17 MAY


Fixed Income , Topics

Activity cycle remains firmly in the ‘downturn’ stage


Government bonds: Neutral position on US & German curve

The activity-cycle remains firmly in the ‘downturn’ stage after significant deceleration both in the US and the euro zone area, as cracks are appearing in economic releases for several regions. It is important to note that nearly every developed market country is now in downturn stage in terms of the economic cycle, though a full blown recession does appear unlikely. The cycle could receive some support from Emerging markets as active fiscal easing has propped up the macroeconomic picture in China. Meanwhile, the inflation cycle has also seen a significant decline, having reached a peak in 2018. This move appears to be led by the US, where inflation saw a sharp dip on the back of the housing and expectations component. In Europe, though the indicator is holding up, though the momentum seems to be stalling in the recent months. Central banks across the globe continue to maintain their dovish stance, though it appears to now have been baked into the price as the probabilities of a Fed rate cut have already risen. The Central bank could also face some political pressure as president Trump continues to insist on lower rates in the US amidst the trade tensions with China. The PBOC appears to be ready to play its part in supporting the Chinese economy by adopting an accommodative posture. The ECB for its part has clearly ruled out rate hikes in 2019 and promised another round of TLTROs in September. In the emerging market universe, some countries (India, Indonesia) have already implemented rate cuts over the past months.

Overall, a combination of lower growth, weaker activity cycle, softer inflation and extremely supportive central banks is indeed a positive sign for Fixed Income markets and spread products in particular. However, after 3 months of falling rates and tightening spreads, valuations are looking less appealing. Furthermore, event risks have not subsided though Brexit has been delayed until end October 2019 and a trade deal between the US and China has seen yet another twist with the Trump administration hiking tariffs in the middle of the negotiations and China reciprocating shortly after. Though a trade deal is still possible, this new development has certainly delayed the much awaited resolution on this longstanding issue. Finally, the European elections remain a focal point, as populist support continues to rise across the continent, particularly in Italy where the anti-European party leads the polls ahead of the general elections.

US unemployment levels are still at historic lows and financial conditions appear to have stabilized. German rates are still stretched in terms of valuations. However, the Fed and the ECB have shown considerable hesitation regarding the strength of their economies and are unlikely to carry out rate hikes. Additionally, the macro-economic outlook for the US and Germany doesn’t seem to be seeing considerable improvement. In the context of the above mentioned risks to the market (trade wars, Italy, Brexit), the US Treasuries as well as the German Rates are likely to benefit from their safe haven status. We remain neutral on the US curve and German curves.

Long position in Euro Linkers
In spite of uncertainty coming from trade negotiations that weight on the asset class, the linkers market saw mixed performance in April, with US linkers lagging while Japan and UK linkers performed well. Among EU linkers, Italy lagged in BEI terms. Our Framework remains positive on EUR and US linkers, driven by strong carry. The break-even model is positive in most areas, supported by energy prices though the inflation cycle turned negative in most areas (with the exception of the euro zone and Japan).

Positive view on Spain and Portugal
Non-Core markets continue to be supported by the ECB monetary policy. Adjusted forward guidance and TLTRO announcement at March meeting offered extra support to non-core markets. Technicals (Carry/RD,) also remain a supportive factor. We believe that the chances of the socialist party to form a government (through coalition) in Spain increased following the outcome of the elections while also not obliged to rely on support from less moderate regional parties, thereby providing some stability. We hence maintain our overweight on Spain and Portugal. We continue to keep a prudent stance on Italy, where event risk will be principally driven by politics in the short term, as tensions between governing parties are increasing in the build-up to the European elections.


Credit: Low conviction on US Credit

We favour the European credit investment grade asset class even though the European economy is weak and idiosyncratic risk is rising. Earnings season saw better results than expected and deleveraging continues. Credit quality on High Grade names appears healthy with more upgrades than downgrades. The spread tightening has been driven by strong inflows in the asset class. Supply is limited and cash is still high compared to strong demand. In light of the US-China trade war, the risk of European auto tariffs and strong performance year to date, some profit taking could take place. But the dovishness of central banks and low rate environment should limit any widening in spreads. This context combined with the Chinese fiscal stimulus that would support Europe at a later stage thereby avoiding recession, makes the case for EUR credit.

US credit Investment Grade continues to attract little interest from a European perspective as hedging is costly and fundamentals continue to deteriorate. While earnings season was better relative to expectations, leverage is at the highest level over the last 10 last years and cash balances are decreasing for a majority of US companies. However Asian investors and particularly Taiwanese ones remain attracted to US credit markets. The US economy is stable, inflation is below 2% and the Fed is on hold. The US credit cycle has expanded, but non financials corporates face challenges such as environmental issues (ex: electric vehicles for automobile sector, e-commerce for retail, digital transition for media) and higher employee and raw material costs weigh on margins. As the global outlook is weakening, default rates are likely to trend upwards and idiosyncratic risk could materialize. Taking into account the carry-to-risk element, and relative to other asset classes we maintain a preference for Emerging markets over US credit in spite of downside risks.USD strength and trade war are the major headwinds but China can rely on further fiscal and monetary easing should there be an escalation in trade wars. We are more cautiously selective on emerging markets than over the previous month as idiosyncratic risks are rising.



We are now less constructive on EMD HC after the strong first quarter. While the asset class continues to explicitly benefit from the outright-dovish Fed stance and the stable outlook for commodities, the US-China trade relationship is quite unclear. Trade de-escalation is largely priced in and trade-war risk is binary – trade negotiations between the US and China will either extend or break and trade re-escalation has not been priced in at all. Asset class valuations are not as attractive as at the start of the year, although there are pockets of value in select EM credits in which we are concentrating exposures.

In EMD LC, we have kept a small short bias in EMFX, in the face of lacklustre growth, the resurgence of trade tensions and the persistent outperformance of the US economy. On the other hand, duration should remain supported, as inflation is well anchored globally and inflows have been subdued since the sell-off last year. We would tend to add duration on retracements.

Hard currency
The EMD HC (+0.2%) return was flat, with the spread (+0.7%) return almost fully offset by the Treasury return (-0.4%). EM spreads were stable (-7bps, to 244bps) while 10Y US Treasury yields rose 10bps to 2.50%. Sentiment towards the asset class was mixed: Oil (6.5%) rallied on supply constraints, Chinese and US 1Q GDP were better than expected but idiosyncratic EM credits like Argentina and Turkey remained under pressure on the back of rising policy risks. In Argentina, disappointing inflation prints and the related announcement of price controls led to a further decline in Macri's popularity in election polls. As a result, Argentine assets priced in a higher probability of the worst-case scenario of a CFK win and an investor-unfriendly restructuring in 2020. HY (-0.1%) underperformed IG (0.6%), with Tunisia (5.7%) and Lebanon (3.1%) posting the highest, and Argentina (-9.1%) and Venezuela (-4.3%) the lowest, returns.

With a yield of 6%, EMD HC valuations are less compelling than at the end of 2018 after a strong start to the year and as EM risk premiums have already largely priced in the US-China trade-tension de-escalation. The EM HY-to-IG spread is still attractive, as are the EM single- and double-B rating categories versus its US HY counterpart. The medium-term case for EMD remains supported by the benign US Treasury and commodities outlook. Global growth and trade stabilization can support the next leg of the EM spread compression but we are expecting more data to confirm the positive trends. On a one-year horizon, we expect EMD HC to return around 5%, on an assumption of 10Y US Treasury yields at 2.75% and EM spreads at 335bps.

We underperformed the benchmark index by 7bps, on a net basis. The largest contributor to the underperformance was the overweight (OW) in Argentina (sold off dramatically as the market priced in the higher probability of a restructuring in 2020) with the underweights (UWs) in Lebanon and Russia also detracting from performance. The underweight (UW) in Turkey and the overweights (OWs) in Ecuador, Qatar and Uzbekistan continued to deliver performance, as did the long asset class protection position via CDX.EM.

We are still constructive on commodity exporters like Angola, Azerbaijan, Ecuador, Kazakhstan, Nigeria, Petrobras (Brazil) and Pemex (Mexico), as we expect oil prices to remain stable at around $65-75 but we scaled down our OWs after the very strong start to the year.

We also maintain an exposure to specific idiosyncratic re-rating stories (high-yielders with positive reform momentum) like Argentina, Ukraine and Egypt, which appear attractive relative to the balance of macro-economic and political risks.

We took some profits in Ukraine, and added back exposure to Turkey (after the correction in March/April) and to Oman and Bahrain. We added to our absolute (+25bps, to 6.92yrs) and relative (+22bps, to +0.07yr) duration positions, as the Fed remained dovish.

Local currency

EMD LC was stable in April (-0.18%), with the correction in rates offsetting the carry contribution (0.5%), while FX was near flat (-0.2%). US Treasuries sold off marginally on the back of profit-taking, stronger US data and higher oil that, in turn, had ripple effects on EM rate markets. Argentina was under pressure (ARS: -6%) but the other EMs were not affected. Argentine assets came under pressure ahead of uncertain elections in October, and as the protracted recession is not boding well for the re-election of the reform-committed President Macri. The Turkish Lira (-5%) also sold off, due to the continuing leakage of FX reserves and rise in FX HH deposits, Erdogan's challenge of local election results in Istanbul and uncertainties around its US and NATO relationship. Elsewhere, the US Dollar was stable, with the MXN (+2%) and RUB (+1.7%) outperforming. Rates sold off up to 30bps in Hungary and 20bps in Indonesia, Colombia and Chile.

We believe that, with a yield of 6.3%, EMD LC compares well to FI alternatives, especially as we are now expecting a respite from US-China trade tensions and US growth exceptionalism and a more dovish Fed policy stance. On a one-year horizon, we expect EMD LC to return around 6%, assuming a conservative -0.5% EMFX and +0.8% duration returns.

We underperformed the index by 15bps, on a net basis. The main performance detractor was the long ARS position we initiated after the currency had cheapened and the BCRA had hiked rates to 73%. The poor performance of Macri in the polls and the extended activity weakness put pressure on the trade. The OW in ZAR, and the UWs in CLP and MXN detracted moderately, while the shorts in THB, MYR and HUF contributed positively. We reduced the short USD position by 3% to 2%, as our view on EMFX returned to more balanced.

The beta increased by 0.09 to 1.05. The absolute duration decreased by 0.25 yr to 5.64 yrs, as we did not add to existing rates positions around inflows. Our relative duration position is now 0.46 yr (-0.25 yr).


Currencies: Neutral position on USD

Developed Markets

The overall framework is negative for the US dollar based on investor positioning, trade and capital flows and PPP. The twin deficits exhibited by the US should keep the greenback under pressure vs. major currencies. Furthermore, the trade wars between US and China is likely to have a negative effect on the greenback, compounded with declining activity and inflation cycles. However, in light of the risks that are omnipresent in the market, the US dollar could gain favour with the investors as a safe haven currency. In this context, we prefer to have a neutral position on the USD.

Our scoring remains very positive for the currency so we maintained our long position on NOK. Furthermore, the currency is also supported by a relatively strong economy, where activity cycle is expanding and economic surprises are likely to be positive. In this context, the Central bank could raise rates and boost the currency further. Supportive oil prices are also deemed to be a headwind.


Emerging markets

EMFX are unlikely to outperform in a global growth slowdown, although external rebalancing is taking place in most EM, and EM central banks have managed to deliver hiking cycles to maintain attractive FI risk premiums versus DM. We expect quantitative tightening to be paused in the US and delayed in Europe, which should also support EMD LC.