Is Helicopter Money on the Way ?

CONVICTIONS

Key allocation themes across our strategies

Money Markets The ECB fosters (once more) its support to markets

For nearly five years, the ECB has been acting vigorously regarding both its monetary policy – with a deposit facility rate negative for two years – and unconventional politcy, with asset repurchasing programs covering an ever-growing investment universe. All of this officially aims at hoisting the inflation rate toward its objective of 2% while keeping a close eye on GDP growth and the euro exchange rate. As a logical consequence: bond yields are decreasing slightly in absolute term, and, for the shortest segment (0 to 3 years), keep reaching new historical lows (e.g. chart 1).

Furthermore continuing pressures weighing on price indexes contribute to pull away any change in the ECB policy, whose main tangible result so far is to be found in the rebound – timid yet effective – of the economic activity in the Eurozone. Contrariwise, we cannot exclude the intensification of the ECB measures in case the deflation threat were to materialize in the Eurozone. This scenario would imply money market rates event more negative than today, and more assets purchase.

It can’t be ruled out, as the pace of rates’ hikes by the Federal Reserve is revised downward by market participants, as many of them are not yet convinced of the strength of the recovery in the United States. The rise in the euro / dollar exchange rate (+ 5% since the beginning of the year, see Chart 2) could thus convince Mario Draghi and the Governing Council to take a further step in their ultra-loose policy.

In this environment, it is key for investors to get used to the fact that a minimal risk investment can no longer be considered without an erosion of the capital. When it comes to invest excess liquidity, it should be recalled that:

• money market funds remain the most appropriate type of funds to store the operational part of cash: they offer their holders both safety and liquidity necessary for these very short-term investments, while offering an attractive return versus other alternatives 
• enhanced treasury funds, potentially supported by this favorable context to the valuation of short-term bonds, will provide support adapted to the investment of the strategic component of treasury.

Euro Aggregate

The lull brought by the ECB to the market through its latest set of measures has been extended during the past few weeks. However, in such a sneaky way, we witnessed a rise of credit spreads, on sovereigns (conspicuously on peripherals for example) but also on credit corporate where the iTraxx index widened by approximately 10bps compared to lowest levels of March. The political uncertainties (Brexit, Spain, Greece to name but a few) account for a good portion these movements, as the uncertainties drive volatility which pushes the spreads up. But we can also see these as a consequence of the strong activity on the primary market. Indeed, we can see on both Sovereign and corporate sides, that issues on the primary market are more and more important, and mainly occurring on the long part of the curve.

Sovereign issuers have thus widely used the 30-50Y buckets for their issues (until 100Y maturity for Ireland), while the corporates have privileged the 10-15Y maturities. In the portfolios, this has for effect to push up the duration, particularly on the credit portfolios where the participation to primary market issues is inescapable. On the longer run, this also implies an increase of the market duration which will not be without any consequences if the rates ever hike back. On a more cyclical view, we have reduced the portfolios’ risk (sell-off peripherals) to take into account a potential rise of volatility with the upcoming UK referendum. We remain however still overweight in SPS and in duration on prime assets.     

Emerging bond market:  

Emerging Markets Emerging Market debt had another strong month in April, with local Currency and hard currency benchmarks posting their fourth and third consecutive monthly positive gains, respectively. Monthly gains stood at 2.6% and 1.8%, respectively, taking the year-to-date performance to 13.9% and 6.9%. We are now overweight the market across external debt, local debt, and FX – although we continue to have a higher degree of confidence with external debt.

On Hard currency debt, we added risk in the month of April, adding to our positive allocation to Brazil sovereign and Mexico quasi-sovereign space, as well as adding to our overweight in Argentina via the primary market. The latter marked a watershed moment, with the biggest single debt issue recorded in EM as Argentina issued USD 16.5bn of debt across four tenors. Demand stood at an unprecedented USD 70bn. We view Argentina to be a new darling for EM given the new reform path adopted by the Macro administration. Brazil continues to be our biggest overweight on our hard currency fund, a position that we have broadly maintained since January.

The bulk of our exposure comes via low cash priced long-end paper. We have also added to our exposure on Pemex and the quasi-sovereign complex in EM begins to normalize vs. the sovereign. Pemex should benefit more than others on the bounce back in oil prices, but also should receive support via the transfer of ~MXN200bn of FX gains on central bank reserves to the Finance Ministry.

Elsewhere, we have been reducing our overweight on Central and Eastern Europe on two factors: firstly valuations and the desire to be in less defensive positions, and secondly as we are concerned that the CEE’s much-cherished ‘safe-haven’ status of the past two years could come under scrutiny as we approach the British EU referendum. Within the EM complex, we view CEE to be the most exposed to the prospect of a Brexit. We have reduced exposures to Hungary, Romania and Croatia, whilst having moved Serbia to market weight from underweight given favorable valuations and a positive outcome in the recent parliamentary elections. On FX, we have shifted our portfolio markedly towards higher-yielding countries, and Latin America in particular. On the FX side, COP has been a favored long given the huge adjustment of the currency over the past two years and the aggressive rate hike cycle of the central bank. We have been funding this position via a short in CLP. We also have overweight in BRL and MXN. On the former we think positive sentiment and strong external rebalancing will support the currency, although the central bank’s reverse swap operations will limit extent of currency gains as they imply that the CB is a net buyer of USD. MXN remains one of the underperformers of the year and we see scope for catchup on the currency. In CEEMEA, we are overweight RUB,

In CEEMEA, we are overweight RUB, which should benefit from an increasingly credible central bank and a large current account surplus. On local currency bonds, we have moved to neutral on CEE having long held overweight positions. Within the region, we are overweight Poland, but underweight Hungary as we see greater disinflationary pressures remaining in the former. We have moved to a strong overweight in the long-end of the Russia local curve as we see strong disinflationary pressures in the pipeline over the next 12 months, likely to push inflation towards 4% by end-2017, implying a 5% real yield at current levels, which is too high. We see scope for >100bp of tightening here. We are also overweight the long-end of Brazil’s local curve and see scope for further curve inversion as inflation expectations fall markedly and the central bank remains on hold likely until mid-year before starting a rate cut cycle. The strength of the rally over the past two weeks leaves us cautious on valuations here.

Forex: we still like USD and JPY

The broad base weakness of the US dollar continued in April. The disappointing growth data in the US, together with rising inflation expectation on the back of high level of core inflation and commodity price recovery, has continued to hurt the US dollar. The biggest beneficiary of this dollar weakness last month was the Japanese yen, especially after the inaction from the Bank of Japan. The commodity price sensitive currencies such as Canadian dollar, Norwegian krona, Colombia peso, South African rand and Russian ruble had strong rally. Brazilian real has benefited from an additional boost from some improvement in the political situation. The selloff of the dollar has even extended to the British pound despite the continued uncertainty about the Brexit risk. The Asian currencies generally underperformed as the Chinese yuan declined slightly. The Renminbi has declined to its lowest level in terms of effective exchange rate since the beginning of the year.

We maintain our long position in the US dollar and Japanese yen. Regarding the dollar, its long term uptrend starting from 2011 may have ended after a too long pause since one year ago and especially with substantial retracement. However, we still keep a long position in dollar in the portfolio for two reasons.

First, the Fed is dovish and the dollar has declined a lot recently. With core inflation above 2%, low employment rate and rising commodity price, the chance that the Fed will turn hawkish is higher. We still expect that the Fed will hike this year and so the dollar has good potentials to catch up. Second, the dollar position serves to hedge the Brexit and equity market risk.

Regarding the yen, it is still undervalued, current account in Japan is improving and this is also a good hedge to Brexit and equity risk. We stay underweight most of the Asian currencies. The dollar has been performing poorly for a few months and the decline accelerated last month. The usual reasons given for this: more dovish Fed together with better growth prospect in China may have driven capital out of the US. However, it is not really the Chinese growth that matters. The Chinese yuan still finished at the lowest level in terms of effective exchange rate, underperforming all currencies in the world. At the same time, the yen was the strongest currencies against the dollar, the euro also stayed strong vs the dollar.

Therefore it is not China, but more a dovish Fed that drove down the dollar. More liquidity supply in China is expected to weaken CNY overtime, which is still overvalued in terms of real effective exchange rate. Finally, we reduced short Swiss francposition ahead of UK referendum.

US Markets : Interest Rates May be Low, but Total Return Beckons

This month we bring a few of our major themes together in summary form. Although government bond yields are low, opportunities for generating total return across the fixed income universe are excellent. To highlight the impact of recent spread changes, in the chart below we have taken interest rates out of the total return equation—the returns for bond sectors are shown net of duration-matched hedges.

Slow growth and low real interest rates. This is what a deleveraging global economy looks like. In addition, flat or falling standards of living cause political tension, with knock on effects on political structures and growth.

The FOMC is more concerned with “financial conditions” as a whole than the short-term policy rate alone. In other words, the Fed affects the markets in many dimensions, and market conditions feed through to the economy. Prices and flows in foreign exchange (the dollar), equity markets and corporate bonds are all on the FOMC’s dashboard and influence the pace of monetary tightening. In this framework, for example, falling equity markets could provide the same impulse as higher short-term rates, as could a stronger dollar or wider corporate bond spreads.

Liquidity is tidal—manage assets accordingly. Every investor should have a liquidity plan that contemplates cash requirements and market performance scenarios. The liquidity tide has risen substantially since mid-February, when spreads were wide, bids were scarce, and volume was low. Now, in early May, fixed income spreads are much narrower and bonds are easy to sell. The relative value of cash, including its option value for portfolio repositioning, has increased as asset prices have risen.

US markets are attractive internationally. As shown in the chart we distributed earlier this year, bond markets are bigger here, and real yields and risk-adjusted spreads are more attractive than in most developed economy bond markets. These conditions are attracting significant flows of private sector capital from Europe and Asia.