The activity-cycle remained stable, still in an expansion phase in G4 countries, although momentum has stalled. This stability is reflected in data from the US, where the activity cycle is sturdy. Europe continues to exhibit strength, with the expansion stage remaining well-anchored and with momentum on all sub-indicators continuing to rise. The UK remains the laggard, with continued deceleration over recent months. Meanwhile, the inflation cycle extended its recent strengthening with the US and the Eurozone once again leading the way. Overall, inflation reflects an upward trend across developed markets, with most countries in the inflation or reflation phase of the cycle. In the current context, the monetary policy implemented in the US is deemed appropriate, while the market continues to expect 2.5 more hikes (1 in December, 1 in March and potentially one additional hike in June). In Europe, our monetary policy gauge indicates that the ECB should continue to normalize its monetary policy, although an initial rate hike is not expected before summer 2019 and the latest meeting did not yield any surprises.
Tactically short on the front end of the US curve
US treasury yields steepened sharply in September, breaking the 3% level on the back of better inflation data, a strong labour market and bullish confidence sentiment. Powell, during the latest FOMC, confirmed the strength of the US economy and the trajectory of the rate hike cycle, while the longer-term dot plot chart was revised higher to 3%. However, challenges are still looming which could disrupt this positive momentum. We still expect the curve to flatten further, justifying out underweight position on the front end of the US curve (2Y).
Neutral stance on Bunds
Although core bonds trended in-line with US treasury, the rise was limited. Despite signs of support on the inflation front and an expanding economy, Italian event risk, the Brexit deal and supportive flow dynamics should temper the upward risk on German rates for the time being.
Reinforce Long USD linkers
The linkers asset class has returned a positive performance over the past couple of months across all regions except the UK. We maintain our positive view on this asset class, with a specific preference for US and Euro linkers. Valuations linked to inflation outlook are relatively attractive and the inflation cycle is currently very strong in both regions. Furthermore, our breakeven model suggests a favourable framework for both segments.
Neutral on peripherals, more negative on Italy
We have benefited from our underweight position in Italian bonds, which was set up in January this year. In September, based on a more favourable budgetary outlook, we tactically reduced some of our underweight position on Italian sovereign bonds. The relief was short lived however. The Italian budget released on 27th September proposed a 2.4% fiscal deficit for the next 3 years. It came as a major surprise. Finance Minister Tria’s credibility, unrealistic growth assumptions and risk of fiscal slippage are all weighing on government BTP treasuries. As long term challenges remain steep for Italy and notably a ratings agency review, we are maintaining a prudent view and further reducing our exposure, preferring Spain and Portugal where contagion remains contained so far.
European IG credit markets have become more popular with the support of the ECB but also because of their critical mass and healthy fundamental backdrop. While headwinds such as the Turkish crisis, EM turmoil and tariffs are likely to spill-over and challenge the Euro IG markets, technical factors are more supportive for the next month. Investors have drastically reduced their positioning and supply also surged in Q3 but will be more moderate in Q4, as the reporting season will close the door on the primary market. After the strong high-beta performance and taking into account carry vs risk, we prefer IG to HY.
US credit market reflecting lower risks
Against the backdrop of a rebound in the economy over the second quarter and supportive company results, this asset class could be temporarily well supported thanks to its domestic economic power. In this context, we maintain a selective view on US credit and we are avoiding some secular sector challenges. Hedging costs have risen, reducing the value of dollar markets for a European investor. High yield continues to offer attractive carry.
We remain moderately constructive on emerging hard currency debt, as the asset class is benefiting from a supportive reform momentum and energy exporters. We nevertheless now hold asset class protection as a hedge against headline and trade war risks.
We are more defensively positioned in emerging local currency debt as local bond market valuations are not excessively attractive. EM currency valuations, on the other hand, are attractive from a longer-term perspective but we shall remain cautious in the short term given the elevated risks from higher US Treasuries, a stronger US Dollar, and trade wars.
EMD HC's (+1.5%) reversed almost fully the August correction, with Argentine and Turkish risk premiums declining sharply as policymakers in both countries delivered reasonable crisis-fighting responses. In Turkey, a surprise and higher-than-expected 625bp policy rate hike, a credible medium-term programme focused on fiscal consolidation, and geopolitical risk de-escalation persuaded investors that Turkey had sufficient policy tools to deal with its self-induced crisis. In Argentina, an upsized and front-loaded $57bn IMF programme, plans for sharp fiscal tightening, a new BCRA governor and a less interventionist FX regime have also, so far, been supportive of Argentine asset re-pricing. EM spreads tightened by 35bp, resulting in a 2.6% spread return, while US Treasury yields rose 10bp, detracting 1.1%. IG (+0.3%) underperformed HY (2.8%) materially, with Turkey (11.0%) and Argentina (9.3%) posting the highest returns and Costa Rica (-4.7%) and Paraguay (-1.8%) the lowest.
With a yield of 6.4%, EMD HC compares well to FI alternatives, although we acknowledge that near-term external and domestic risks to the asset class have increased – from an extension of the US-driven trade tensions to the announcement of further US sanctions on Russia and Turkey, and in 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 1-year horizon, we expect EMD HC to return around 6.3%, on an assumption of 10Y US Treasury yields rising to 3.2% and EM spreads tightening to 320bps.
The main contributors to the outperformance were (a) the overweights (OWs) in Argentina and Turkey, both of which recovered sharply, delivering a credible crisis response, as well as (b) the underweights (UWs) in US Treasury-sensitive credits like China, Panama, Peru and the Philippines. The basket of CDS protections we held against headline and outflow risks detracted from performance, as EM CDS spreads tightened materially. The fund reduced its exposure to Indonesia, South Africa and Sri Lanka while adding exposure to Pakistan and Turkey as we expect spreads to compress further.
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 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 (UW) further include US treasury-sensitive credits with tight valuations such as Panama, Peru, Chile, China, Uruguay and the Philippines. We also hold and 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.
In September, LC EM debt staged a rally as Turkish/Argentine risk premiums declined, retracing the sell-off of late August. The index gained 2.6%, 1.6% from FX and 0.5% from each carry and duration. The rally on LC was driven by the decline in risk premiums in Turkish and Argentine assets as an adequate policy response was implemented in both countries despite the still-uncertain EM growth outlook. The Turkish lira soared 10.3% and local yields declined 400bp as the central bank surprised with a larger-than-expected hike of 625bp and the Ministry of Finance announced conservative fiscal targets. The ARS was contained within the 37-40 range as the IMF and Argentina agreed an upsized ($57bn) and front-loaded financing programme, and a crawling peg for the currency. The ZAR (3.5%) and RUB (2.8%) rallied, due to their higher market beta. The BRL (3.2%) also bounced, on Bolsonaro consolidating his lead in the polls. Amid strong Oil (6.7%), Asia FX was down on the month, while the COP outperformed Latin America. The Euro complex was stable, with adverse noise from Italy.
We believe that, with a yield of 6.7%, the local currency asset class compares well to Fixed income alternatives, although we acknowledge that near-term external and domestic risks to the asset class have increased – from an extension of US-driven trade tensions to the announcement of further US sanctions on Russia and Turkey and in 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 1-year horizon, we expect EMD LC to return around 8.7%, as the prospect of an EMFX rebounding (2%) from current distressed levels has now increased.
Specifically, we remain overweight on high-yielders that are 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 declined further during the month (to -0.36yrs vs. the index) amidst tighter global financial conditions and no space for EM central bank easing. We are very defensively positioned in the EM currency space, with underweights in Asia FX (KRW, MYR, PHP, THB) on global trade tension risks, the RON (material fundamentals deterioration and fiscal loosening) and the ZAR (low growth, fiscal risks, limited space for reform progress ahead of the May 2019 parliamentary elections).
We are relatively defensively positioned in an environment of elevated external risks – trade tensions, US sanctions, higher US Treasuries and strong US Dollar – with an UW in local duration (-0.36yrs) and EMFX versus the benchmark index (Long US Dollar position of 15%).
The overall framework is negative for the US dollar based on investor positioning, trade and capital flows and PPP. The twin deficits in the US should keep the greenback under pressure vs major currencies. However, the currency should receive some support from the Fed, which is likely to continue hiking rates. Moreover, short-term factors remain supportive for the US dollar (fiscal plan, budget, cash repatriation). Finally, in the current context of geopolitical risk, the dollar is an attractive safe-haven asset to hold.
Norges Bank implemented a dovish hike in September, highlighting that global tensions could be a risk for the economy. As our scoring remains highly positive for the currency, we maintained our long NOK position. Furthermore, the currency is also supported by a relatively strong economy, while the activity cycle is expanding.
Although rate differentials remain penalizing, the yen appears attractive based on our long-term framework. In the current environment of geopolitical uncertainty and the heavy dose of event risk, the yen remains an attractive safe haven and a diversifying asset. Nevertheless, flows prevent a major appreciation of the currency as the Japanese are buying US Bonds.
The overall framework – based on rate differential, carry-to-risk and economic surprises – is negative for the US dollar, which remains under pressure. However, we aim to manage the exposure in a tactical manner, as trade remains vulnerable to Fed communications, especially with the uncertainty surrounding the Federal Reserve.
We are relatively defensively positioned in an environment of elevated external risks – trade tensions, US sanctions, upcoming Brazil elections – with an UW in local duration (-0.22yr) and EMFX versus the benchmark index (Long US Dollar position of 6.3%).