Markets were very much itching to end 2023 on a high note and delivered strong performances across asset classes, with the exception of commodities. While equities lead the way, thanks to the combined effect of spread compression and a fall in rates, credit was not far behind. EUR IG credit delivered in excess of 2.5% over just one month. Indeed, with the German 10Y falling by a full 40 basis points, investors in longer-dated government dated could enjoy even higher returns. Emerging market debt also enjoyed a particularly strong month, with hard currency and local currency returning 4.7% and 3.6% respectively.
This was certainly a welcome holiday season gift to many investors, with this rally catapulting the performance of many asset classes from good to double-digit.US and EUR HY and EMD sovereign debt all offered in excess of 10%. Unsurprisingly, Japanese government bonds brought up the rear, with a barely positive performance.
This very rapid turn of markets towards these levels did not necessarily surprise us in the levels reached, but rather by its swiftness. As a result, our views on key markets for the month ahead have shifted and overall, we move to a more neutral position both in terms of duration positioning and credit positioning.
US Rates: Following exuberance, we prefer to wait for some softness before buying
After the strong decline in US rates in December, we decided to take partial profit and have returned to a neutral position on Treasuries. The speed and magnitude of the decline was extremely beneficial in light of our long positioning, but now leaves rates at a level where we are no longer comfortable holding an overweight position. We note that the labour market is still resilient and that markets now appear to be pricing in an optimistic trajectory in terms of Fed action.
Over the past few months we have seen big moves in financial conditions, along with the decline in inflation. Notably, we do not expect a full six rate cuts for 2024, and in particular we do not expect the Fed to cut as early as March. On a one-year horizon, we see four cuts and indeed we note that our expectation is still in excess of what the Fed is itself communicating.
At these levels, risks are clearly concentrated towards markets taking fright and stepping back momentarily, which could see the 10Y jumping back up to around 4.25%. This is a level we would like to see, in the absence of major shifts in the macro picture, before adding back duration exposure again.
Longer term, we don’t think that rates have fully run their course and our cycle analysis and fair value models suggest that in light of consistent progress on inflation, we can expect the 10Y to still move down from 4%.
EUR rates: Investors tune out the ECB at their peril
“Don’t fight the FED” is a market mantra, but what about the ECB? Market expectations seem to be stubbornly ignoring the rhetoric coming from Frankfurt. With traders expecting essentially the same amount of cuts as from the FED (six, for a cumulative 1.5%), will growth and inflation data be where it needs to be for the ECB to go that far? While the spike in December YoY inflation numbers is due to a base effect and not reflective of underlying price pressures, anything short of a harsh recession is probably not enough to trigger so many cuts. The messaging from the ECB has been more nuanced without the FED’s noticeable dovish inflection, and we think investors should take them at their word when they say they are “on guard” against spikes in inflation.
From our underlying cycle and fair value analysis, our conclusions are much the same as for US rates – inflation control is on track and core rates are fairly valued.
In terms of technical factors, we see a significant volume of issuance coming to market this year, not least as a result of the ECB phasing out PEPP reinvestments from July. However, overall we believe this is well flagged by the market and indeed the amount is somewhat lower than most initial expectations.
Eurozone: Expensive semi-core?
We continue to hold a long-standing conviction favouring Austrian rates against French rates, which we see as being overvalued. We have now also downgraded and underweight Belgium, where we see both rating risk and the risk of political uncertainty due to difficulties around government formation following elections later this year.
At the same time, we are upgrading our underweights on Italy and Portugal to a neutral position. We do not have fundamental concerns with Italian spread levels where they stand now. Over the past year, the country’s government has demonstrated prudent fiscal stewardship, and the Bund / BTP spread – while moving somewhat in line with EUR rates overall – did not betray excessive fears regarding Italy’s ability to meet its obligations in a higher rate environment. Finally, the recent agreement of EU finance ministers to revise the Stability and Growth Pact should also be supportive. With spread levels now having returned to those of spring 2022, we no longer see justification in foregoing the higher carry Italy offers among EUR sovereign issuers.
We are also upgrading our view on Portugal to neutral. Our underweight had been driven by valuation concerns. Although not a large move by any means, we took the opportunity of a recent widening in the spread to return to a neutral position. In light of the country’s strong economic and fiscal outlook, valuations look increasingly justified by fundamentals.
USD: Still overvalued, but we await a catalyst
After a strong performance in December, we have taken profit on our long JPY vs. USD trade. Fundamentally, we still believe that while the US dollar is overvalued, valuation is, in our view, usually a poor short-term driver of currency performance. Globally, investors have now unwound much of the long positions they held in the greenback – the selloff that we expected was the driver for underperformance, but in our view also removes any short-term catalyst that could drive further weakness.
We have introduced a long NOK vs. SEK and AUD vs. NZD pair trade. Among the Scandinavian countries, we see the recent SEK outperformance as having been driven by the Central Bank’s currency hedging programme, which it is now set to wind down. The Riksbank has been selling substantial amounts of USD and EUR in an effort to maintain the value of its currency reserves, which had appreciated in SEK terms. Conversely, the Norwegian Central Bank, Norges Bank, has announced its intention to cut its purchases of foreign currency against NOK.
In the Antipodes, our long AUD position vs. short NZD is driven by conventional monetary policy rather than central bank interventions in currency markets for non-monetary reasons. With the Reserve Bank of Australia having been one of the most dovish developed market central banks vs. a very hawkish Reserve Bank of New Zealand, the latter is now substantially further along in its monetary cycle, with two cuts priced by August – compared to two cuts for the whole year in Australia.
In EM, we prefer LC and some attractive EUR-denominated debt
We retain our preference for LC rates over hard currency EM, although we like pockets of that market, in particular EUR-denominated debt issued by Romania and now Bulgaria, where we recently took advantage of a primary issuance. We also like MXN and BRL for their very high real rates as well as IDR and INR as carry trades.
Prudent on credit in light of high supply
We are tactically downgrading our view on EUR credit (both IG and HY). Whilst we do not have major concerns on fundamentals (EBITDA margins, leverage ratios and cash positions generally remaining strong) nor on valuations, technicals are a concern. Research indicates that investor positioning on credit is very long. Supply should also be extremely high in January, with around €100bn expected in IG coming to market. Whilst appetite remains strong and primary deals continue to be oversubscribed, all else being equal and without compensating tailwinds, we prefer to move to a more prudent position. We are also downgrading US IG credit both on concerns around valuations following a tightening of spreads and very substantial supply expected.