Inflation-linked bonds continue to be a favorite

The momentum of economic activity has been weaker in the US and in the G4 countries in general over the past month. This weakening has been underpinned by weak US ISM prints and industrial production in the Eurozone. However, the recent slowdown does not point towards an imminent recession and the activity could bounce back in October. In the UK, the impact of the “Brexit” vote is not being felt yet as the activity cycle appears to be rebounding.

To add to this “moderate” optimism, there appears to be a rather clear trend of reflation amongst developed economies, in-line with our scenario of increasing inflation that had been established in the previous months. This trend is confirmed in the US, where wage inflation is finally materializing, and in the Eurozone, where it appears to be accelerating (with housing and wages once again participating in the phenomenon). Elsewhere in Japan, the disinflation appears to have troughed. Furthermore, countries like New Zealand, Canada and Norway are also experiencing the “reflation” trend (along with a strengthening activity cycle), which could be further supported by stable oil prices.

The combination of a temporarily subdued macro-economic outlook and a certainly improving inflation outlook has led central banks to maintain a neutral stance over the past month. Going forward, we could expect a rate hike from the federal reserve before the end of the year following better inflation outlook. The European and Japanese monetary policies are in expansionary mode. However, both central banks appear to have little room for further easing and the efficiency of the current accommodative stance is being called into question. The UK government has recently suggested that a fiscal stimulus is on its way. The question remains as to when the end of QE can be expected and how long can the BoE tolerate higher inflation.

In terms of the credit cycle dynamics, the signal given by a slowing activity and debt cycles points towards a reduced momentum for spread compression while default rates could soon be trending higher.

There was little change in the overall behavior of rate markets as risk assets continued to move upwards, led by high yield and emerging market debt which were supported by the Feds neutral stance. On the developed markets front, Japanese sovereigns performed well. Spanish Govies outperformed their Italian counter parts, vindicating our long Spain/short Italy strategies. Finally, inflation linked also performed well, once again supporting our long-held strategy on the asset class. 

Inflation-linked bonds continue to be a favorite

The US and Eurozone are in a reflation phase. Wage and consumer inflation sub-indicators are posting solid numbers while energy inflation should also help push headline inflation higher in the coming months. However, we do not believe that this has been priced by the market yet as exhibited by the low expectations built into the inflation cash and swap markets both in the EU and in the US. Both markets have seen the inflation linked bonds outperform the nominal ones. The real yields in the US also appear to be very cheap versus the UK ones. We continue to favor long end breakeven positions in the US as limited inflation premium is built in. 

Short position on US rates

The reflationary phase in the US appears to be underpinned by the increase in wages and not only as a base effect of oil. In this context, the federal reserve could be increasingly tempted to raise rates before the end of the year. The GDP growth and inflation levels could indeed justify higher rates, more so if the political scene clears up with a democratic victory in November. In this context, we hold a short duration position on US rates, primarily on the mid portion of the curve.

Short positions on Core Europe, Neutral stance on non-core

The ECB’s highly accommodative monetary policy is very supportive for core European yields. However, the central bank appears to be running out of ammunition for further easing and the efficiency of the current program is being increasingly questioned. Inflation pick-up is visible in the Euro area as well. Stretched valuations continue to be a source of concern as over the course of the month, core yields declined further towards even lower levels (GER 10Y at -0.11%). Additionally, investor positioning on core sovereigns appears to have increased. In this context, our framework continues to point to the relative expensiveness of core markets, justifying our underweight.

Our long position on Spanish sovereigns vs Italian sovereigns has been a source of positive performance over the past month. Economic developments and growth prospects have been positive compared to other peripheral countries while Italy continued to witness relatively weak PMIs and bear the burden of political risk. Going forward, we expect Spain to also experience volatility driven by uncertainty surrounding the formation of a government. The spreads between Spain and Italy have already reduced sharply over the past month. Hence, in spite of the relatively stronger picture in Spain, we took profits on our long stance vs. Italy and remain cautious on the non-core segment. We aim to diversify our exposure towards Eastern Europe (Latvia, Lithuania, Slovakia). 

Currency strategy

Since the beginning of the year, the Brazilian Real (BRL, +19.4%) and the Japanese Yen (JPY, +13%) have continuously been the top performers vs. EUR, while the British Pound (GBP, -18.1%) and the Mexican Peso (MXN, -13.1%) remain at the bottom of the rankings tables as this year’s worst performers. The GBP continued to tumble this month as the post-Brexit trauma continues to weigh on the cable.

Negative framework for USD, slightly positive for Eur.

While it is possible that the Federal Reserve raises rates towards the end of the year, we expect future rate hikes to be gradual. Furthermore, purchasing power parity against major currencies still indicates that the USD is expensive. Hence, in spite of leaner investor positioning, we do not see an incentive for long dollar position. The framework (purchasing power parity indicator) and investor positioning appears to be slightly positive for the Euro. However, low rates in the Eurozone do not support the currency.

Profit taking on short GBP positions

Despite the Brexit issue and the uncertainty that it implies, the UK activity cycle seems to be holding up quite well. Additionally, the reflationary phase appears to be well entrenched. In this context, we aim to take some profits on our tactical short position on the Pound Sterling, which has already seen sharp declines for the past few months.

Positive on the NOK, Negative NZD & AUD

Our framework is strongly positive on the NOK. Cyclical & FX frameworks are pointing towards a re-appreciation of the NOK, especially since oil prices have stabilized. Conversely, we remain neutral on the Swedish Krona. Even though long-term drivers are positive, monetary policy remains uncertain in the context of slowdown in activity and acceleration of inflation.

NZD and AUD appear overvalued and long-term drivers suggest more downside for both currencies (PPP overvaluations, current account). It appears that the New Zealand central bank is not entirely comfortable with the strength of the Kiwi (which has seen sharp appreciation in 2016). As a result, we can expect some easing in the form of a rate cut or forward guidance.

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

Emerging market currencies are still highly sensitive to external risks and global growth. However, EM FX valuations are attractive on average and if global growth continues to recover, the asset class could be well supported. Commodity prices have stabilized and the very recent OPEC commitment to reduce production should continue to support the sector. Furthermore, central banks in certain high yielding countries (E.g: Brazil) remain hawkish, in an attempt to anchor inflation expectations.

In this context, we maintain our overweight on the Argentinian peso (ARS), which benefits from the strong capital flows this year thanks to accelerating investments and well-received sovereign debt issuance. Additionally, the currency should also be supported by structural reforms. We also continue to hold an overweight on the Brazilian real (BRL) which should benefit from reform progress and containment of government spending, while hawkish monetary policy and inflation turnaround will also be sources of up-lift. 

A more tactical overweight is placed on the Mexican peso (MXN) which would obviously benefit from oil prices. Furthermore, in terms of valuations, the currency appears to be deeply underpriced, and one could expect a turnaround based on the increasing probability of a democratic party victory in the upcoming US elections. 

On the other hand, we are maintaining our structural underweight on Asian currencies. 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 (THB) is also entrenched in a depreciation stance amidst an accommodative monetary policy and deteriorating fundamentals. Finally, the South African Rand (ZAR) and Turkish Lira (TRY) could suffer from rising political risk, justifying our underweight position.