With equities performing the strongest over the month, the picture was rather mixed for fixed income asset classes, with no clear outperformance from any risky asset classes. Local currency emerging markets led the pack, following by ex-US government bonds, which also eked out a positive performance. Global investment grade and US govies were down, and EUR converts performed poorly in light of equity market gains.
US rates: Debt crisis averted, but no change in our views
Given the stark consequences of an inability to find a compromise, we felt it was always highly unlikely that the Biden administration and Congress would be unable to find a solution that avoids the worst outcomes. While pent-up financing needs for the US government means that we will see a glut of liquidity from T-Bill issuance in the coming months, it seems likely that the effects of this will be limited to the short end of the curve. We do not expect a material impact on longer-term US rates. Here, recent US data has comforted us in our moderately positive view. We saw a few signs of deterioration in the outlook for the business cycle. Headline labour market data continues to be very strong, but we see this primarily as a lagging indicator to economic activity. On inflation, the trend of a move back in the direction of the target is holding as well – but the landing point remains uncertain. Finally, although the US banking crisis now seems to have been averted without contagion to the wider system, a degree of risk-off sentiment persists, as indicated by tightened lending standards.
The end of ECB hiking cycle?
We expect two more 25 basis point hikes before the end of the year, for the deposit facility rate to top out at 3.75%. The downward trend in the inflation cycle seems to have been confirmed, especially with weaker than expected economic data coming out of Germany. At this point, the risk of a third hike continues to fade into the background. Our fair value models indicate a 10Y Bund rate below current levels. While it remains uncertain when slowing inflation and growth and the end of the hiking cycle will be fully priced in, we took advantage of the May jump in rates to build an overweight position in EUR duration. We also reinforced our 10 – 30 steepening bias, driven not only by the likely end of the hiking cycle, but also the end of APP reinvestments from July onwards.
Despite S&P electing not to downgrade France, we retain our underweight on the country, with an overweight on Austria. We still feel that fundamentals indicate a concentration of risk towards a spread widening, rather than tightening. We have initiated small positions in eurozone issuer Slovakia (off-benchmark for many funds) and continue to hold a slight underweight on Portugal. Our Portugal underweight is not motivated by fundamental considerations, but rather by rich valuations after an impressive spread rally.
With Spain, a major eurozone issuer will be holding a general election in July. A tight election result that leads to drawn-out coalition negotiations is a risk; however, ultimately, the major centre-right and centre-left formations have consolidated their support compared to smaller, emerging parties. As a result, we see no need to adjust our view on Spanish rates.
UK: We see a long-term downward trend in rates, but volatility in the meantime
Last month, we initiated an overweight position in UK rates based on our conviction that the three to four further BoE hikes the market is pricing in is more than the fragile economy can handle. However, last month did nonetheless see an uptick in UK yields, and we concede the market may take a different view for the time being. Nonetheless, commentary from the Chancellor of the Exchequer that he is willing to accept a recession as the price for controlling inflation may gradually cement this expectation in the views of the market. While our conviction holds, we will remain open for re-entry opportunities into this trade. We have moved to a negative view on GBP vs. USD, as there are arguments supportive of this trade in both directions: stickier and higher inflation in the UK vs the US and a recession bringing down inflation should both lead to a relative depreciation of sterling.
Canada close to fair value now, long on New Zealand
We now take a neutral view on Canada, after having held an underweight position. In our view, given the strength of the Canadian economy, the market was underestimating the possibility of a more aggressive Bank of Canada. The BoC has now adopted a more hawkish rhetoric, and the market expects them to raise rates again. As we now feel that likely central bank action is appropriately priced, we have returned to a neutral position on Canada.
After a long period in which the Reserve Bank of New Zealand was arguably the most hawkish G10 central bank, the RBNZ has now changed tone and indicated it is on hold. Given that more than half of the country’s mortgages will require refinancing before the end of 2024, the flow-through to the real economy will likely be sharply felt.
Japan: Risk is heavily skewed to a rise in yields, but interesting carry for EUR investors
On rate movements, our view is that there is very little reason to believe that material falls are likely. On the other hand, it is a distinct possibility that the BoJ’s Yield Curve Control policy will crack. Purely from a price movement perspective, therefore, holding Japanese government bonds has a risk profile clearly skewed to the downside. However, given that JPY rates hedged to EUR are offering very good carry, there is clearly a price to pay for investors electing to underweight the country. This does present something of a dilemma – but in our view, on balance, an underweight position is warranted. Economic data in Japan remains strong, which makes the BoJ’s hold on the curve more tenuous than it otherwise might be. Ultimately, we believe the risk of a sharp spike in rates outweighs the forgone carry.
Positive on EUR IG credit, we pay close attention to the property sector
We continue to see EUR IG as the most attractively valued credit asset class. Spreads offer an interesting yield pick-up to rates, and we believe that company fundamentals should continue to hold up. Overall, the eurozone should escape a recession. Whilst this also holds for US credit markets, firms there are nonetheless facing a harsher tightening of financing conditions. Combined with lower spreads and a generally poorer rating profile, we do not see value in the asset class.
European banks are holding up well and should continue to do so, but we continue to monitor the property sector very closely. Commercial real estate has already gone through a difficult adjustment because of Covid, with most firms having built up significant cash reserves. This strengthening of their balance sheets should allow them to retain their investment grade rating. Difficulties are concentrated in the residential sector, where interest coverage from rental income is now razor-thin or evaporating, and very low vacancy rates offer little room for operational improvement.