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Pascal BLANQUE, Eric BRARD
Eric BRARD, Laurent CROSNIER, Myles BRADSHAW, CFA
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We are happy to share our fixed income portfolio management teams’ views and convictions for 2016. These are the result of the internal discussions we have had over the past few weeks aiming at drawing a perspective for the next few months. The convictions are reflected in our current key portfolio positions.
Our detailed central economic scenario and cross asset views can be found in the monthly Cross Asset Investment Strategy.
In our central scenario (70% probability), growth continues in the developed countries in 2016. The decline in potential growth in China continues, but fears of a hard landing in 2016 and 2017 (which we define as GDP growth of around 3-4%) are contained. Growth stimulus via a combination of interest rate policy, bank reserves policy, budgetary policy, fiscal policy and income policy, and not via an aggressive currency policy leading to a sudden drop in the Yuan (of 10% or more), provides reassurance, and the impact of the 2015 slowdown remains confined to the emerging economies for the most part. Overall, global growth remains close to 3% (a much more pessimistic scenario than the market consensus). This global trend (lower growth in the emerging countries, loss of competitiveness in the «advanced» countries due to exchange rates etc.) will nonetheless lead to a weakening of growth in the advanced countries in 2017. The Fed retains a more cautious policy than indicated by its projections. It tightens policy extremely carefully and slowly (50bp in 2016). The ECB pursues an accommodating monetary policy: short-term rates remain unchanged for another three to five years, a QE2 is considered as well as another lowering of the deposit rate. This last strategy is a useful tool for limiting bank deposits with the ECB, but further easing does not guarantee that the benefits will be transferred to the real economy. In contrast, the prospect of seeing this rate cut and an extension of the QE programme will ensure another welcome depreciation of the euro. Ultimately, the ECB, the BoJ, and the PboC will remain accommodating for the next few years. Long-term yields remain low, particularly in Europe. The euro stabilizes against the USD and the yen regains some vigour. Growth is solid enough to support the search for yields and spreads. Rates, EPS, and lower stress favour the equity markets, specifically the European ones, where the yield on dividends is four times higher than long-term rates. Be warned, though; the overall environment will create much more volatility than in recent years.
Source Cross Asset “2016 and beyond”, November 2015
As recently stated by Philippe Ithurbide, Global Head of Research at Amundi, 2016 opens up on a decoupling and divergent world. It also starts in the same low interest rate environment that has now dominated our asset class for many years. So, what are the key ideas ?
1- Interest rates: no strong directional trend in 2016
This is one of the central question marks everyone has in mind: are we going to face a significant rise in interest rates in the wake of the monetary tightening in the US ? Our answer at this stage is clearly no, as a number of factors do put some downward pressure on rates. Despite the very slow but nevertheless on-going economic recovery in the developed economies, global bond markets are still moving in an environment of monetary easing almost everywhere, except in the US. The clear downtrend on oil prices and the economic slowdown in China have taken the centre stage in the fixed income teams discussions because these are strong factors weighing on the world economic recovery and particularly the emerging countries.
It would take a clear turnaround and strong economic surprises in the developed economies in particular to create the conditions of a marked increase of long term rates in 2016.
As a consequence, we do not expect to enter significant short duration positions. More generally, we do not believe that structural duration bets, either short or long, are going to be key in generating performance in the coming months. However, many relative value opportunities are emerging from the list of divergences or decoupling that we see in the current economic and market cycle.
2- Yield curves : the case of the US market
We believe that there is a strong case for the US yield curve to flatten. While short term rates will edge higher in the wake of the Fed hikes, long term rates will be supported by a number of factors. A stronger demand for safe assets linked with both the impact of regulation and the higher level of risk in the current world, a favourable spread differential with the major developed treasury markets, the scarcity of high quality assets in the global markets and also rising liquidity concerns should favour domestic and international appetite for long term US Treasuries in 2016.
3- US and Euro zone: the monetary policy divergence
The perspective of diverging monetary policies in the US and the rest of the developed economies, particularly in the Euro zone, creates a short US/long Europe theme that is already part of our investment policy themes. This theme is here to stay in 2016. This arbitrage could also prove to be a good hedge against any economic surprise coming from the US on the upside.
4- Investment grade credit : financials vs corporates, high beta vs low beta
2015 can probably be considered as a good proxy for what 2016 could offer on this front. Spreads have ceased to decline or even started to edge higher, and we should see more on this in the coming months. The asymmetry of risk/returns in the asset class combined with a number of factors has reduced the appetite for credit risk. Among these factors: i) a greater attention given to liquidity risks, ii) a vanishing euro government risk sentiment illustrated by the tightening in euro peripheral spreads, iii) the increasing risk perception on the US side (linked with the energy sector, or with the overall corporate re-leveraging cycle), iv) plus a series of specific events (VW).
Does this mean that overall positions should be cut ? No, but we have to adapt portfolios to this new environment, less liquid, more exposed to specific risks, but full of relative value opportunities :
Long financials against industrials: regulation as well as monetary policies still play very much in favour of financials that are getting safer. The asset class benefits from a much higher visibility than corporate industrials, and does not convey the same sector specific risk.
From this starting point, we tend for the best financials to go down the capital structure and favour subordinated debt to senior unsecured. Additionally, this approach helps build portfolios that are better positioned in terms of liquidity risk (lower cash consumption for the same level of risk). More generally, on a risk adjusted basis, we tend to prefer high beta structures (hybrids for instance) that are more protective (liquidity perspective) in case of specific events. Low beta names that are making the bulk of credit portfolios are exposed to systemic liquidity events just because they are considered first when it comes to selling positions. There is thus a case for high beta versus low beta issues in the credit markets, particularly the Euro. The view is different in the US where high beta names are exposed to a strong risk aversion linked with the energy/commodity sector developments. This opens the door for arbitrages in the global corporate space (long EUR vs US high beta names, long US vs EUR low beta names).
5- High yield credit
Divergences can also be found in this space, opening attractive arbitrage opportunities. We remain constructive on the Euro HY, where we make a strong difference between the low BB/high B segment and the low B/CCC one, with a preference for the former over the latter. This results from both the view that the US high yield troubles could have a spill over effect on the lower quality end of the euro high yield, and the fact that weaker names in euro are more exposed to a turnaround in this market.
6- Currencies: the case for a stronger USD
After a strong appreciation since the mid of 2014, the US dollar is no longer considered as undervalued. Some currencies like the Japanese yen and certain emerging market currencies look very cheap now. However, given the low policy rates in the developed world and falling terms of trade in the emerging market world, rising dollar will continue to play the role of policy adjustment for the rest of the world. Instead of calling a currency war, currency has now become a major policy instrument for many areas in the world and therefore offer lot of opportunities for investors.
One good example is in the Asian space. The Chinese yuan devaluation has exposed the overvaluation problem of many Asian currencies. A problem which originated from the massive yen depreciation over the past years and it has become unsustainable once the yuan has started de-anchoring. We expect more downside risk of most of the Asian currencies, particularly in the Korean Won and the Singaporean dollar as the government of both are expected to accept more currency adjustments to revive their flagging domestic economies.
Another example is in the commodity space. We can benefit from the rising correlation between the commodity price and commodity related currencies such as the Australian dollar, the Canadian dollar, the South African Rand, the Norwegian Krone. It is especially the case for investors who do have access to commodity futures. Investors can use currency markets as a proxy for playing the theme on commodity market.
7- Emerging debt: a patchwork of specific risks
Emerging Markets are caught between tightening policy rates in the US, a free-fall in commodity prices, which is partially driven by a China slowdown, and heightened idiosyncratic risks. The saviour has been flexible exchange rates. Despite mounting risks, EM fundamentals have held up relatively well, with current account balances actually tightening on average and fiscal balances escaping a sharp deterioration, despite a significant worsening in terms of trade for Emerging Markets. Weaker currencies imply greater scope for external rebalancing and mitigate the loss of USD-linked commodity revenues. As such we continue to see value in EM credit, both sovereign and corporate. We are overweight external debt in commodity exporters that have flexible exchange rates such as Russia, and underweight credit in countries that continue to peg their currency, such as Saudi Arabia. EM currencies meanwhile will remain under pressure as the main adjustment valve for the challenges facing Emerging economies. Amongst the major EM countries, we think much of the worst may now be priced in Brazil, with the country now having lost its IG status, we find the credit complex to be attractive. South Africa has room for more weakness amidst a difficult year with credit ratings, local elections and loss of institutional credibility. Risks are also under priced in Turkey as we approach the change of Central Bank Governor and are faced with political risks.
8- And also…
Inflation: if obviously not a central investment theme (for the time being), inflation linked securities are to be considered. Euro I/L are on the cheap side still, and could prove to be a good hedge if things are not going as widely expected.
Brexit: this risk should remain in the headlines over the coming month and weigh on the UK market (including the GBP) overall. Beyond the impact on the UK market, this theme will bring back on the front burner the issue of the Euro zone political stability. Thus, a real trigger of volatility.
Liquidity: the globalization of markets, the impact of regulation, the decline of interest rates, a lot of factors are playing against liquidity. This aspect will keep dominating market participants concerns in 2016.
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Pascal BLANQUE, Eric BRARD
Eric BRARD, Laurent CROSNIER, Myles BRADSHAW, CFA