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Fixed Income Letter - After the first 100 days of the Trump administration, what’s next for markets?

EDITORIAL

The election of Donald Trump as U.S. president five months ago presaged a sea change for markets, particularly those in the U.S. Market participants have been in discovery mode since then, trying to discern how much of the disruption and change promised by Candidate Trump will actually come to pass, whether via legislation, de-regulation or other executive action.

Our current view is that we still don’t know whether growth and inflation expectations have plateaued or whether they can improve further. However, we have learned a lot about the Trump administration’s capabilities in effecting its platform. So far improvements in markets have been driven more by sentiment and expectations and less by actual new policies or hard economic data.

 

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What is in store? As the chart shows (for tax policy), market optimism has faded in the legislative arena, where Congress has not yet backed the president’s agenda. This affects health care, tax reform, and deficit spending for infrastructure.

In contrast, optimism remains in the regulatory arena, where the Executive Branch has more discretion to act independently. Although very little has changed yet in terms of actual regulations, business sentiment indicators have risen and stayed higher since the election. JP Morgan’s annual reported cited “the expectation of a more business-friendly environment” as a supportive factor for its share price.

Trade policy is another area in which the new president promised dramatic change, with major implications for the distribution of jobs, revenues and profits, and the pricing of foreign exchange. Here too, expectations of change have diminished, for example as rhetoric around revising NAFTA grows less aggressive. Still, the administration continues to argue that trade deficits are directly linked to job losses, so we expect continued efforts to extract “wins” from our trading partners. Markets are waiting for further signals.

 

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OK, so what’s next for markets? We and many others had expected volatility as a disruption-minded administration came into power in Washington along with a united-party Congress that was likely to cooperate in areas of tax reform, health care reform and, perhaps, infrastructure spending. But the surprise has been a lack of disruption and major change. The good news for asset allocation is that, particularly in U.S. fixed income spread sectors, prices have risen and spreads have tightened to levels that are only likely to be attractive if current low volatility is sustained indefinitely, along with a continued expansion of the current business cycle. A relatively conservative asset allocation is now appropriate, with below-average exposure to riskier assets (including corporate bonds, asset-backed securities and commercial mortgage-backed securities in US fixed income). While riskier assets may continue to outperform in coming months, the risk of underperformance has risen with the tightening of spreads.

Government mortgage-backed securities are an excellent asset class, one which we recommend for any investor in dollar fixed-income over the long term. They have high credit quality and excellent liquidity. Part of the yield premium in this sector compensates for rate-driven changes in prepayment behavior. With interest rate volatility on the low side we expect that higher interest rate volatility, and reduced Federal Reserve purchases, will allow us to increase our holdings at better valuations in the medium term. In the mortgage sector, opportunities can arise quickly and we want to be ready.

On the interest rate front, there are a couple of clear tactical positions. First, U.S. real yields maintain an attractive advantage among developed country bond markets. The declining cost of currency hedging reflected in cross-currency basis swaps makes this advantage even more apparent to international investors. Second, there is scant premium for higher-than-target inflation in the U.S. An increase in U.S. long-term rates would likely be led more by inflation pricing than by real yields. The implication is that TIPS should be a significant strategic holding in fixed-income or multi-strategy portfolios at the expense of nominal Treasury bonds.

 

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Dan Dektar,

CIO Amundi Smith Breeden

CONVICTIONS

Global Bond: Attention turning to core European rates

Core rates have remained within a range since the beginning of the year. Trump’s failure to deliver and the French elections risk have kept yields under pressure.

Turning to fundamentals, the data flow has remained very good globally and it seems that we are, for the first time since 2010, in a global synchronous recovery of developed and emerging countries. Deflation and secular stagnation themes are in the past and the market is now questioning the margin of Central Banks to maneuver to normalize their monetary policy without triggering the end of this cycle. This environment remains bearish for bonds in the medium term.

However, in the short term, data might disappoint high expectations. In the U.S., positive surprises have essentially been driven by soft data, whereas hard data have remained subdued (and Q1 GDP should be closer to 1% quarter-on-quarter annualized rather than 2%). The risk is that the confidence indices might not sustain such high levels and converge down, thus implying a downward correction for economic surprise indices. Year-on-year headline inflation will also certainly drift down as the peak in the basis effect on oil prices is now behind us.

On the other hand, as we head towards the lower bound of the recent yield range, valuations look expensive. In the short term, the probability for a Fed rate hike in June is expected at 50% by the market, which seems fair considering the current uncertainties; however, further expectations seem too low, especially for 2018 and 2019. In the long term, the debate regarding the Fed’s balance sheet could also begin to put upward pressure on yields.

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In the Eurozone, after the French elections, assuming that Marine Le Pen does not win, the market should rapidly focus on improving fundamentals and prospects of normalizing monetary policy, i.e., the relative virtues of QE tapering versus raising rates (it is clear that ECB members have not yet found a consensus).

In terms of changing the relative trends of monetary policies, it seems to us that the focus should turn to the Eurozone in the second part of the year. Coupled with valuations, this argues for a shorter duration position for the Eurozone versus the U.S. Our estimates of term premiums also drove us to the same conclusion: the margin for upward correction on yields appears to be higher in the Eurozone.

As there appears to be no reason for a sharp acceleration of yields in the short term (but beware any unexpected Trump announcement), this environment remains favorable to emerging and credit bonds (especially euro financials).

 

 

Laurent Crosnier,

CIO Amundi London

 

Are emerging markets and Asian fixed income still a boon for diversification as we enter Q2 2017?

The historically low correlation of EM bonds to global asset classes is observable from the correlation matrix below. For global investors, both Asia-specific as well as more global EM bond strategies provide a strong portfolio diversifier given their attractive risk rewards and low correlation to the Citi World Government Bond index (WGBI) and Global Aggregate. Unfamiliarity and under-allocation by global investors also decreases the correlation of EM bond markets with global assets.

Within EM, Asia, being a surplus region, tends to have increasingly stronger within-region demand as in-region investors begin to buy into their own domestic fixed income markets. This strong technical bid will reduce correlation with global asset classes given the distinctive nature of Asian based investors.

 

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In the current environment where we are at the cusp of gradual normalization of low interest rates and after years of quantitative easing, it is increasingly important to focus on a more dynamic approach towards asset allocation. The Asian fixed income market and the wider EM bond markets have been providing exceptionally strong risk-adjusted returns over the past five years.

While the correlation of EM debt assets has historically not been high with other global asset classes, recent developments lead us to believe that the diversifying benefits of EM as an asset class will be even greater going forward. We have long been arguing that EM current account balances are undergoing significant improvement across the board. In fact, the average current account balance amongst EM majors is now at its highest level since the early 2000s. This has a significant implication for EM’s correlation with U.S. rates. Recall that the “Taper Tantrum” sell-off of 2013 was the most concentrated amongst the so-called “Fragile Five” of Turkey, South Africa, Brazil, India and Indonesia. Their large current account deficits left them exposed to portfolio flows, which are in turn driven by the global rates environment. The now much tighter current account balances in EM imply that periods of sell-off in U.S. treasuries should not have anywhere near as negative an effect on EM as it did in 2013. This was evident on the back of the Trump sell-off in U.S. rates in Q4. It is also well represented in the chart below:

 

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As such, there is a strong case for allocating to these asset classes in order to construct an efficient and well-diversified portfolio.

 

Philip Chow,

CIO Amundi Singapour

 

Strategy in Tokyo

Inflation seems to be coming back. Recently, prices of many goods and services increased mainly due to a weaker JPY and a rise in oil prices. Wage increases were not very strong in “Shunto” (spring wage negotiation) in general, so the purchasing power of households will remain weak and may weaken more in the coming months, which will keep the pace of economic growth very slow.

In this environment, it is too early to discuss the termination of QQE. BOJ Governor Kuroda confirmed the maintenance of yield curve control (YCC) again, so the JGB market has been very quiet and the 10 year yield has stayed within a range of 5-10 bps. As a result, 20 year and 30 year yields are also moving within a quite narrow range of 10 bps. In conjunction with the introduction of YCC, the BOJ announced that it would reduce the amount of JGBs to be purchased in order to tackle the potential shortage of net supply to make the purchase operation sustainable. Recently, the shorter end of the curve was affected by this change and the 2 year JGB yield moved in a range of 15 bps this year.

This provides us with opportunities to take positions based on relative value analysis.

  • Relative value positioning based on yield cushion analysis: long 2, 7, 10, 20 year at the cost of a deep short position in the 5 and 30 year.
  • Reduced some of the 2-5 year flattening position to take profit after a sharp increase in the 2 year yield

 

 

In addition to YCC, the BOJ seems to be signaling to the market that a negative corporate bond yield is not sustainable. As you can see in the attached chart, the BOJ has moved back to zero from the deep negative territory of the corporate bond yields it purchased, while the JGB yield is staying at the same level.

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Although we expect that the BOJ will continue to purchase corporate bonds, capital gains, which investors can expect by participating in the operation, should decrease significantly. We need to monitor whether this will change the investor sentiment or not.

  • Overweight in the shorter end of the Japanese credit sector while maintaining the weighted duration of the credit portfolio neutral.

 

 

Arie Shinichiro,

CIO Fixed Income Amundi Japan

 

Subordinates: The place to be?

For once, let’s take a moment and enjoy this: generally speaking, the economy is improving. True, we might have hoped for a more robust recovery after these past few lean years, but 1% to 2% growth is still something to be satisfied with. Unemployment has fallen considerably in the U.S., and tentative headway has been made on this front in Europe. Of course, we could still be disappointed as the Trump effect fades. In spite of all this, things are getting better.

So what are economists saying at this stage of the cycle? That eventually, with companies becoming healthier, interest rates must go up and spreads must go down. I will spare you the reasoning that leads to that conclusion.

Against this backdrop, what is the best exposure to the bond markets?

1 – to intermediate maturities, to avoid heavy duration exposure in case interest rates go up;

2 – to risk premiums that are subject to compression.

 

With those caveats, the natural conclusion points to hybrid, subordinate, and industrial bonds. The average duration is low at about five years, and the average premium is between 400 bps and 500 bps. So there is something to be expected in the event of narrower spreads. When you consider that banking sector margins are likely to improve with the re-steepening and greater regulator indulgence, there seems to be a convergence of factors in favor of hybrids.

And one last argument: if ever exogenous factors (in Europe in the short term) were to disrupt our best-case scenario, spreads would have to widen by about 100 bps to lead to a negative return on this segment. It could happen, but this does offer some protection.

To summarize, in these times of challenging allocations, there is at least one asset class expected to see an increase in net inflows in the coming months. Let’s not miss the boat!

 

Marie-Anne Allier,

Head, Euro Fixed Income Paris

Eric BRARD, Global Head of Fixed Income at Amundi
Laurent CROSNIER, CEO & CIO at Amundi London
Marie-Anne ALLIER, Head of Euro Aggregate at Amundi
Shinichiro ARIE, Head of Japanese FI at Amundi Japan
Patrick GUIVARCH, Head of Insurance Solutions at Amundi
Philip Chow, Fixed Income CIO, Amundi Singapore
Daniel C. DEKTAR, Chief Investment Officer, Amundi Smith Breeden
Dan ADLER, Amundi Smith Breeden

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Fixed Income Letter - After the first 100 days of the Trump administration, what’s next for markets?
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