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USA: six months on, corporates recover but cash yields climb

EDITORIAL

 

USA : Six months on, corporates recover but cash yields climb In the commentary we presented in this space in March, we pondered the question, “Are investments weak, or is it the investors?” We averred that forced selling, regulatory tightening and de-risking had created “plenty of opportunities to earn generous yields.” Since then, asset prices have been lifted by a virtuous cycle fueled by reduced selling from sovereign funds, increased asset purchases from central banks, and lower realized volatility. The accompanying chart illustrates the 0.9% decline in U.S. corporate bond yields and corresponding declines in European and Japanese index yields. The Merrill Lynch Corporate Index has returned 8% since the end of February; U.S. stocks are up more than 13%.

Our judgment earlier this year was that lower prices were caused by changing investor preferences rather than deteriorating cashflows. The rebound in risk markets since then also seems to be driven by investor preferences. So, are fixed income markets too expensive now? We wouldn’t say they are onerously expensive—for example, investment grade corporate bond spreads are in the 45th percentile (20 years). But, being value investors—and considering that liquidity can be variable--we would recommend moving risk positioning down a notch or two in most non-sovereign bond sectors. We are still quite positive on non-government U.S. securitized sectors, though we are waiting for higher rate volatility to increase our government MBS weights substantially.

As indicated above, we remind ourselves that today’s thinner liquidity conditions imply that investors should require higher spreads to buy or hold fixed income securities. When the market tide turns market spreads can widen quickly and overshoot reasonable levels, once again raising the questions from earlier this year.

The good news is that new windows keep opening! Our long-held theme of “regulatory tightening” continues to present opportunities for unleveraged investors in high quality credit markets. We call it “the deleverage dividend.” This time the opportunity is in the money markets. Reform of money market mutual funds in the U.S. has decimated demand for short-term financial paper (many funds are converting to government-only holdings). This is reflected in the recent rise of three-month and six-month LIBOR, to 0.84% and 1.25%, mostly independent of increases in short-term government rates. While it isn’t clear how long short-term private yields will remain at such elevated levels, the situation is begging for flexible investors to reduce government money fund holdings and enjoy the large incremental returns that are available due to the transition to a lower-leverage financial system. In this case, it is the “shadow banking system” that is de-leveraging. The availability of such high short-term yields does not by itself present a large total return opportunity, but it does offer a good short-term destination for rotation from sectors that have richened substantially in recent months.

2016-09-fixed-income-letter-graph-1

Daniel Dektar
Chief Investment Officer

CONVICTIONS

 

Money Markets: Negative rates in the eurozone: 2 years on

 

Make Just over 2 years ago, in June 2014, the ECB broke the taboo of negative rates, taking the deposit facility rate below the psychological threshold of 0%, to -0.10%. Three cuts later, this rate is now at -0.40%, and it is hard to guess whether or not this is a low. For the ECB, the issue is the following: as long as this measure has not been shown to produce more negative than positive effects for the economy and the banking system, and more importantly, as long as the level of inflation remains below the official target of 2%, the cuts are likely to continue. In parallel with this particularly proactive conventional monetary policy, the ECB also led an unconventional monetary policy, with the launch :

 

- at the end of 2014 of the ABS and Covered Bonds purchase programme,

- at the beginning of 2015 of public debt purchases under the PSPP programme,

- and then in June 2016 purchases of private debt securities under the CSPP programme.

 

All these measures are driving Eurozone market rates towards ever lower levels, and squeezing credit margins, which are now close to their pre-subprime crisis level, in 2007. The range of money market and bond yields is therefore sinking, slowly but surely, into negative territory. Investments with the shortest maturities and least risky investments were the first to be impacted, but such is the strength of the trend that it is gradually affecting securities with longer term maturities and issuers which, until now, still offered positive remunerations. As an illustration, investments with a 2-year maturity combining high credit quality (Investment Grade) and positive remuneration have virtually disappeared from the market. The impact of this exceptional situation on treasury funds is twofold :

- decline in the current return of portfolios, into negative territory for money market funds, and barely positive for bond enhanced treasury funds;

- appreciation in the value of securities held, proportional to their maturity for all treasury funds.

Consequences: the performances of so-called “standard” money market funds (whose average life is currently between 200 and 270 days), are proving remarkably resilient to the downward pressure of returns, with barely negative levels but, more importantly, levels well above market indices (notably Eonia). As for bond enhanced treasury funds, they have fully benefited from the capital gains generated by the easing of spreads and continue to offer holders positive performances on their respective investment horizons. However, the exceptional market environment is not the only reason for the attractiveness of cash funds. An increasing number of banks are passing the cost that the ECB’s negative rate policy is having on their P&L on to their customers. Deposits, which until recently offered little or no interest, have gone from the status of being a stable and profitable source of financing for credit institutions (while money market indices were positive) to being a real commercial and financial headache since the minus sign has entered the money market. For example, nearly all European banks involved in depositary activities now “tax” their customers’ deposits, at rates that can go up to 100 basis points (1%). As for individual customers, they are gradually charged with account management fees. With daily liquidity, a rigorous and diversified selection of assets held in the portfolio, and, more importantly, with a capital protection* and performance target in line with that of the money market, cash funds remain the most appropriate instrument for managing liquidity, at a time when holding cash has never been so expensive.

 

Key allocation themes across our strategies

 

Euro Aggregate

 

The major A calm and therefore favourable August for carry strategies enabled portfolios to benefit from their long positions on premium assets (in the disorder concerning credit, peripheral countries, yield curve, etc.). Portfolios remain without any major conviction with regard to rates, recognising on the one hand that the levels reached are probably extremely disconnected from economic fundamentals (and therefore too low) but also that Central Banks are sufficiently powerful to upset rate models. Yield curve positions are ultimately the best means of taking duration positions: the curve is actually highly directional, flattening in rally phases and steepening in periods of rate tension. We continue to steer clear of the Euro but also US short maturity (implementation of 2-year and 5-year sales on US rates against Euro rates) and tend to focus portfolios on 7-10 year maturities (the very long maturity seems vulnerable to probable Treasury announcements on desires for 50-year issues). We are also reducing positions on peripheral countries while remaining overweight.

The good performances in August have driven spreads to the bottom of their range and the imminent Italian referendum coupled with the absence of a Spanish government makes us more cautious on these levels. On the other hand, we are not topping up our positions on TIPS and Euro inflation which, in our view, still retain their full potential to rebound on current levels. Since the beginning of the summer, investors have been clamouring for credit, IG or HY, in order to improve the already puny returns on their bond portfolios. In light of this enthusiasm, issuers have fulfilled their desires beyond all expectations: we have seen an avalanche of primary issues since the end of the summer – amounting to between 15 and 20 billion Euros per week in September. Famine has been succeeded by abundance and frustration by satiety. Attention now needs to be paid to avoiding a situation whereby once sated, the market does not become satisfied or even nauseated. As in the case of rates, the ECB needs to manage this influx by confiscating from the market the surplus that could create difficulties for it. At nearly 2 billion Euros of purchases per week, the ECB will need little time to restore some order to the market.

 

2016-09-fixed-income-letter-graph-2

Key allocation themes across our strategies

 

Global Fixed Income : summer break

 

As the choc from the Brexit progressively vanished from the front stage, markets went sleepy during the summer and volatility collapsed. They have now to refocus on fundamentals and policy prospects (be it monetary or fiscal policies, elections, referendums…). Global growth seemed to gain some momentum during the summer, especially in the US where growth should rebound somewhat after a weak first semester. Economic data surprised positively and job market statistics confirmed the trend.

In this context, J.Yellen’s tone turned more hawkish at Jackson’Hole, where she said that “the case for an increase in the Federal Funds Rate has strengthened in recent months”. However, even if the probability of a 2016 hike has been priced higher(around 70%), markets remain cautious… The Fed remains in risk management mode, and any risk event or disappointment in data could prevent them from acting. Elsewhere, market expectations for further easing remains high, and may be disappointed. The debate over the limits of monetary policy is raging and solutions may shift to fiscal policies. In this context, with extreme valuations, the case for being long duration looks less compelling and we have reduced our duration call on our global and US exposure. After an impressive flattening of the US curve during the summer, we have taken some profits on our US curve positioning, as higher hedging cost have now reduced the relative attractiveness of long US bonds vs other markets. We have also increased our US inflation breakevens exposure as we approach the end of the year and yoy inflation data should at last benefit form a positive basis effect coming from higher oil prices and weaker dollar. The extreme cautiousness of the Fed should also favour this asset class. On the other hand, we have taken our profits on our long UK breakeven position, which has benefitted from the Sterling depreciation. The performance of the credit asset class was remarkable during the summer months, as Brexit fears receded and demand remained supported by ECB and BOE QE, and the continuing hunt for yield. New issuance was exceptionally high on the US market, with 2 to 3 times higher volumes than usually in August. UK Banks even managed to issue new AT1 bonds with demand higher than 10 bns on each program. We stay positive on the financial sector, mainly in Europe on core names, whereas we favour the industrial sector in the US, with higher maturities.

 

Key allocation themes across our strategies

 

Forex : stay long dollar and yen buying more high yielding currencies

After a big surge in trading activities in the currency market due to UK referendum in June, the currency market has seen a sharp decline of trading volume in August. The surprising resilience of equity market and disappointing Q1 and Q2 US growth has driven investors to sell dollar and buy emerging market currencies from high yielding Russian Ruble, Brazilian Real to equity market sensitive currencies Korean Won and Taiwanese dollar. At the same time, cautious investors have also bought euro and yen to hedge any unexpected market volatility ahead. The dollar however turned around sharply by the end of the month when rate hike expectations for September and December increased after the annual meeting of central bankers at Jackson Hole. The dollar recouped all of the losses against most of the currencies. The best performing currencies in the month has been the oil sensitive currencies such as Russian Ruble and Colombian Peso as oil price rebounded from its two months’ decline. The worst performing currency was South African Rand as the political risk has come back to the top of the screen. The Chinese yuan resumed its decline as the interest rate divergence between the external funding cost in dollar and domestic interest rate has continued to widen. We stay long US dollar and Japanese yen. There is still upside potentials for the dollar as the Fed is expected to further normalize the monetary policy. There is also good reason to keep the yen long as it has both a status of risk-off currency and undervalued money. Having said that, the risk of disappointment has risen due to the flatness of the US Fed fund rate expectation and uncertain reaction from Japanese government towards the economic weakness. We stay underweight the low yielding Asian currencies such as Korean Won, Taiwanese dollar, Singaporean dollar as they are still overvalued in terms of effective exchange rate. We are overweight the high yielding Asian currencies such as Indian Rupee and Indonesian Rupiah as their big domestic markets helped their economies suffer less from the continuing decline of global trade volume.

On the relative value space, we keep the long Brazilian Real against short Mexican Peso as the political risk in Brazil has passed the peak. A short peso position is to hedge the regional risk. We are long Russian Ruble against short Canadian dollar as the high carry in Ruble compensate the risk while a short Canadian dollar is to hedge the oil price risk. We are long Norwegian Krone against Swedish Krona, the economic momentum favors Norway compared to Sweden.

 

Key allocation themes across our strategies

 

Emerging Market Debt : Balance of Brexit risks can favour EM debt

 

EM debt assets posted their third consecutive month of gains in August across Local and External assets – although there was a meaningful reduction in local currency returns on the month. EM External sovereign, corporate and Local debt returned 1.8%, 1.3% and 0.1% respectively. The month was one of two halves, particularly for local markets. The first half was characterized by a strong rally driven by continued inflows amidst a quiet summer market, continued chase for yield, as well as a market-friendly election outcome in South Africa. Sentiment turned more cautious in the second half, however, as Fed commentary made a September rate hike more plausible. Heightened uncertainty surrounding South Africa’s Finance Ministry meanwhile dampened sentiment, just as the election outcome had resulted in euphoria for the country’s assets.

Summary of cross-asset EM debt views:

 

Our high overweight conviction on EM hard currency debt relies on :

- Increasingly flexible exchange rates in Emerging markets ensure EM fundamentals enjoy a newfound in-built automatic stabilizer at time of external shocks, particularly from commodity prices

- EM external debt offers a yield pick up compared to developed market corporates for the same credit rating bucket

- Top picks at the moment are Brazil, Argentina, Russia and Indonesia where there has been substantial improvement in political landscape, combined with reducing external vulnerabilities and scope for fiscal reform.

Several factors justify our overweight position EM local rates:

 

- Developed market rates environment highly supportive

- Inflation expected to be within central bank targets in almost every country in EM (apart from Turkey)

- ensures central bank policy remains either neutral or with easing bias > positive for rates

- Enhanced credibility of inflation targeting regime in EM countries can lead to further flattening of rates curves

- Our top picks at the moment are Serbia, Malaysia, Brazil, Russia and Indonesia.

Neutral with small positive bias on EM FX:

 

- Valuations are attractive on long-term basis, particularly given improvement in current account balances

- Volatility of EM FX has declined compared to DM FX

- Sensitivity of EM FX to hawkish surprises in US rates has declined

- However:we can mention that EM central banks will dampen the pace of currency appreciation, but will allow it to freely float on the depreciation side in case of external shocks and that EM growth will still be constrained by a slowing China

- Investment approach:  

  • short lowyielding low-inflationary Asia block of China, Thailand, Taiwan, South Korea and Singapore as a hedge for negative tail risks from China 
  • long higher yielding currencies in EM such as IDR, BRL and RUB where currencies benefit from stabilizing commodity prices, gradual Fed hikes and sharp improvement in carry/vol ratio in EM FX compared to DM FX.
ADLER Dan , Amundi Smith Breeden
DEKTAR Daniel C. , Chief Investment Officer, Amundi Smith Breeden
JAUER Philippe , Fixed Income CIO at Amundi Singapore
GUIVARCH Patrick , Head of Insurance Solutions at Amundi
ARIE CFA Shinichiro , Head of Japanese FI at Amundi Japan
MORISSEAU Cédric , Head of Global Bond and Currency Management at Amundi
ALLIER Marie-Anne , Head of Euro Aggregate at Amundi
DARMON Thierry , Deputy Head of Euro FI & Credit, Head of Treasury & Absolute Return Management at Amundi
CROSNIER Laurent , CEO & CIO at Amundi London
BRARD Eric , Global Head of Fixed Income at Amundi

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