24 SEP


Themen , Fixed Income

Stable activity cycle and predictable central banks


Government bonds: tactically short on the lower end of the US curve

The global activity cycle remains in expansion phase and central banks have communicated in line with expectations. In this context, we are tactically short on the front end of the US and EUR curves, while preferring linkers.

The activity cycle remained stable and in expansion phase in G4 countries, though the momentum might have stalled a bit in recent months. This stability is characterised by data from the US, where the activity cycle is sturdy, but where momentum has stabilized and the probability of downturn has increased slightly. Europe continues to exhibit a strong picture, with the expansion stage still well-anchored, and where momentum on all sub-indicators continues to rise. The UK remains the laggard, with a continuous deceleration over the past months. Meanwhile, the inflation cycle extended its recent strengthening, with the US and euro zone once again leading the way.

All in all, the inflation picture is exhibiting an upward trend across developed markets, with most countries in the inflation or reflation phase of the cycle. In the current context, the implemented monetary policy in the US is deemed appropriate, while the market continues to expect three more hikes (two in 2018, and an additional hike in H1 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 and the recent meeting did not yield any surprises.

Tactically short on the front end of the US and EUR curves
US treasury yields moved up over the second half of August as a result of better inflation data, but are not immune to a rally on the back of significant political risks and concerns over trade wars. We continue to expect the curve to continue to flatten, thereby justifying our underweight position on the front end of the US curve (2Y). In Europe, currently, we are maintaining a moderate level of short positions in favour of a flattening bias, with valuations being stretched on the lower end of the curve, and we aim to manage this position tactically as we see flow dynamics changing, with the ECB’s QE programme coming to an end. On other core markets, we aim to close our long allocation to France and, instead, pursue a positive allocation to Belgium as the spread between the two countries (long end of the curve) appears to be quite enticing.

Long EUR & USD linkers
The performance of the linkers asset class has been positive over the last couple of months for all regions except the UK. We continue to hold a positive view on the asset class, with a specific preference for US and Euro linkers. Though the carry is now less attractive, valuations linked to inflation expectations are quite attractive and the inflation cycle is currently very strong for both regions. Furthermore, our break-even model suggests a favourable framework for the two segments.

Neutral peripherals, less negative Italy
We have benefited from our underweight position in Italian bonds, which was established in January this year. While we remain concerned regarding the budget deficit and expect a level of 2.5%, we do not expect a big upturn in debt levels in 2019 nor do we see a downgrade in ratings to below investment grade in the short term. Hence we have decided to reduce some of our underweight position on Italian sovereign bonds tactically, taking advantage of slightly more favourable budget outcome expectations. We continue to monitor debt financing and growth data as we manage this position tactically and remain prudent over the longer-term prospects. Increased net issuance in Italy and the end of the ECB purchase programme will be important to monitor in terms of flow dynamics for 2019.


Credit: cautiously and slightly positive on the Euro credit market

While – with the support of the ECB, but also because of their critical size, good fundamentals and the recent widening of spreads – European IG credit markets have become more popular, we expect some additional widening to take place by year-end 2018. Technicals, it is thought, will be less supportive for the last quarter of 2018, with a large supply expected and headwinds such as the Turkish crisis, EM turmoil and tariffs likely to spill over and challenge the Euro IG markets.

US credit market exhibiting lower risks
Against a backdrop of a rebound in the economy over the second quarter and supportive company results, the asset class could be temporarily well supported thanks to its domestic economic power. In this context, while we maintain a selective view on US credit (which will offer more value than the European credit market until year-end) and avoid some secular sector challenges. We aim to add some US high-yield exposure to take advantage of the carry.


Emerging Debt: positive, despite trade-war risks.

We remain positive on emerging debt hard currency, as the asset class is benefiting from supportive reform momentum and energy exporters. We have, nevertheless, put some asset class protection in place as a hedge against headline and trade-war risks.

Hard currency

The asset class (-1.7%) sold off emphatically in August as Turkish and, subsequently, Argentine risks rose during the month, causing a sharp correction in high-yielders. This bout of EM volatility was triggered by a sharp sell-off in the Turkish lira, which, at the worst point, was 40% weaker, under threat of US sanctions and amidst a very poor communications and policy response. Contagion spread to the rest of the EM high-yielders, particularly Argentina, where the authorities continued to find it difficult to roll over domestic debt, even at yields of 40%. The Central Bank of Argentina hiked its policy rate by 15%, to 60%, but that did not stabilize the peso, which sold off 29% on the month. Weak EM credits with high external funding requirements suffered the most. EM spreads widened by 50bps, resulting in a -2.6% spread return, while US Treasuries rallied by 10bps, which added 0.9%. IG (+0.3%) outperformed HY (-3.7%) materially, with Suriname (1.5%) and Vietnam (0.9%) posting the highest, and Zambia (-17.8%) and Argentina (-11.9%) the lowest, returns.

With a yield of 6.6%, EMD HC compares well to FI alternatives, although we acknowledge the increased near-term external and domestic risks to the asset class (extension of US-driven trade tensions, the announcement of further US sanctions on Russia and Turkey, the absence of growth recovery outside of the US). The medium-term case for EMD remains supported by the resumption of the synchronized global growth recovery and the very attractive asset class valuations. On a one-year horizon, we expect EMD HC to return around 7.3%, on an assumption of 10Y US Treasury yields rising to 3.2% and EM spreads tightening to 340bps.

In this context, we reduced exposure to headline risks in the EMD HC strategy and now have a more balanced positioning, with an overweight in EM names and an underweight via a basket of EM single-name CDS (China, Brazil, Mexico, Russia, South Africa, Turkey) to hedge against elevated global growth and trade risks. In August and early September, we reduced exposure to Indonesia and South Africa, added a Russia CDS protection in anticipation of further Russia sanctions, and bought front-end Turkish sovereign debt trading at distressed levels as we do not expect a Turkish sovereign default in 2019.

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

Our underweights (UW) 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 and EU sanctions, geopolitical risks, dependence on commodity exports and limited value versus IG peers and the index.

Local currency

August was another trying month for EM local markets, sold off at 6% amidst thin summer liquidity. Currency corrections in Turkey (TRY -26%) and, later, Argentina (ARS -28%) sent tremors through the entire asset class, under unrelenting external trade and strong USD pressures. Turkey really tested the markets' patience when the diplomatic stand-off with the US over Pastor Brunson added to the refusal to respond to macro imbalances with orthodox policies. Argentina, on the other hand, is trying to push orthodox policies, but results are slow to show and the current account deficit is still deteriorating. On the external front, growth continued to slow everywhere but in the US; EU countries are still facing political uncertainty around the Italian budget and Brexit; China remains silent on the possibility of a larger stimulus, focused as it is on trade negotiations with the US. Most of the negative asset class performance came from forex. High betas were drawn by Turkey and Argentina, and used as cheaper hedges when interest rates soared to 30% in Turkey and 60% in Argentina. The lower betas (the CEE block and Asia) outperformed.

We believe that, with a yield of 6.7%, the asset class compares well to FI alternatives although we acknowledge the increased near-term external and domestic risks to the asset class (extension of US-driven trade tensions, the announcement of further US sanctions on Russia and Turkey, the absence of growth recovery outside of the US). 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 9%, as the prospect of a currency rebound (2.5%) from current distressed levels has now increased.

Specifically, we remain overweight on high-yielders supported by high real rates and constructive disinflation dynamics (Brazil, Peru, Russia). We are underweight 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 the central bank policy hikes induced by tighter global financial conditions.

We are relatively defensively positioned in an environment of elevated external risks – trade tensions, US sanctions, the upcoming Brazil elections – with UWs in local duration (-0.22yrs) and emerging currencies versus the benchmark index (Long US Dollar position of 6.3%).


Currencies: tactically neutral on the USD

Developed Markets
The overall framework – based on rate differential, carry-to-risk and economic surprises – is negative for the US dollar. The twin deficits exhibited by the US should keep the greenback under pressure vs. major currencies over the medium term. However, the currency should receive some support from the Fed, which is likely to continue to hike its rates. Moreover, short-term factors remain supportive of the USD dollar (fiscal plan, budget, cash repatriation). Finally, in the current context of geopolitical risk, the dollar is an interesting safe-haven asset to hold. In this context, we currently hold a neutral position to the dollar.

As the Norges Bank cleared the path for a rate hike in September 2018, and as our scoring remains very positive for the currency, we have maintained our long position on the NOK, which is also supported by a relatively strong economy with an expanding activity cycle.

On the other hand, we hold a negative exposure to the NZD, which could be impacted by the trade wars between US and China (as China is an important trading partner of New Zealand), the slowing activity cycle and a very dovish central bank.

Though rate differentials remain penalizing, the Yen – 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. Our long position on the currency has been particularly beneficial in this context.

Emerging markets

In the near term, defensively positioned on EM currencies with OWs only in select CEEMEA currencies like CZK, HUF, PLN and KZT, and UWs in those Asian currencies at the greatest risk from the escalation of global trade tensions

We recently took profit on our shorts in high beta FX, expecting some stabilisation. Seeing a significant risk of escalation around US-China trade tensions, we are keeping underweight in Asia FX. Duration-wise, we expect global inflation to move up, with spare capacity having tightened around the world. We prefer being underweight in low-yielding countries where the central bank now appears behind the curve (Hungary, Poland, Czech Republic), along with Thailand, where the 10-year is trading below US treasuries.