April very much saw investors across most asset classes on the edge of their seats, waiting for the fog to lift on the inflation and larger macroeconomic picture and on how the Fed would react. With US prints coming in strong again, we saw yet another re-pricing upwards of US rates, with the 10Y rising by approximately 50 basis points. In Europe, we saw tentative and still fragile signs of some strengthening of the growth picture. Investors also suffered, albeit smaller, losses in Euro government bonds.
IG credit spreads were largely flat over the month, but other risk assets, including EM debt, HY debt and global equities, showed some softness, indicating that we are very much in a situation where monetary policy is calling the tune for the markets. It is hardly an exaggeration to say that, barring any major shocks, the extent and timing of policy rate cuts will likely be, by far, the biggest driver of returns in the coming weeks and months.
The Fed is in a binary situation
Market expectations of Fed rate cuts have seen wild swings this year, going from nearly 7 all the way down to just over 1 at the very end of April. In our view, a single cut was never in itself a realistic possibility – we expect the Fed will implement two or three cuts, but failing that, in all likelihood it will not cut at all. With Fed futures pricing creeping back towards two in the beginning of May, we still retain a moderately constructive view. The Fed’s own DOT expectations are still for three cuts.
Inflation had indeed surprised on the upside for three months in a row before an in-line April print. We also see a market that is still short on US rates, which should give technical support.
Our interpretation of Jerome Powell’s statements is erring on the dovish side. In other words, an economic scenario that can reasonably justify rate cuts probably will in fact lead to rate cuts.
Some signs point to the fact that recent higher prints should abate towards the end of the year. For one, we see core services inflation far outstripping core goods inflation, with the former being driven to a greater extent by wages. At the same time, the labour market seems to be undergoing a substantial slackening. Fewer and fewer workers are choosing to leave their jobs of their own accord. Shelter inflation is another factor that we observe closely. Inflation of rents on new leases is now in barely positive territory, while Owners Equivalent Rent (OER), a very substantial component of CPI at 25%, is still above 5% YoY. Historically, we observe that new leases are a good indicator of OER with an approximately 12-month lead time.
A fragile recovery in the eurozone, a deceleration in inflation that seems firmly in place
A consistent theme in the post-Covid economy has been a continuously stronger US economy compared to Europe. Nonetheless, surprises relative to expectations have recently been stronger in the eurozone than in the US. This should not jeopardise the disinflationary trend, and a first rate cut by the ECB in June is now a near-certainty. Further out, however, uncertainty is greater – and recent positive surprises will likely lead policymakers to proceed with great prudence.
Overall, we remain constructive on EUR rates. In addition to the inflation and monetary policy dynamics, supply and demand should also be a tailwind for government bonds. We have seen important front-loading of supply in the first four months of the year.
We have no relative preference for core vs. non-core countries at the moment. On a per-country basis in core / semi-core rates, we still hold a relative preference for Austria vs. France and Belgium. We also see select Central and Eastern European issuers as offering interesting value.
Emerging Market Debt: The first substantial spread widening in a long time
During the previous committee, we moved back from a positive to a neutral position on EM hard currency and local currency debt. Between mid-April and the beginning of May, we did indeed see a spread widening of HC debt of approximately 35 basis points in only a few weeks. The only comparable move over the past 12 months was the 50-basis point widening from end-July to mid-October last year.
In keeping with the theme of a strongly bifurcated market between IG and HY issuers, HY spreads widened by 75 basis points whilst IG hardly moved. Even at these levels, barring any clear catalysts for a re-tightening of spreads, we prefer to retain our neutral view even at these slightly improved valuations levels, which overall are still quite stretched.
With monetary pivots now largely priced into local currency debt in our view, we similarly retain a neutral view on that segment. We are more constructive on EM corporates. Whilst spreads are tight here too, we see valuations as attractive relative to developed market USD credit, especially considering that the fundamental picture for EM corporate issuers is very healthy.
EUR credit: We don’t see much more space to run
The near-linear decline in EUR investment grade credit spreads over the last year has brought risk premia down to quite tight levels. Currently, spreads are approximately 20 basis points below the average of the past five years. Given good fundamentals and a favourable macro backdrop, we do not see spreads tighter than historical averages as being indicative of overvaluation in themselves.
This earnings season, slightly over half of firms published positive earnings surprises, marginally above historical averages. Net debt/EBITDA has not moved much. Rate cuts should also be supportive. However, we believe that spreads have now probably reached fair values. We also note an increasing compression of spreads between ratings bands. BBB-A spreads are very close, as are BBB-BB spreads at the frontier of IG and HY.
We also see supply pressures as unfavourable in the shorter term, with May being one of the months of the year with the greatest levels of net supply to the market.
This prompts us to take profit on our long-standing overweight conviction and return to a neutral view on both IG and HY EUR credit. That said, we still see interesting opportunities and pockets of value in financial vs. non-financial issuers and in subordinated issues. Active bond-picking should also still allow investors to benefit from the pick-up in carry that is still present, whilst mitigating risks.
Central bank pivots leading to opportunities in currency markets
Based on differentials in the pathways for interest rates, we see opportunities in select currency pairs. Mirroring our view on rates, we take a long EUR vs. GBP position. As we expect more rapid disinflation in the UK, the potential for dovish surprises is probably greater from the BOE than the ECB. As this is not counterbalanced by greater economic strength in the UK, we prefer to be short GBP.
We also implement a short CNY vs. USD. The Chinese Central Bank (PBOC) gave warnings on the rally in Chinese government bonds, while led to a spike in yields. However, deflationary pressures in China remain present and renewed downward pressure on yields is possible. This position could also help mitigate any temporary further upward moves in yields.