June was a more volatile month, with markets – torn between the strong central bank and fiscal support on the one hand, and trade wars and the Covid-19 resurgence on the other – seeing sharp up and down movements. Central banks were already very active, and the ECB added EUR 600 billion to its PEPP programme, while extending its duration to June 2021. The FED and the PBOC also remained highly accommodative, adding strong language to their previously dovish tone. Furthermore, there were signs of the economy bottoming, with improved employment figures in the US and better macro data in China. However, the positive trend was disturbed towards the second half of the month as key countries (US, Russia, Brazil and India) saw cases of Coronavirus spiking and concerns over a second wave emerged. Additionally, tensions over the on-going trade tussle between the US and its counterparts (EU and China) resurfaced, adding to the uncertainties. And, finally, yet again, negotiations over Brexit turned sour, with the UK highlighting its willingness to walk away with a no-deal. This context, however, did not stop bond markets – shrugging off uncertainty and weak fundamentals – posting another month of positive performance. Spread products such as High Yield and EM Debt, also supported by oil prices that rallied on the back of better demand from China and the OPEC supply cuts, led the way.
One continues to look with wonder at the sheer power of central banks, which appears to be the primary driving force behind the current surge in debt (and even equity) markets. With defaults and bankruptcies looming, weaker-than-ever fundamentals and close to $100 billion worth of debt now in fallen angel territory, high-yield markets still managed to deliver a quarter of double-digit returns. It also begs investors to wonder if it’s simply the liquidity provided that is the driver of returns, or is it also the animal spirits that have awoken in the wake of the central bank puts. Such boldness, however, cannot hide the fact that, overall, macro-economic weakness is omnipresent. Our activity cycle index has seen a complete collapse, with every G4 country in recessionary territory. This proprietary index has, indeed, not only enabled us to expect a downturn in the US since early 2019, but also follow the degradation as we watched the indicator continue to plunge until it reached recession in February. Incidentally, the NBER (National Bureau of Economic Research) only recently declared that the recession in the US had indeed officially started in February, thereby validating our model. The fact that the recession started before lockdowns in the US and Europe once again shows that the outlook was weak even before the full force of the virus hit the global economy. As disinflation firms up across the globe, we realize that central banks now have no choice but to continue to adopt a highly accommodative stance, signalling strong support for bond markets. However, while we do pay close attention to data prints, it is clear that the world is still struggling with the coronavirus, and countries like the US, Brazil and India have still not seen the peak, let alone the second wave that could potentially arrive in Q4 2020. Fundamentals still have a long way to go before seeing a recovery in growth or inflation, and businesses will have to contend with lower efficiency, production and demand in this context. With this scenario in mind, caution and selectivity will be key as we watch countries struggle between de-confinement and the new normal that has taken hold of the world and indeed of financial markets.
Neutral stance on US and European Rates
The V-shaped recovery that was predicted earlier in the US is not taking form and the country has settled into the disinflation phase. Some positive employment numbers and data prints have been seen in recent weeks. While, a month ago, de-confinement had led to a positive sentiment, the country is now witnessing new highs in COVID-19 cases every day, and its medical infrastructure appears to be extremely fragile. In this context, certain states are re-confining, which is likely to lead to further economic weakness. Furthermore, the fiscal plan is yet to be announced, with political posturing leading to further disagreements as we enter the election campaign period. In this context, we expect treasuries to remain range-bound.
On the other hand, other rates on the dollar bloc do seem interesting, as we hold a slightly positive stance on Canadian and New Zealand rates. The Canadian sovereign curve appears to be relatively steeper, while New Zealand is benefiting from a dovish central bank that’s going to increase its QE programme in a bid to keep the cost of debt-financing low.
Significant attention was paid to the ECB’s decision to increase and extend the PEPP (by EUR600bn). However, we are also mindful that the EU fiscal recovery plan is being debated and, upon approval, could ultimately have a strong positive impact on the economy. As valuations continue to be expensive on the core Eurozone markets, we aim to hold a negative stance on this segment. Non-core rates find favour with us, as we hold a positive bias on Spain, Portugal and Italy against German rates. Peripheral sovereigns outperformed core sovereigns over May and remain supported by the ECB’s asset purchase programmes. In addition, they are to be the main beneficiaries of the recently proposed Next Generation EU recovery fund, with a proposed size of EUR750bn. Though the recovery fund is backed by France and Germany, the key questions are whether the fund will have enough firepower and how soon consensus can be reached with the more sceptical member states (Austria, the Netherlands, Sweden and Denmark). Overall, our stance on EUR duration is neutral.
Developed Market Currencies: Negative stance on USD, underweight on GBP
Our proprietary framework continues to point towards a negative view on the US dollar. The Fed’s rate cuts, QE programme and dovish stance also point towards a weaker dollar. In addition, should the US economy falter as a result of the Coronavirus (while the EU appears to be delivering better results in dealing with it), the greenback could see additional declines. In this context, we prefer to have a tactically negative position on the US Dollar, which we continue to monitor carefully.
The Pound Sterling is likely to remain under pressure as the UK remains one of the countries the most affected by Covid. Furthermore, the twin deficits remain weak and the trade negotiations with the EU appear to be increasingly difficult. In terms of Brexit, not enough is being done to extend the transition deadline, and talks appear to be at a dead end. Finally, the Bank of England continues to maintain (and naturally so) an extremely dovish stance, which is likely to benefit our underweight stance on the currency.
In an environment where political risk (trade wars, protests in the US, Brexit) is ripe, the Japanese Yen is an appealing safe-haven asset that is currently offering protection at relatively cheap levels. This justifies our tactically positive stance on the currency.
Credit: Favourable View on Investment Grade
The EUR IG market ended Q2 on a positive performance, even if supply was huge, with strong demand from investors chasing yield. We expect a slowdown in supply during the summer and all eyes will be on the Q2 earnings and guidance announced by companies. As expectations are very low (-37% in EPS for the Stoxx 600) and, taking into account some rebound in PMI, we could expect, with guidance, some positive surprises and better visibility. Selectivity is still key, with specific stories like Wirecard and Mohawk emerging.
EUR HY should be supported by a still-attractive BB carry in a low-yield environment, with supply not an issue, as companies rely more on bank loans than on capital markets, tentative signs of economic recovery and, finally, a priced-in default rate (expecting 6.5%, whereas spread implied 8.5%). We are playing the basis while cash market over derivatives is really attractive.
Finally, we think EUR Convertibles should benefit from positive dynamics/coordinated action from the EU Next Generation recovery fund, positive surprises/better visibility from quarterly results, less political noise than in US and some economic recovery from China.
Emerging Markets: Extended rebound amidst global activity recovery
EMD HC (3.5%) extended its recovery in June on optimism around the broadening global activity recovery as Asia and Europe eased lockdowns, and oil prices rebounded by 16.5% on accelerating US output decline. Risks around the inability of certain US states and Latin American countries to flatten the infection curve re-surfaced towards the end of the month but markets largely ignored these concerns in anticipation of further fiscal and monetary stimulus. Some EM distressed credits (Angola, Zambia) rebounded in anticipation of debt relief from China or the near-term completion of debt-restructuring negotiations (Argentina, Ecuador). Primary market activity remained elevated, with another $25bn+ of EM supply. EM spreads completed a 59% retracement of the March move, tightening another 41bps to 474bps in June, while 10Y US Treasury yields were stable, at 0.65%, resulting in positive Spread (+3.5%) and zero Treasury returns. IG (1.8%) underperformed HY (5.7%), with Suriname (+52.5%) and Angola (35.6%) posting the highest, and Belarus (-2.6%) and Armenia (-2.1%) the lowest, returns.
EMD HC valuations appear attractive relative to asset class fundamentals on both an absolute and a relative basis. EMD HC now offers a yield of 5.5% and a spread of 474bps, or more than 100bps wider than its 5-year average. The HY-to-IG spread differential is trading at 614bps, or 250bps wider than its 5-year average. The medium-term case for EMD is supported by valuations, although fundamental, technicals and flow picture are still complicated by the uncertainty around the easing of the containment measures and the resolution of EM liquidity and solvency issues. On a one-year horizon, we expect EMD HC to return around 13%, on an assumption of 10Y US Treasury yields at 1.15% and EM spreads at 350bps.
We retain an overweight on HY versus IG, primarily via distressed credits with upside from current levels. We participated in multiple attractively priced new deals in the IG and HY space – Brazil, Croatia, Honduras and Uruguay. We passed on a Belarus deal, as we consider current valuations to be extended versus regional peers like Ukraine.
In the Energy exporter space, we are net short vs the index, although energy exporters still contribute around 1/3rd of the overall beta DTS of the strategy.
In the IG space, we hold positions in Chile, Colombia and Indonesia but remain underexposed to the most expensive parts of the IG universe like China, Malaysia, the Philippines and Peru.
In Brazil, Mexico and Turkey, we hold overweights in attractively priced corporate bonds versus underweights in sovereign bonds
We hold single-name CDS protection positions in Mexico against Pemex and a long CDX.EM protection against any unexpected rise in asset class volatility.
EMD LC saw a quiet month, returning 0.5% from carry, with flat FX and duration contributions. While FX continued to perform strongly early on, with broad-based weakness in the USD, we later saw some consolidation across asset classes. Flows in LC funds have failed to materialise, despite the strong Q2 performance, and the rally has run out of steam. While Covid-19 has run rampant in the US, Latam and India, the daily death toll has stabilized globally below 5k/day, which is below the April peak (7.5k/day). Data show a quick, but partial, recovery.
Latam FX, affected by a heavier virus toll, underperformed, with MXN -4%, PEN -3%, CLP -2%, while Asia, first to ease the lockdown, outperformed: THB +3%, IDR +2.3%. In Europe Euro-related are outperforming (CZK +2%, PLN +1%) supported by the stimulus being planned by the EC.
Yields were, on average, flat, with South Africa, Russia and Chile underperforming, with a 20-30 bp widening, in reaction to further issuance being announced or expected, while Turkey outperformed (-81 bps), with new regulations enticing local banks to buy more Turkish global bonds.
EMD LC now offers a yield of 4.5%. While EMFX has retraced a third of the Q1 sell-off, flows have not yet returned to the asset class, auguring a better performance to come, albeit over a horizon of one year or more. We are cautiously optimistic that pre-virus activity levels will be restored over the course of the year, as is already the case in China, even though differentiation across regions and countries will be high. Core inflation could reach a trough in this coming month; however, adopting a forward-looking view, we are already gradually reducing duration in our portfolio, starting with the countries with the lowest yields and those that are more advanced in the recovery cycle.