We expect interest rates to gradually increase with a 12-month target of 0.90% for the German 10-year yield. We thus have a negative stance on government bonds.
Tactically short on the lower end US curve
Over the recent weeks, US treasuries had rallied on the back of significant political risks and concerns over trade wars. Our long position hence proved rewarding in this context and we intend to hold an underweight position on the front end of the US curve (2Y). In Europe, currently, we maintain a moderate level of short positions in favour of a flattening bias to the EUR curve, with valuations being stretched on the lower end of the curve. We have chosen to express this through some shorts on the belly of the EUR curve (namely the 5 year portion), vs. the 30 year portion.
Underweight Italy in our neutral non-core allocation
We have benefited from our underweight position in Italian bonds, which was established in January this year. In spite of the situation being temporarily resolved (with the government being formed), we believe that the country is now vulnerable to the policies of a populist regime that has shown its Eurosceptic tilt and we continue to hold a negative view on Italian debt. In the current politically charged context, we continue to have a preference for Portuguese and Spanish sovereigns vs. an underweight for Italian sovereigns.
Constructive view on Euro credit market
European assets have become more popular with the continued support of the ECB (until the end of 2018 at minimum), but also regarding their critical size. The European credit market posts a total size of more than € 2.5 trillion with large sectorial & geographical diversification. Issuers have large subordination degrees. Fundamentally, Investment Grade corporates are in good shape. They have strong cash balance sheets, lower leverage and high interest coverage and stable margins. Banks have built higher core equity buffers, reduced their bad loans and restored gradually their net interest margins.
Back to neutral on US credit market
With the backdrop of a rebound in the economy over the second quarter and supportive company results, the asset class could be temporarily well supported thanks to its domestic economic power. In this context, while we maintain a selective view on US credit and avoid some secular sector challenges, we aim to continue to reduce our hedges on the US high yield front through the derivative markets.
We remain positive on emerging debt hard currency, as the asset benefits from a supportive reform momentum and energy exporters. We nevertheless put some asset class protection in place as a hedge against headline and trade war risks.
Due to the respite in US-driven trade tensions and better euro zone growth, emerging debt in hard currency (+2.6%) recovered in July after a negative first half (-5.3%).
With a yield of 6.3% hard currency debt compares well to fixed income alternatives as the risks to higher US Treasuries from monetary policy normalisation and trade wars have so far been offset by the global growth recovery and the solid performance of commodities. On a one year horizon, we expect emerging debt hard currency to return around 4.6%.
In this context, we have reduced our exposure to headline risks and now have more balanced positioning with overweight’s (OWs) in emerging markets names and an underweight (UW) via a basked to EM single name CDS (China, Brazil, Mexico, South Africa, Turkey) amidst escalating trade tensions in June. We are still constructive on commodity exporters like Angola, Ecuador, Kazakhstan, Nigeria, Petrobras (Brazil), and Pemex (Mexico) given our positive outlook in oil prices. We also maintain an exposure to specific idiosyncratic re-rating stories (high yielders with positive reform momentum) like Argentina, Ukraine, and Egypt which now appear even more attractive relative to the limited creditworthiness risks.
Our underweights (UW) further include US treasury-sensitive credits with tight valuations such as Panama, Peru, Chile, China, Uruguay, and the Philippines. We also hold and underweight in Russia which is vulnerable to further US or EU sanctions, geopolitical risks, dependence on commodity exports and limited value versus IG peers and index.
Although the overall framework – based on rate differential, carry-to-risk and economic surprises – is negative for the US dollar, we have a tactical positive view on the currency. In spite of the significant twin deficits exhibited by the USD, which should keep the greenback under pressure vs. major currencies over the medium term, the currency should be remain supported by the Fed, that is likely to continue hiking rates. Moreover, short-term factors remain supportive for the USD dollar (Fiscal Plan, Budget, cash repatriation). Finally, in the current context of geopolitical risk, the dollar is an interesting safe-haven asset to hold.
As the Norges Bank should clear the path for a rate hike in 2018, and as our scoring remain very positive for the currency, we maintained our long position on NOK. Furthermore, the currency is also supported by a relatively strong economy, where activity cycle is expanding. We also have a positive view on the SEK, which benefits from positive long term drivers.
On the other hand, we hold a negative exposure to the NZD, which could be impacted by the trade wars between US and China (as China is an important trading partner of New Zealand), the slowing activity cycle and the dovish central bank.
Though rate differentials remain penalising, the Yen – based on our long-term framework – appears attractive. In the current environment of geopolitical uncertainty and the heavy dose of event risk present, the Yen remains an attractive safe haven and a diversifying asset. Our long position on the currency has been particularly beneficial in this context.
Regarding emerging markets currencies, we have overweight’s in select CEEMEA currencies like CZK, HUF, PLN and KZT and underweights in Asian currencies that might suffer the most from the escalation of global trade tensions, and high beta proxies like BRL, RUB, TRY and ZAR. Overall, we assess the near-term outlook for emerging currencies to be complicated by the currency/geo-political crisis in Turkey and the October general elections in Brazil.