cycle) and US treasury yields have risen in recent months. Furthermore, recent comments by a Fed member hint at increased hawkishness, and Janet Yellen’s speech seemed to betray some anxiety over losing credibility by waiting too long to raise rates and having to raise them more abruptly at a later stage. In this context, we tactically hold a short position on US rates. We are, nonetheless, mindful that the market appears to be very short on the mid- and long end of US sovereigns, though to a lesser extent on the 2-year segment, and hence we continue to adopt a tactical stance towards US treasuries.

Short position on 10-30 year portion of EUR curve

The ECB’s expansionary monetary policy is supportive of non-core European yields, as are the supply-and-demand dynamics. However, in the face of improving inflation numbers as well as the macro-economic outlook, there appears to be some concern regarding the ECB’s future policies. Furthermore, demands from several countries for a move towards fiscal easing as well as the debate around the probable tapering of the current programme could call into question the central bank’s accommodative stance in 2017, as would the hawkish tone employed by the ECB at its recent meeting. To add to this, we have an element of political risk which cannot be neglected, as France, the Netherlands and Germany head to the polls. Investors, furthermore, continue to reduce their long duration to core rates, threatening a rise in rates in a region where valuations are already stretched. There are some core rates on which we hold a positive view, namely Belgium, where supply-and-demand dynamics are supportive and valuations relatively favourable.

Our stance on non-core sovereigns in the Eurozone is growing more positive while investor positioning is much lighter on the segment. We hold a prudent stance on Portugal while being more tactically favourable towards Italy and Spain, on the back of a good TLTRO pick-up and waning political risk. We aim to continue to diversify our exposure towards Eastern Europe (Latvia, Lithuania, Hungary and Poland). We are looking to take some profits in these regions, though we are not worried about growth there and favour some relative-value trades.

Currency Strategy

Over the course of the past month, there was a surge in the Mexican Peso, which saw a sharp appreciation that propelled it to the top of the YTD list after several months of negative performance. EM currencies saw good returns overall, with the South African Rand (ZAR, +3.6%), Indian Rupee (INR, +1.80%) and Brazilian Real (BRL, 1.64%) out in front. The US Dollar had a good run in February (+1.2% vs. the Euro) as, over the course of the month, it recouped some of January’s losses. The New Zealand Dollar (NZD, -2.82%), Norwegian Krone (NOK, -0.89%) and Chilean Peso (CLP, -1.45%), on the other hand, suffered the most.  

Negative framework for USD but JPY remains a safe haven

Though long-term indicators continue to point towards an expensive US Dollar, the carry and investor positioning are supporting the currency. Additionally, supply/demand dynamics remain tight, and could drive the greenback higher over the short term. However, the post-election question of whether the new president Donald Trump would allow the dollar to strengthen is coming into focus. Since taking power, Mr. Trump has taken a tough stance towards countries running high trade deficits with the US (Japan, Mexico, Germany), and recent comments clearly signal his eagerness to limit USD strength.

Though rate differentials remain penalizing, the Yen, based on our indicators (PPP, Trade and capital flows), appears attractive. Furthermore, in the current environment of geo-political uncertainty and the heavy dose of event risk present, the Yen still remains an attractive safe haven and diversifying asset.

Emerging FX: overweight higher-yielding FX vs. underweight low-yielding Asian currencies

EM FX has rebounded YTD on an accelerating EM growth recovery and expectations of reflationary US policy bias. We expect this trend to continue, notwithstanding some volatility around Fed Funds hikes.

We have a slight USD long position, but with an OW in higher beta/higher-yielding currencies (BRL, COP, MXN) and an UW in lower-yielding Asian currencies.

Our continued overweight stance in the Colombian Peso (COP) and the Brazilian Real (BRL) are justified by the fact that we expect commodity FX to outperform the broader EMFX universe and by the strong external/FX Reserve position of Brazil and the upside macro and political risks for Colombia.

We hold a tactical overweight on the Mexican Peso (MXN) as it offers an attractive long-term valuation and could benefit from recovery after the sharp decline that followed the US presidential election. We also like Banxico’s credible policy management (introduction of an FX swap programme and application for a Fed swap line). 

We are maintaining our structural underweight on Asian currencies. The Chinese Yuan (CNY) is expected to continue depreciating in the medium term due to the liberalization of its capital account and its slower growth The Thai Baht (THB) is also entrenched in depreciation mode amidst an accommodative monetary policy and deteriorating fundamentals, while the Indonesian Rupiah (IDR) is vulnerable to the risk of bond outflows in the context of high investor concentration.