In terms of performance, we continue to see strong returns of equity markets vs government bonds. Amongst G10 sovereign rates, the US delivered a neutral performance (-0.03%) over the 1-month period, whereas peripheral sovereigns, at -0.12%, were slightly weak. We note the strong resistance over the month of Australian sovereigns, while New Zealand government bonds suffered. On European govies, in spite of the month’s slightly weak performance, over the longer term (6M-1Yr), peripheral sovereigns remain the best performers. On linkers and break-evens, the asset class appears to be holding up well, with US and Japanese linkers delivering the strongest performance over the 3-month period. On corporates, a flattish performance was witnessed over the course of the month, but with the continued outperformance of financials (sub debt) vs non financials. Finally, on currencies, the EM bloc offers a sharp contrast with the ZAR and THE BRL as top performers, while the Turkish Lira and Thai baht were laggards. The Yen and the Dollar, meanwhile, continued to suffer.
Our activity and inflation cycle analysis shows a strong rebound of the Eurozone, which has now entered the expansion phase alongside the US, while Japan and the UK remain in recovery. In terms of monetary policy, which we believe will be the most important factor in 2021, we appear to be at a turning point in the cycle. We expect, over the next 18 months, to see some tapering as the central bank purchase programmes progressively decrease. This will, of course, will have an impact on bond yields and credit markets, as we expect communication on tapering in the second half of the year. The Banks of England and Canada have already announced tapering, and we expect the Fed to start to do so in 2022. On the European side, we expect the PEPP to end in March 2022. We do, however, note that, currently, key indicators like the labour market recovery are still far from complete and well below the thresholds that mandate a tapering announcement from the Fed.
Maintaining a negative stance on US rates and the dollar bloc
Overall, across developed markets, we expect a general rise in rates on the back of better growth, inflation and low valuations. The return of growth and inflation is welcome in the US, and could continue on the back of the additional fiscal stimulus that will be proposed by the Biden administration. When looking at economic surprises in the US, we note the divergence between the weaker hard, and the better soft, data, with a better sentiment prevailing despite hard-data weakness. On the inflation front, housing (which has been strong in recent months) and expectations pillars are the main drivers, once again highlighting the better soft data and improved sentiment. As explained earlier, we expect the Fed to start preparing markets for tapering in H2 2021 (perhaps at Jackson Hole), as the unemployment rate and inflation expectations progress towards FED Committee goals. An overheated housing market and excess liquidity in the monetary market may lead to some earlier tweaks with regard to its asset purchases, especially MBS purchases. In this context, it is worth reminding ourselves that the Fed recently decided to wind down its Secondary Market Corporate Credit Facility. In this context, we expect US rates to continue to move upwards.
Our negative exposure to New Zealand rates continues, on the back of some positive economic data and tapering of monetary support in the form of scale-backs in central bank asset purchases. We expect the curve to further steepen in the near term.
We also hold an underweight on Canadian rates, with a central bank that has already announced tapering of its QE programme, something that could further taper purchases in the coming months.
Negative on core Eurozone rates, positive on non-core via Italy and Portugal
In Europe, the ECB kept its policy unchanged (as was widely expected), and net purchases under the PEPP over the coming quarter will continue to be conducted at a significantly higher pace than during the first months of the year. Moreover, now that all EU members have ratified the “Own Resources Decision” – which establishes how the EU’s budget is financed - the European Commission can start borrowing resources to fund the recovery programme. This programme, commonly known as the Next Generation EU Recovery Fund, should support the economic recovery over H2 2021 while the vaccination programmes across the EU continue to be another source of support. Hence June 2021 could be the historic moment where we witness the first issuance of mutualised EU debt.
Overall, cyclical indicators, both on economic activity and inflation, are still supportive of the economic recovery, which is being further supported by the global recovery. Macro data are surprising on the upside. Survey data continue to improve, with strong economic confidence and PMIs which are exceeding expectations. As such, it came as no great surprise to see the ECB revise upwards GDP projections for 2021 and 2022 to 4.6% and 4.7% respectively. Though the outlook for inflation was also revised upwards for this year and the next, the ECB believes that this is due to temporary factors and higher energy price inflation (13% YoY) and expects price pressures to remain subdued overall. Hence no champagne cork-popping in Frankfurt, despite meeting the inflation target for the first time in three years, as, excluding energy and food, core inflation over May remained at 0.9%. Meanwhile, vaccination programmes are accelerating and, with countries increasingly easing lockdown measures, the European recovery is picking up speed.
On the duration front, we are maintaining a negative view on core Euro rates, given their expensiveness, and we expect them to give up some of the Q1 relative outperformance on the back of improvements on the economic, inflation and vaccination fronts. We maintain a favourable view on non-core countries (Italy & Portugal), which are well-supported by the ECB’s asset purchase programmes and the EU’s upcoming recovery fund, but have become neutral on Spain, after its strong performance.
We also hold a positive stance on Eurozone break-evens, on the back of the recovery of the inflation cycle, the rising nominal rates and the positive carry offered on short-term linkers. We maintain this allocation, with a BEI-target of 1.4% on 5-year linkers.
Currencies: Long NOK, small Long position on MXN
We are maintaining our long NOK. Norges Bank has adopted a hawkish stance on the back of the output gap turning positive and the risk of financial imbalances due to a low interest-rate policy paving the way to a potential hike in rates by the end of the year.
We also hold a constructive position on the Mexican Peso. The leftist party Morena (of president ALMO) lost its qualified majority in Congress last week, and this will prevent the ambitious reforms that would have hurt the government balance sheet. Furthermore, the US-Mexico-Canada agreement being concluded and Biden being now in power bode well for the manufacturing sector in Mexico, especially given the strong US recovery. Finally, the USDMXN cross just broke the post-COVID range, and this could be the opportunity for a leg of appreciation.
Credit: Favouring European Investment Grade & Convertibles
EUR Investment Grade: We maintain a slightly positive outlook on the European Investment Grade segment, with a large preference for financials vs non financials. Fundamentals are very supportive of credit markets, as quarterly earnings were very strong, with rising stars outpacing fallen angels. Financials are helped by the high level of core equity tier 1, non-performing loans are at low levels and provisions are very low. As the macroeconomic recovery continues to firm up and inflation levels increase, we expect some tapering of developed market QE programmes from their central banks We expect this to be done, however, in a cautious, transparent and orderly manner, with credit markets remaining resilient. Though issuance is lower in IG, the ECB backstop remains in place (as confirmed during the last ECB meeting) and will be a strong source of support till year-end. However, most of the spread compression is behind us, only the carry remains and risk reward is less favourable. We expect more specific risk, with some mergers & acquisitions, as companies have lots of cash and the business cycle is entering into expansion.
EUR High Yield: We are keeping a neutral stance on Euro HY, as the compression trade is over and dispersion is very low, offering fewer opportunities. The single-B segment is, in terms of supply, active, and this should cap the spread-tightening on the segment. However, BBs vs BBBs are still attractive, with potentially more rising stars
US Investment Grade & US High Yield: We hold a negative outlook on US IG. Though our earnings expectations on US credit remain strong, we believe that the balance-sheet recovery has been fully priced in and we take note of the reappearance of M&As and slightly more aggressive supply dynamics (resulting in longer duration) on the Investment Grade front. In this context, we maintain an underweight positioning on US IG, while staying neutral on the US High Yield front.
Finally, we think that EUR Convertibles should benefit from positive dynamics such as the coordinated action from the EU Next Generation Recovery Fund (recently ratified by EU members), more positive surprises in Q2 quarterly results and better visibility, as herd immunity is reached. Inflows are more supportive in Europe than in the US.
