20 FEB


Fixed Income, Monthly Strategic Insight, Topics

We maintain our preference for Inflation-linked bonds, especially US ones

The rebound in economic activity in December 2016 was confirmed in the month of January 2017, further clearing up the uncertainties surrounding the global economic outlook. The US remains the primary driver of this phenomenon, as witnessed by strong consumer sentiment and ISM services data published over the course of the month. The economic cycle, which is continuing to accelerate, is now firmly in the expansion stage. In the Eurozone, economic momentum has finally picked up after months of stagnation, and all indicators are in positive territory. Meanwhile, the economic cycle has recorded a new 4 year high, with a strong pick-up in consumer sentiment. The UK, on the other hand, is still struggling with Brexit, which finally appears to be catching up. Economic activity is losing momentum, as exhibited by falling consumer and economic sentiment numbers and higher unemployment.

To add to this generally improved economic outlook in the G4, the clear and widespread reflation trend in developed economies is gaining momentum, in line with the scenario we established in previous months. The US is once again leading the way, with wage and consumer inflation contributing to the uplift and expectations finally turning positive. While this trend isn’t as pronounced in the EU, wages and housing indicators are pointing upwards in the region. Though not consistent amongst sub-indicators (with expectations still being a mitigating factor), the overall picture does look positive.

The UK is benefiting from a lower GBP and is already in inflationary territory, while in Japan, the disinflationary trend bottomed out a few months ago, though momentum remains weak. Furthermore, other developed countries are also starting to experience a general rebound in inflation brough out on by ultra-low policy rates.

The combination of expanding economic activity and an improving inflation outlook is increasingly likely to lead to Central Bank policy normalisation in 2017. Though Janet Yellen might want to see further evidence of better employment figures before switching to more aggressive normalisation in the US, the current picture does warrant an increase in rates. Furthermore, the next stage of normalisation in US may consist in beginning to reduce the Fed’s balance sheet, which was mentioned in the latest FOMC minutes. It is important to note that the market remains cautious regarding future rate increases, pricing in less than 2 hikes for 2017 (compared to our scenario of 3 hikes). Finally, the hawkish trend is supported by the Bank of England’s less expansionary policy and the fact that no further accommodation is needed or provided by the ECB and BoJ. Broadly speaking, the reflationary trend is going to be a challenge for Central banks, especially since excessive accommodative policies are producing unwanted side effects.

In terms of the debt cycle, the numbers continue to suggest a new leg of credit boom, as both the business cycle and credit cycle are in the expansion phase. In the credit boom cycle, we expect spreads to tighten marginally and default rates to stabilise.

Global Rates Strategy

January 2017 was a good period for risk-on assets, which performed well, led by convertible bonds and the high yield segment. Among developed country sovereign bonds, however, a majority of markets saw weak performance. In fact, US, Australia and Norway were the only segments to post positive returns (albeit very slight). Eurozone govies suffered considerably, as all countries delivered negative performance. Though periphery sovereigns underperformed core markets, French government bonds were particularly hurt by the uncertainty surrounding the presidential elections in May, while Swedish sovereigns suffered due to hawkish comments by its central bank. The strong rebound in Emerging market debt continued this month in the wake of the rally in risk assets, as both local and hard currency markets delivered positive performance.

We maintain our preference for Inflation-linked bonds, especially US ones

The US and Eurozone are in a reflation phase. Wage and consumer sub-indicators are posting solid numbers, while the energy segment should also help push headline inflation higher in the coming months. However, we do not believe that this has been priced by the market yet, as exhibited by the low expectations built into the inflation cash and swap markets, both in the EU and in the US. Nominal yields have risen with inflation but real yields have not. Furthermore, in the US, we believe there is a differential between the estimated CPI and the real CPI (which is lower), hence there is still some room for breakevens to move upwards. Our proprietary model shows a small decline in momentum, leading us to take some profits on our US inflation-linked bonds. However, in light of the inflation and economic cycle, we still favour long-end breakeven positions in the US, as a limited inflation premium is built in. In Europe, core inflation is less present, and the inflation cycle is not as strong as in the US (and is more driven by base effects of oil). We have also taken some profits on Euro inflation-linked bonds and temporarily hold a neutral stance.

Tactically and Slightly Long in US

The base case scenario continues to point towards rising rates in the US (on the back of better activity and inflation cycle) and US treasury yields have already seen a rise over the past few months. The market is very short at the mid and long end of US sovereigns, though to a lesser extent on the 2 year segment, and a near-term consolidation is expected. Some of these positions were unwound in January (on the 5 to 30 year portion of the curve), and there has been a break in the sell-off, though rates have not necessarily moved lower. With good economic news largely priced in, we have taken some profits on our short positions on the US curve, and are temporarily and tactically taking a slightly positive duration stance on Treasuries.

Short position on 10 – 30 year portion of EUR curve

The ECB’s continued expansionary monetary policy has been supportive for core European yields, as have supply and demand dynamics. However, with inflation numbers and the macro-economic outlook improving (PMI prints), there is some concern regarding the ECB’s future policies. Furthermore, calls from several countries to move towards fiscal easing, as well as the debate over the probable tapering of the current program, could call into question the ECB’s accommodative stance in 2017. In addition, there is an element of political risk which cannot be neglected as France, the Netherlands and Germany head to the Polls. Furthermore, investors have reduced their long duration to the core rates, threatening a rise in rates in a region where valuations are already stretched. Against this backdrop, we hold a short position in French sovereign bonds.

Our stance on non-core sovereigns in the Eurozone is neutral. We hold a cautious stance on Italy, Ireland and Portugal while remaining overweight on Spain. We aim to continue to diversify our exposure towards Eastern Europe (Latvia, Lithuania, Hungary and Poland). We ar looking to take some profits in the region, though we are not worried about growth in the area and like some relative value trades.

Currency Strategy

Over the course of the past month, carry currencies such as the Australian dollar (AUD, 2.9%) and the New Zealand Dollar (NZD, 3.1%) saw strong returns. EM commodity currencies such as the Brazilian Real (BRL, +1.1%) and the Colombian Peso (COP, +2.5%) were also among the top winners vs. EUR. However, currencies such as the Turkish Lira (TRY, -3.1%) and the Chinese Yuan (CNY, -0.9%) were at the bottom of the rankings as this month’s worst performers. The US dollar also suffered this month, losing close to 2% (vs. the Euro).

Negative framework for USD, though favoured by tacticals

Though long-term indicators continue to point towards an expensive US Dollar, carry and investor positioning are supporting the currency. Additionally, supply/demand dynamics remain tight, and could drive the greenback higher over the short term. However, the post-election question of whether the new president Donald Trump would allow the dollar to strengthen is coming into focus. Since taking power, Mr. Trump has taken a tough stance on countries running high trade deficits with the US (Japan, Mexico, Germany), and recent comments clearly signal Trump’s eagerness to limit USD strength.

Supportive Framework for the JPY

Though rate differentials remain penalizing, the Yen is attractive based on our indicators (PPP, Trade and capital flows). Furthermore, in the current environment of (geo-)political uncertainty and given the heavy dose of event risk present, the Yen is still an attractive safe haven and diversifying asset.

Positive on the SEK, NOK & NZD

Sweden is benefitting from an inconsistent rebound in inflation as a result of ultra-low rate policies and a decent growth outlook. With positive long-term drivers and our positive PPP score, fundamentals are pointing towards the re-appreciation of the SEK. We took some profits on this position during the rally, but have maintained a long exposure. We also hold a favorable view on the NOK (which also benefits from a positive score in our model) and the NZD, where accelerating business cycle indicators are likely to be supportive..

Neutral on Emerging FX, but overweight on selective commodity-related FX vs. underweight on Asian currencies

The US elections ushered in a new paradigm for EMFX - the expected reflationary and protectionist US policies are posing risks to the Fed’s gradual normalization and supporting a strong US Dollar in the near term. Most EM central banks remain hawkish and focused on anchoring inflation expectations.

We now have a more neutral position on EMFX, with an overweight stance on commodity FX, and tactical exposure to the Mexican peso (MXN) and Malaysian ringgit (MYR), fully hedged by underweight positions in Asia FX.

Our continued overweight stance on the Colombian Peso (COP) and Ruble (RUB) are justified by the fact that we expect commodity FX to outperform the broader EMFX universe, and the strong external/FX position of the RUB and upside macro and political risks for the COP.

We hold a tactical overweight stance on the MXN, which has attractive long-term valuations and may benefit from an extended correction (after sharp post-US election declines) and a reversal of the extreme short positioning on the currency.

We are maintaining our structural underweight stance on Asian currencies. Due to the liberalization of its capital account and its slower growth, the Chinese yuan (CNY) is expected to continue depreciating in the medium term. The Thai baht (THB) is also entrenched in depreciation due to an accommodative monetary policy and deteriorating fundamentals, while the Indonesian Rupiah is vulnerable to risks of bond outflows amid high investor concentration. We are neutral on the South African Rand (ZAR) and the Turkish lira (TRY) for the moment, as the strong macro vulnerabilities (external sector imbalance; dependence of portfolio flows) of their respective economies are not of imminent concern in a stable US Treasury environment.