June was marked by a significant uptick in political uncertainty both in the US and the EU. European parliamentary elections saw right-wing parties gain increased prominence, particularly in France where the strength of their victory led President Macron to call surprise legislative elections. In the US, a poor debate performance by President Biden increased the odds of a Trump victory in the elections, sparking some volatility on markets.
On the macroeconomic front, inflation continued to trend slightly lower and economic prints remained modestly weaker. Central banks maintained their very cautious stance, with both the ECB and the Fed determined to stay data-dependent and refusing to pre-commit.
It was a rather mixed month for bond investors depending on which side of the Atlantic they were invested in. While US rates rallied during the month, with the 10Y coming down by over 25 basis points, they registered an upwards movement during the final days. This was mirrored by German rates, which also ended the month lower. However, the French 10-year rate saw an almost consistent rise of close to 30 bps, ending at 3.3%, higher than the Portuguese 10-year rate for the first time since 2006.
Corporate credit also performed well, both on the US and EU front and across investment grade and high yield. Spreads across both EUR IG and HY markets widened slightly (11 bps and 36 bps respectively). Despite recent repricing volatility, credit markets did not suffer as a result of a deterioration of demand on the primary market or severe selling pressure on the secondary market, reflecting investor preference for credit as well as the segment's resilience.
Emerging market debt was a mixed bag over the month, as the hard currency market yielded positive returns while the local currency market suffered. Elections once again dominated the emerging region. In Mexico, the left-wing coalition managed to secure an absolute majority, opening the doors for implementation of some extremist policies that had been floated during the campaign. This led to a dramatic sell-off in the Mexican Peso, triggering a carry trade unwind in FX. In South Africa and India, the ruling parties and coalitions failed to secure a majority in the legislature, and while this was much less dramatic in India, in South Africa the two-week negotiations between the ANC and other parties (mainly the DA) focused market attention.
US rates: data continues to support easing
Growth in the US continues to surprise on the downside, as reflected by data over the month of June. Indeed, both ISM Manufacturing and Services numbers posted below 50 prints, a rare occurrence post-Covid. Additionally, the labour market also saw some loosening, with non-farm payrolls declining modestly and the unemployment rate creeping up to 4.1%. Finally, inflation numbers (including the PCE) moved slightly lower. Still, the Fed maintained a relatively cautious tone and dot plots still point to less than two rate cuts, the first of which we continue to expect in September. While Jerome Powell acknowledged that the US economy was no longer overheated and suggested that the case for rate cuts was stronger, he refused to communicate anything on the timing of the cuts.
The upcoming US elections appear to be significant cause for concern both in terms of rates and volatility. Indeed the outcome will have a material impact on the US fiscal scenario and the economy in general. The recent debate was marked by the poor performance of President Biden and his position as candidate was challenged by his own faction, with several members of the Democratic Party calling for him to be replaced. Uncertainty around this question is likely to exacerbate volatility at a time when the economy is slowing and rates remain elevated.
The overall picture calls for a long position on US rates (particularly the 5-year and 10-year portions), which continues to exhibit better carry dynamics than the short end, and still remains a safe haven in a context of heightened geopolitical risk. We also have a preference for implementing this view through a Long US vs Short Canada trade. Indeed, while the Canadian economy has underperformed the US this year, economic surprises have begun to trend higher in Canada (vs. the US). The market pricing of rate cuts in Canada appears to be more aggressive compared to the US, and valuations also favour US rates.
EUR duration: positive overall, negative France
The business cycle and economic dynamics remain on the weaker side, in spite of the improvements we witnessed in May. Indeed, in June we saw the May manufacturing gains unwind in the PMI on the back of the new orders and output component. We note that the inflation cycle is clearly decelerating, this time with the consumption and housing cycle as the primary detractors, while wages and production remain somewhat stable.
The ECB proceeded with its first rate cut in five years, and we expect two additional cuts this year, with the next one in September. However, Ms Lagarde emphasised “data dependency” and did not commit to a particular trajectory. Inflation and growth assumptions for 2024 and 2025 were also revised upwards – though inflation expectations are still lower than they were in December 2023.
Overall, we see the disinflationary trend as remaining in place, alongside the weak macroeconomic outlook. Furthermore, technicals are expected to be fairly supportive, as flow dynamics are improving and the pace of supply is likely to recede over the second half of the year, while investor duration positioning seems to have remained fairly stable. Therefore, we retain our small overweight on EUR rates overall, and look for better levels to take profit from our position.
The French legislative elections reached a conclusion, with no faction being close to obtaining a majority of seats in Parliament. The left-wing alliance (NFP) managed to get the highest number of seats, but forming a government appears to be complicated, notably in light of an economic agenda that includes policies that are likely to exacerbate the fiscal deficit. Other options include a centre-left coalition (including Macron’s party, which took the second largest number of seats), which would provide a more balanced approach, but is unlikely to quell political risk. Finally, a technocratic government without a majority could provide some economic stability but also a potential legislative gridlock. In a context in which the country’s fiscal deficit has already triggered warning lights (vis-à-vis EU regulations and rating agencies), and in the absence of monetary support, French rates and spreads are likely to come under continued pressure. We are comforted in our underweight position on France, given uncertainty around the formation of the government and the fiscal policies implemented thereafter.
We further closed our long-held overweight position on Austria, which has performed well against core sovereigns since the last quarter of 2022, while the upcoming September elections in the country could bring some political noise.
On the non-core front, valuations remain decent, while supply dynamics are becoming more supportive on non-core too, with the exception of Italy. The outcome of the PEPP quantitative tightening is not a big negative in terms of flows for 2024. We initiated a long position on Spain, where we see political stability and a fiscal situation that has seen considerable improvement.
EUR credit: spreads are still tight, fundamentals are resilient
We continue to hold a neutral view on the Euro Investment grade asset class. So far, this has also been a good earnings season for European firms, with clearly more beats than misses (in estimates). Sector volatility this month has largely been driven by the events in France, as some segments suffered a spread widening due to their direct and indirect exposure to French risk, such as Insurance, Banks, Utilities, Construction & Media. On the other hand, for some in the non-financial segment, we witnessed resilience in several sectors with low direct exposure to France and/or idiosyncratic stories such as Basic Materials, Chemicals, Food & Beverage and Technology. Despite recent repricing volatility, credit markets did not suffer as a result of a deterioration of demand on the primary market or severe selling pressure on the secondary market, reflecting investor preference for credit as well as the segment's resilience. Spreads, however, remain at very tight levels and do not seem to be adequately pricing risks.
We have slightly upgraded our view on Euro high yield, from negative to neutral. Fundamentals remain well oriented, with most companies focused on debt reduction to adapt their capital structure to a higher-for-longer rate environment. This segment has also not retraced as much as the IG segment since the heightened political uncertainty in France. At the bottom of the rating spectrum, cracks are appearing, as some balance sheets are not sustainable in the new interest rate regime. Technicals remain strong, with more rising stars than fallen angels and weaker credits being downgraded to CCC and below. The size of high yield markets is shrinking and demand remains strong especially in Europe. We maintain a negative stance on US high yield, where spreads are less attractive and where fundamentals (and specifically rating drift) are weaker.
In the context of the snap elections, we have generally kept a very close eye on French names, especially banks and those with close ties to the state – again underlining the importance of bottom-up issuer selection.
In emerging markets, we took profit on our overweight on corporates
We maintain our neutral stance on emerging sovereign debt. The aforementioned political risk impacted certain currency markets over the month of June, but broadly EM debt markets showed resilience, with the hard currency segment outperforming the local currency one. The distressed/high yielding portion of the segment has been a driver of performance this year, though most of the good news seems to be already in the credit price. We see that important issues such as the positive development on inflation and central bank easing as well as fiscal consolidation seems to be baked into the risk premia of quite a few credits. Some, such as Indonesia, are starting from relatively low levels of debt-to-GDP and have sustainable plans for expanding debt levels, investing in value-added activities, as well as in fiscal multiplier-increasing projects, such as free school meals for all school children. Others are not in the same position, so additional debt issuance could contribute to spread widening over the course of the year, offsetting some of the duration gains from the decrease in risk-free rates.
While we had a positive stance on EM corporates, we have decided to take profit as spreads now look very tight after their strong run, while the global environment is also becoming less supportive.
FX opportunities concentrated in EM
In EM, we keep our longs on INR and IDR, which are delivering very attractive carry, and on TRY, which in addition to carry offers potential thanks to a re-normalisation of economic and monetary policy in Turkey.
We also maintain our short CNY vs. USD, which we also hold as a partial hedge with positive carry against potential further downward moves in Chinese government bond yields given our UW position on Chinese rates.