International trade tensions are likely to remain a key point of investor focus
■ The prospect of a full blown trade war will be a source of concern for investors, as was the case in Q2, markets will remain volatile and tense.
Federal Reserve and European Central Bank policy
■ The ECB announced its intention to end its asset purchase program by the end of December, and keep its reference rate at this level, for at least another year. At the same time the Federal Reserve is continuously making hawkish signals, marking an ever widening policy trend between the two central banks.
Credit and Equity Markets Look Highly Valued
■ The prolonged period of low interest rates carries risks for global financial stability. There are the signs of stretched valuations in real estate, stock, and credit markets in several countries. In such situations, small changes in outlook perception can lead to strong market reactions, as shown by the recent turbulence.
The end of the Goldilocks scenario!
The time when picking almost any asset class would produce positive returns, seems to be coming to an end. During the second quarter, examples of once sought-after assets that ended up under heavy stress were plentiful:
The Italian political crisis – No clear winner with an outright majority emerged from the polls of the March 4 general election and created a political deadlock from which emerged a populist government, who campaigned on proposals such as drastically cutting taxes or introducing a minimum monthly wage. Analysts have estimated that the various measures could cost EUR 100 billion a year, which would worsen the country’s debt, already the second highest in the eurozone after Greece. This political crisis provoked a sharp drop in Italian Government bonds, and the uncertainty also affected other risk assets in the region.
The emerging market debt rout – While it cannot be attributed to any single factor, but more a set of events that raised investor concerns, such as diminishing foreign exchange reserves in Bahrain, strikes in Brazil and a stronger US Dollar, which resulted in emerging market corporate and government bonds being under harsh selling pressure.
Trade Tensions – United States President Trump has continued putting pressure on US trading partners, imposing tariffs on imported steel and threatened to tax car imports. Later in the quarter, during the G7 meeting, President Trump took a harsh stance against Canada, the US second largest trading partner, and its Prime Minister Justin Trudeau, criticizing their trade practices. As a consequence, NAFTA talks are likely to stall.
Widening of policies – It was once expected that Europe and the US would experience synchronized growth and central bank policies. Evidently, this is not the case. The Fed policy makers, are gradually raising rates and continuously delivering hawkish signals, as their European counterpart continues adopting an accommodative policy and will end their QE program in December.
Turkey Government bonds and Turkish lira – Ruling for the past fifteen years, Recep Tayyip Erdogan won the presidential and parliamentary election in June, securing a mandate to rule with greater executive powers. He has pledged to become a part of the monetary policy. Investors fear a currency meltdown and more financial trouble ahead.
Argentina – The country’s central bankers are fighting rampant inflation as well as a collapsing currency, having set its benchmark rates as high as 40%. The South American country also had to seek the International Monetary Fund help in the form of a USD 50bln stand by arrangement.
These events, having a more severe impact on global financial markets, lead us to think that volatility and “flash selloffs” will be something investors have to deal with. Anticipating them will be more difficult and it will be harder to pinpoint the reasons. At this point, we consider markets being very over-bought.
USD Government rates
- The risk of a global trade war between the US and its main trading partners will remain the prime investor concern over the coming months
- The FED has delivered a hawkish message. Short term rates are set to rise, the longer ones should trade around their present levels
- Some believe this could lead to a yield curve inversion
Tensions around trade issues have been at the forefront of investor concerns during the second quarter.
The 10-year Treasury note continued to trade around the 3% psychological barrier. Inflation worries, which dominated investor sentiment during Q1 seem to have been tamed but are still in investor’s minds. Right now, the focus seems to be balanced between the direction of the general level of prices, which is putting selling pressure on government bond prices, and the heightened tensions on the trade front as well as global geopolitical tensions, which are supportive for Treasury prices.
At the end of May, the Trump administration imposed border tariffs on steel and aluminum imports from the European Union, Canada, and Mexico, while it has not yet evolved into a full-blown trade war, it is likely that Europe and the other countries affected by tariffs will retaliate. This escalation of tensions is likely to unnerve markets and be a source of volatility over the coming months, and therefore, keep a steady flow of Treasury buyers looking for haven assets.
Equity Markets Are Still at Risk
We believe US equity markets are highly valued and global sentiment is becoming more and more unfavorable. When negative events happen, such as the February volatility squeeze or the March falling FAANGs, markets tend to sell off sharply. Therefore, downside risk is higher than upside potential. Those risk off events tend to take place more often and are likely to be supportive for Treasuries.
On the other hand, the continued Fed balance sheet normalization, as well as the budget deficits ran by the Trump Administration, which in order to be funded will need to be met by record issuances by the Treasury department, are a continuing pressure factor for Treasuries prices.
On the short end of the curve, the Fed policy makers’ intentions are clear, and indicated additional increase of Federal Funds for the second half of 2018 and throughout 2019. This scenario is likely to support strong US growth fueled by low unemployment, strong consumption, and business investment, as well as generous government spending along with the effects of tax cuts.
Risks of A Yield Curve Inversion
This sustained tightening of the monetary policy led short term rates to rise at a faster pace that the longer ones. The actual spread between the 10-year US Treasury maturities and the two, fell to a level not seen since 2007. In this environment, rising short term rates and longer ones remaining at their actual levels, a further reduction of the spread seems likely and an inversion seems not to be an impossible scenario. Many Fed officials have expressed concerns over a yield curve inversion and while the curve has not yet inverted, investors should be attentive of further compression of the differential, as in the past, yield curve inversions have been good indicators of downturns.
In our view, investors should hold short term FRN securities to benefit from the gradual rise in rates, and target holding quality fixes rate securities for the longer end.
EUR Government rates
- ECB will be ending its asset purchase program at a moment which might not be optimal
- Italy was at the center of attention during Q2, but the story might not be over yet, as the government’s political agenda has the potential to disrupt markets
- While the US is aiming its tariffs at China, it is unlikely that Europe will be spared
ECB signals the end of QE
In addition, it has also been made clear that ECB will reduce the monthly pace of the net asset purchase to EUR15 billion until the end of December 2018. Asset purchase, which was an exceptional countermeasure instrument, is now considered as normal and as an integral part of the ECB toolbox, as mentioned by Mr. Mario Draghi, during the last meeting.
The decision to halt their bond buying program comes at time where the Eurozone is going through a sluggish economic growth, and where threats of an international trade conflict as well as political uncertainties in Italy were present. While current data supports the decision to halt quantitative easing, it is not certain that economic conditions in six months’ time will warrant the end of the program, if what Europe is going through now what many describe as a soft patch, becomes a more severe downturn. We believe that if the more pessimistic scenario reveals itself to be the correct one, it is going to be difficult for the Central Bank to continue its QE program without harming its credibility, even if they now consider it as a “normal” tool.
Peripheral Sovereign issuers might not be out of trouble yet
CHF Government rates
- The Swiss Franc valuation remains a key Central Bank concern
- The Political climate in Europe is likely to be supportive of CHF valuations
- Debate is fierce on whether the Swiss National Bank is intervening or not
Swiss franc will remain a key focus area for both the Central Bank and investors during the third quarter.
The fact that the CHF weakened during the first quarter, and even reached CHF 1.20 for 1 EUR, the level the SNB heavily defended until January 2015, prompted some market commentators to suggest that the 1.20 mark would open the way for the SNB to raise rates. Given the SNB various board members multiple comments over the last quarter all stating that the Swiss Franc remains “highly valued”, we remain skeptical that the SNB considers 1.20 being the “high water mark” rate of exchange to adopt a more hawkish stance. The relief was short for the Swiss Central bank as, the political turmoil in Europe and more particularly in Italy, provoked a rise in demand of the Swiss currency.
On a real basis, the CHF is not detrimental to the economy
However, when looking at the CHF on a real basis, based on production prices and consumption prices, as shown on the graph below, we can see that the currency trend has been favorable to the Swiss economy. As a reminder, the real effective exchange rate index measures the real external value of the Swiss franc, and is the nominal index adjusted for price developments in Switzerland and abroad. It is frequently used as an indicator for assessing the price competitiveness of an economy. A rise in the index value indicates a real appreciation in the Swiss franc. When it decreases, this means that the Swiss franc has become cheaper in nominal terms.
The political climate in Europe could support the CHF high valuations
The direction of the Swiss rates and the level of the CHF are closely linked, and as a safe haven currency, the rocky European political climate, notably in Italy as well as global geopolitical tensions are likely to support the high valuation of the CHF and therefore, cap any rise in short term rates. Moreover, inflation, although on a rising trend like its European neighbors, is still far from the SNB target and remains in check.
Imbalances in the real estate market remains a source of concern
The Swiss National Bank states that imbalances on the mortgage and real estate markets persist. While growth in mortgage lending has been only moderate over the last few quarters, real estate prices have continued to rise. Particularly in the residential investment property segment, there is the risk of a correction due to the strong increase in prices in recent years.
In this context, it is a possibility that the SNB, considers targeted measures for residential investment property lending, such as the ones taken between 2012 and 2014.The long end of the curve is highly correlated to the EUR curve, and with the prospect of EUR rates remaining at their current levels, we do not see any meaningful movement on this segment of the curve.
GBP Government Rates
- The risk of a global trade war between the US and its main trading partners will remain the prime investor concern over the coming months
- Economic data leads the Bank of England to take a dovish turn but dissenting hawks find their voice
- The fog of Brexit continues to impair visibility, undermining business & market confidence
UK growth forecasts are downgraded despite some cheer in May
The UK economy grew just 0.1% in the first three months of the year as the “Beast from the East” snow storms caused major disruption in the construction and retail sectors. While policymakers were quick to blame the weather, the Office for National Statistics reported that weakness was widespread and economic activity was also impacted by lower business investment and an underlying slowdown in consumer-facing industries. The UK’s Confederation of British Industry (“CBI”) supported this view and downgraded its 2018 growth forecast from 1.8% to 1.4%.
However, the royal wedding and early summer sunshine helped lift some of the gloom and provided a timely boost to the retail sector. Retail sales jumped 1.3% in May, comfortably ahead of forecasts, and a welcome distraction from the news of Poundland falling into administration and store closures at House of Fraser.
The Bank of England changes course again but for how long?
Entering the second quarter, future markets priced in a quarter point may rate high as a near certainty before a raft of weaker data, led by Governor Mark Carney. The BoE’s “unreliable boyfriend”, a label that has stuck with Carney for four years, once again failed to stick to his earlier guidance citing caution over subdued household consumption and moderating inflation – annual CPI inflation fell to 2.4% in May, down from 3.1% in November, despite the sharply higher energy prices. It therefore caught markets by surprise when the chief economist Andy Haldane broke ranks so quickly at the MPC meeting in June, swelling the number of dissenters to three on the nine-member rate-setting panel. They are more confident that the setback to the economy in the first quarter was temporary, contradicting the assessment of the ONS.
The fog of Brexit continues to leave business and investors in the dark
Two years after the referendum, we are no closer to knowing what the UK’s future relationship with the EU will look like. The Prime Minister may have struggled to forge a consensus with her divided cabinet while the minority Conservative Party government struggles to stave off a rebellion from a pro-EU faction within – and that’s aside from the crunch talks with Brussels which have barely began.
The slow progress and mixed messages has undermined confidence in the UK economy and warnings from companies like Airbus and BMW that thousands of jobs are at risk without a transition deal are likely to grow as the clock ticks down towards 29 March 2019. Mark Carney told the Treasury Committee in parliament that the UK economy was up to 2% smaller, and real annual household incomes were around GBP 900 lower, as a consequence of the Brexit vote. The knock on effect on public finances suggests Theresa May’s populist pledge of an additional GBP 20 billion for the NHS by way of a “Brexit dividend” is short on credibility.
We are underweight gilts where negative real yields across the curve offer investors no compensation for uncertain politics or monetary policy. Corporate bonds offer more appealing valuations on a medium-term view, albeit vulnerable to short bouts of volatility stemming from disruptive geopolitics.
GBP & CHF Graphs
We believe that the upside potential and the downside risks are asymmetrically distributed.
The consensus view is that we are near or at the end of the credit cycle. We believe that this view is supported by the fact that when a negative credit event happens, at the micro or macro level, it spreads more strongly than when a credit positive event takes place. Corporate bond investors are facing an asymmetrical risk/reward distribution, with the downside risk and expected loss being considerably higher than the upside potential and expected gains. This fact is true especially for high yield portfolios, which have a higher volatility.
Quality of portfolios has deteriorated over the years
An analysis of our internal flows over the last five years shows that based on our client’s trading that, portfolio quality has globally deteriorated, moving from low Investment Grade to High Yield. This is easily explainable by the ever tightening spreads, as well as the very low rate environment. Investors, in search of yield have had to fall back on lesser quality securities in order to ensure their minimum target return. Another reason is the large amount of high yield issuers who have refinanced themselves and raised new debt through the primary market, attracted by low rates and tight spreads, supported by strong demand.
End of the credit cycle
Aggressive primary market issuance to fund capital expenditure or M&A activities, credit spreads being close to their cyclical lows and the level of US corporate debt approaching half of US GDP, are all signs that we are near or at the end of the credit cycle. Recent events, such as the emerging debt market selloff, the Italian crisis or the volatility spike, are happening at smaller time intervals and have a greater negative effect on financial markets.
Capital constraints increased regulatory burdens, technological transformations, forcing traditional market makers to reduce the size of their fixed income securities inventory, dedicated to traditional market making activities. This is approximatively 10% of what it was in 2008. This phenomenon is even more patent in times of market stress. Experience shows that, finding buyers for even quality paper in times of crisis is very challenging. This condition may prompt investors to search for new source of return. Fixed income strategies have the potential to help investors access new return sources. If a more severe market correction take place, we can expect High Yield bonds to experience a sharp and quick drop in prices, as it was the case at the height of the Italian mini-crisis.
Reposition portfolios toward quality
While we understand that this is not easy to do, investors should give up some yield in favor of quality. History shows, diversifying into the high yield compartment or holding short duration high yield securities offers no protection in case of market downturns. However, high quality portfolios fare better in times of crisis.
No indicators, such as the default rate, point to an imminent spike in credit spreads, as we believe that we are at the end of the credit cycle investors should prepare their portfolio for the next step. While thin, liquidity is still manageable, it would be advisable to take advantage of it before everyone rushes for the ever narrowing exit.
Fixed income investors should review portfolios and identify the weakest issuers, or the ones posing more risk, and invest into higher quality issuers.
In our view, the best strategy would be to review portfolios and identify the weakest issuers, or the ones posing more risk, and invest into higher quality issuers.