The downturn in the activity cycle continued right up until year-end, with every country in the G10 region now in either ‘downturn’ or ‘recession’ territory. The US is certainly a participant in the trend, though green shoots have sprouted, as highlighted in the FED’s latest statement. In the Eurozone, where the business cycle has also taken a sharp hit, the probability of downturn is now above 50%. The UK economy doesn’t appear to be improving and is still in a recessionary phase amidst Brexit uncertainty. All in all, the weakness in the global activity cycle, confirmed by our in-house models (since the beginning of the year), is present, though the probability of recession is still on the lower side. The US inflation cycle has dipped below average into disinflation territory and, more importantly, the Eurozone, which was at its peak in recent months, appears to have turned a corner and has seen significant declines. Unsurprisingly, under these conditions, central banks across the globe have continued to maintain their dovish stance, to the delight of investors. However, we might observe a pause in central bank activity after the significantly dovish stance that a great number of central banks have reverted to since the beginning of the year. Indeed, the Fed appears to be in “wait-and-see” mode and the ECB already seems to have exhausted its ammunition for the year. However, accommodation is still trending, with the FED now buying the very short end of the curve (while abstaining from calling it Quantitative Easing) and still under substantial pressure from Donald Trump to decrease rates even further. EM countries (China, Brazil, India, …) are also on the dovish path, with rate cuts and accommodation very much part of their monetary policies.
Tactical underweight on US & Core European Rates
Although the Fed delivered three rate cuts this year, Jerome Powell, in his latest speech, did express the hope that interest-rate cuts this year would buoy the US economy against lingering headwinds, including trade uncertainty and a slowdown in global growth. At the moment, the central bank appears to be on hold, in spite of the political pressure it faces to further lower its key rates. If macro-economic data continues to stabilize, the Fed could maintain rates at current levels. Furthermore, with significant weakness already baked into the curves, good news on the trade war front (where, following recent talks, we are seeing movement on “phase one”) could push yields up temporarily. In this context, as the market may experience some profit-taking, we have adopted a tactical underweight stance towards US rates. The Eurozone not only faces tight valuations, but also a central bank that has already done “whatever it takes” and doesn’t seem to have much left in the tank. For the month of December, the ECB has already reached its purchase targets. With the onus now on individual states to implement fiscal reforms, we expect some stabilization in the economy. The spectre of a hard Brexit is fading fast, and political risk is generally less prominent. We thus feel comfortable with a short position on German rates. The linkers market has delivered a mixed performance, with the US and EUR markets performing well, while the UK was a laggard on the back of the strong rally of the Pound Sterling. We hold a slightly positive view on Euro linkers, which should benefit from ECB easing, attractive valuations and better supply dynamics
Positive but cautious on Peripheral Sovereigns
Non-core markets have continued to benefit from the ECB’s quantitative easing. Flow dynamics linked to new purchases and reinvestments should continue to underpin non-core markets, especially since the ECB has not bought enough peripherals to satisfy the capital key targets. With spreads seeing some widening in recent months, valuations look slightly more attractive than in the past. In addition, the political risk has faded somewhat in Italy and Spain, and investor positioning is less extreme after the profit-taking that has taken place.
Developed Market Currencies: Neutral USD
Our proprietary framework continues to point towards a negative view on the US dollar. The Fed’s rate cuts and dovish stance also point to a weaker dollar, with the US president clearly indicating his preference for a weaker greenback. However, we do expect that, after recent actions, central banks are going to take a breather. In this context, we prefer to have a neutral position on the greenback and we continue to tactically manage the position.
As our scoring remains positive for the Norwegian Krone, we have maintained our long position on the currency, a currency that is also supported by a relatively strong economy, where the business cycle – though in downturn territory – is unlikely to fall into recession, and economic surprises should be positive.
Credit: Increase exposure to European Investment Grade
Although we maintain our favourable view on the European credit investment grade asset class, we continue to closely monitor idiosyncratic risks. The ECB backstop remains the primary source of support for these markets and company fundamentals are not deteriorating as expected, as companies are pursuing deleveraging and maintaining decent operating margins. Credit quality on High Grade names appears healthy, with more upgrades than downgrades. However, as 20% of BBB companies risk being downgraded to High Yield, being selective is key. With the current purchase programme, net supply will be negative, supporting the corporate credit cash bond market and containing any widening in spreads, thus further reinforcing the case for European IG credit.
In the Euro IG portion, Credit quality on High Grade names appears healthy, with more upgrades than downgrades, as opposed to high yield. European Credit seems to be the only opportunity in a context of negative-yielding sovereign bonds and, as a result, has enjoyed strong inflows. In the current context of the economic slowdown and uncertainties surrounding trade wars, Brexit and other geo-political risks, the ECB’s decision to adopt an accommodative stance, cut rates and restart its asset purchase programme will have a positive impact on Investment Grade corporate bonds. With the current purchase programme, net supply will be negative, supporting the corporate bond cash market and containing any widening in spreads, thus further reinforcing the case for European IG credit.
Emerging Markets: Cautiously constructive
We remain cautiously constructive on EMD HC as the asset class continues to explicitly benefit from the accommodative Developed Market and Emerging Market central bank stance, from the stable outlook for commodities and expectations of a near-term de-escalation of the US-China trade relationship. The likelihood of the US and China agreeing on a mini-Phase 1 trade deal by end of Q1 2020 at the latest should deliver an uptick in risk sentiment. Absolute asset class valuations are not as attractive as at the start of the year, although there are pockets of value in select EM credits, especially in B- and BB-rated credits, where we are concentrating exposures, and in relative terms – versus US credit – as the percentage of negative-yielding fixed income securities has increased beyond their 2016 highs.
In EMD LC, we are maintaining a positive duration stance, in recognition of some residual relative value between EM and DM local bonds, although we scaled down our duration exposure in October and November, as Emerging Market central banks were more than half-way through their easing cycles.
Our baseline scenario for 2019 was for weak but stabilizing EM and DM growth, which would favour duration over EMFX. Within EMFX, we favoured the currencies of countries that took advantage of the growth slowdown to compress internal demand and improve their external balances.
Hard currency
EMD HC (-0.5%) underperformed on elevated trade deal uncertainty, with both Treasury (-0.4%) and Spread (-0.1%) returns contributing negatively. EM spreads declined by 4 bps (to 324 bps), while 10Y US Treasury yields rose by 7 bps (to 1.77%). EM domestic political risks remained elevated. In Ecuador, assets corrected sharply after the government failed to persuade Congress to legislate the required fiscal adjustment, thus endangering the IMF's funding programme. A much narrower tax bill has, since, been submitted and its December approval is likely to enable an IMF/IFI disbursement of $1.5bn. Risk premiums are likely to remain elevated, as investors need to re-assess the credibility loss suffered by the government. In Lebanon, political players failed to form a new cabinet or articulate funding plans. None of these events managed to spill over into the rest of the EM. HY (-1.3%) underperformed IG (0.2%), with Venezuela (+16.1%) and Argentina (2.0%) posting the highest, and Lebanon (-18.8%) and Ecuador (-14.4%) the lowest, returns.
With a yield of 5.1%, EMD HC valuations are less compelling in absolute terms than at the start of 2019, although they still offer value, in relative terms, to a still-large universe of negative-yielding global FI (at 22% by the end of November). The EM HY-to-IG spread is still attractive, as are the EM single- and double-B rating categories versus their US HY counterparts. The medium-term case for EMD remains supported by the stable US Treasuries and Commodities outlook. Global growth and trade stabilization could support the next leg of EM spread compression but global data continue to soften and trade war risks persist. On a one-year horizon, we expect EMD HC to return around 5%, on an assumption of 10Y US Treasury yields at 1.75% and EM spreads at 325 bps.
We retain an overweight of HY versus IG, although we have scaled down that position materially by additions to IG-rated Chile, Colombia, Indonesia, Panama and Romania, and reduced exposure to energy exporters like Bahrain, Nigeria and Oman.
In the HY space, we remain exposed to idiosyncratic stories like Egypt, Ghana and Ukraine, as these continue to offer value relative to the balance of risks, and to attractively priced energy exporters like Angola, Bahrain and Ecuador. We retain exposure to Argentina, as assets are trading as “distressed” (around the 40s) and well below expected recovery values of around 60-70 cents on the US Dollar. In the IG space, we hold positions in Indonesia and Romania but remain underexposed to the most expensive parts of the IG universe like China, Malaysia, the Philippines and Peru.
We have retained underweights in Lebanon, Russia and Saudi Arabia, as we feel we are not being compensated for sanctions or political risks in these credits. In Brazil, Mexico and Turkey, we hold overweights in attractively priced quasi-sovereigns and corporate bonds versus underweights in sovereign bonds. We also retain a tactical 6% CDX.EM asset class protection position on elevated trade war risks.
Local currency
EMD LC returned -1.8% in November, mostly from FX (-1.6%), with rates contributing -0.26% and carry 0.46%. The US economy’s outperformance and Fed cuts being priced out at the margin supported the Dollar (DXY 0.9%) but EMFX weakness was concentrated in Latam, where social unrest seemed to have spread from Ecuador and Chile. PMIs showed that global growth could be stabilizing, while the US-China trade negotiations continued to be drawn out. The tone remains positive, despite the diplomatic spats around Hong Kong and the Uyghurs community. Core rates were more volatile through the month, with the US 10-year spiking at 1.94% before closing 8 bps higher. EM local rates underperformed by 5 bps.
Latam, as a region, underperformed, led by the CLP (-8%) and the BRL (-5%), with Brazil suffering from a failed oil permit auction. The ZAR outperformed (+2.8%), as it recovered from the poorly received medium-term budget. Rates sold off most in Latam (40 bps in Brazil and Colombia, 30 bps in Mexico), while the rest of the index was mostly flat.
We believe that, with a yield of 5.2%, 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 in an environment of broad-based global monetary policy accommodation. On a one-year horizon, we expect EMD LC to return around 5.7%, assuming a conservative -1% EMFX and +1.5% duration returns. EMFX are unlikely to outperform in a global growth slowdown, although external rebalancing is taking place in most EMs, and EM central banks managed to deliver hiking cycles to maintain attractive FI risk premiums versus DM in 2018 that have not been unwound.
In EMD LC, we prefer to retain exposure to EM rates versus EM currencies and prefer bond markets that offer high risk premiums versus US Treasuries, which happen to be represented by a wide range of low-yielding and high-yielding local markets. The EMD LC strategy is: very long duration in low-yielders like China, the Czech Republic and Malaysia, and in high-yielders like Indonesia, Mexico and South Africa; moderately long duration in high-yielders like Peru and the Dominican Republic; and close to flat the rest of the EMD LC local bond markets.
Growth data globally have stabilized, even though the market was expecting an acceleration of the slowdown. With a possible truce in the US-China trade war, and favourable valuation, EMFX has rebounded but remains range-bound. A break towards the upside will depend on confirmation of the so-called phase one deal as well as positive surprises in EM growth.
