The US Federal Reserve (Fed) has maintained a dovish outlook despite signs of stabilisation in economic data, in particular solid gains in employment. Even with a 25-bp rate cut at the end of July, as well as an earlier end to balance sheet reduction, further cuts are still possible should the economy fail to improve. However, market expectations had strengthened, pricing in up to three 25-bp cuts for the remainder of the year. Fed Chair Jerome Powell’s hints of a shallower cutting cycle is likely to leave investors disappointed, at least in the short term. Meanwhile, trade tensions between the US and China continue to dominate sentiment, with a resumption of trade negotiations yielding little progress. The US yield curve has steepened marginally of late, reducing fears of an imminent recession, but sentiment remains fragile. We continue to believe that recessionary concerns in the US are overblown given that consumption remains relatively robust and financial conditions have eased considerably since the start of the year.
Following the end-of-May European elections, where, as expected, populist parties gained ground at the expense of the continent’s long-standing political centre, the EU voted on the appointment of the influential committee heads. Christine Lagarde, currently managing director of the International Monetary Fund, was nominated to succeed Mario Draghi as European Central Bank president, and will now be responsible for setting the course of monetary policy. Meanwhile, Ursula von der Leyen was elected to succeed Jean-Claude Juncker and become 13th president of the European Commission, responsible for proposing legislation, implementing decisions and upholding EU treaties. Having lost their combined majority, however, the mainstream centre-left is unlikely to secure as many of the top posts, which had in the past four decades allowed it to set the course of legislation. Despite the legislature becoming more fragmented, polarised and perhaps more unpredictable, a solid performance of both the Liberals and Greens will continue grant pro-European parties a strong workable majority.
On the economic front, the most recent data suggest activity within the Eurozone continues to ease, as a slowdown in global growth resulting from China-US trade tensions appeared to have filtered through to the euro area manufacturing sector. Lower growth and softer inflation outlooks eventually led outgoing ECB President Draghi to suggest in a June speech in Sintra, Portugal that, unless inflation improves, more stimulus (by means of interest rate cuts and/or bond purchases) will be needed. This pushed both the euro and European bond yields sharply lower. As widely expected, rates were kept on hold at the latest ECB meeting. However, Draghi affirmed a dovish bias, stating that ‘a significant degree of monetary stimulus continues to be necessary to ensure that financial conditions remain very favourable and support the euro area expansion’. This led the rate market to price in approximately 25bps in additional monetary policy easing in the next 12 months, with the first cut expected as early as the upcoming meeting on 12 September.
In Australia, economic momentum and inflation remained weak. GDP growth has been running well below trend in the past few quarters, coming in as low as 0.4% on quarter in Q1, supported mainly by exports, non-mining business investment and public expenditure. Weak growth in household consumption and investments was understood to have been the main drag on economic performance. Frail economic momentum and a rising labour force participation rate saw a slight uptick in the rate of unemployment, suggesting a moderate build-up in labour market slack. This, together with subdued inflation and a deteriorating external environment, afforded the Reserve Bank of Australia the leeway to deliver a second consecutive policy rate reduction. The RBA cut rates by a quarter of a percentage point to 1% in a move that was widely expected by market participants. If the slack in the labour market continues to build, further monetary policy easing might be appropriate.
In New Zealand, following a widely expected policy rate cut during its May meeting, the Reserve Bank of New Zealand’s Monetary Policy Council decided to keep the Official Cash Rate (OCR) unchanged at 1.5% at its June meeting. An easing of domestic growth in the past year on the back of softer house prices and subdued business sentiment resulted in feeble domestic spending. The RBNZ believes that low interest rates and higher government expenditure will boost economic activity and employment in the coming quarters. Inflation is also expected to converge to the 2% mid-point target, in line with a tightening labour market. In the meantime, however, given the uncertain nature of global economic momentum and the risk of ongoing subdued domestic growth, a lower OCR may be needed, potentially as early as during the upcoming August meeting, to maintain employment near its maximum sustainable level and anchor inflation (and expectations of inflation) near the target.
Following a couple of years of solid growth in Norway, spare capacity continued to gradually diminish. Domestic economic activity has been supported mainly by the past strength of external demand, higher oil prices and low domestic interest rates. While the weakening external environment recently saw a modest easing in economic activity, the pace remains close to its potential. The gradual reduction in spare capacity has also led to a modest build-up in inflationary pressure, with the latest underlying CPI coming in at an above-target 2.3%. Given the strength of the domestic economy, the Norges bank decided to hike the policy rate by 25bps to 1.25% in June. In the coming months, a cautious approach is likely, as uncertainties related to trade tensions continue to weigh on external demand.
In Canada, the latest escalation in trade conflicts continued to put pressure on the domestic economy, with trade restrictions introduced by China directly impacting Canadian exports. That said, the removal of steel and aluminium tariffs and improving prospects for USMCA ratification are likely to boost exports and investment, partially offsetting the negative effects of US-China trade tensions. As such, the Bank of Canada sounded confident that the slowdown in late 2018 and early 2019 was temporary, and indicated that it expects a pick-up in economic activity starting from Q2. The strength of the labour market also suggests that businesses perceive the recent weakness as transient. The most recent data release showed a mild deceleration in inflation, yet the pace remains above the BoC’s tolerance threshold of 2.0 (+/-1%). Given the weak external backdrop, the BoC will nevertheless remain on hold for some time still, preserving its data-dependent bias for determining the future path of interest rates.
The general expectation at the start of the year was that the major central banks were likely to continue to tighten liquidity in 2019 through rate hikes and/or balance sheet reduction. However, the situation now looks materially different given the increasingly dovish turn by the Fed, culminating in a 25-bp rate cut in July, with the possibility of further cuts this year. In addition, ECB President Draghi is hinting at a likely rate cut coupled with a possible resumption of asset purchases in September. We see these developments as positive for emerging market bonds, particularly those supported by sound fundamentals, as they will continue to receive support from international investors. The moderate growth slowdown of developed economies also makes growth in emerging economies attractive on a relative basis. Furthermore, the slowdown in China, which has fed its way through the emerging world, is already well accounted for. We still have to consider the possibility of a prolonged US-China trade war, despite positive rhetoric between Presidents Trump and Xi at the G20 meeting, as tariffs of 25% are still in place on USD 200 billion of imports from China to the US. At the same time, China is utilising a number of stimulus measures to help offset the impact of tariffs. Given the strong performance of emerging markets so far this year, and elevated expectations of developed market monetary stimulus, some near-term caution is likely warranted, but the medium-term outlook remains rosy.
Developed Markets Positioning
The investment team made no changes in duration positioning in the model portfolio, but did make a few notable changes in FX positioning. In particular, the team lowered its US dollar positioning to neutral, while reducing its underweight on the Australian dollar. The team noted a correlation between the continued escalation of Trump’s trade war with China and action taken by the Fed, with the Fed’s interest rate cut now giving way to expectations of a full-blown easing cycle. Global central banks have become far more dovish, with short rates moving aggressively downward in anticipation of further easing in the autumn.
The ECB remained at the forefront of discussions, as continued deterioration in European macro data have led the continent’s central bank to signal a new easing cycle and a restart of the European Asset purchase program. The team also noted concern on the switchover to Christine Lagarde, and noted that next steps for the ECB could include fiscal easing. The team maintained neutral positioning in core duration given the prevailing negative yields, but also given the continued bond rally on the back of hawkish ECB expectations. The team maintained positioning in the periphery with an overweight exposure on the view that ECB aggressiveness will benefit the relative carry in Italian bonds despite the rising political risks.
For the US, the team maintained its neutral view on duration, as concern over increased dovishness in Europe has been equally offset by the lack of weak economic data in the US. Given the Fed’s shift to an easing bias, the team adjusted its overweight in the USD to neutral, noting the potential limited upside for the dollar from here. In Canada, the team raised its positioning by 25bps to offset its underweight in AUD.
For Northern Europe, the team maintained a relatively positive view on NOK given rising inflation. While noting that muted oil price appreciation will limit further upside, the team could not ignore recent hawkishness by the Norges Bank. As for Sweden, the team believes the Riksbank will ease market expectations of a rate hike in the autumn, and it has maintained its slightly positive position in the positive event of a move.
For Sterling, the team has maintained its neutral position on the extreme binary risk of no-deal/deal Brexit. The team reduced its underweight in AUD in order to take profit on previous positioning. However it maintained its underweight bias on further dovishness from the RBA and the secondary effect from the ongoing US/China trade conflict. The team maintained its New Zealand positioning due to higher relative local yields, but noted that both AUD and NZD will move in tandem on the increased China risk.
Emerging Markets Positioning
In emerging markets we remain highly constructive on duration overall, given the increasingly dovish rhetoric from the US Fed and the ECB, with further rate cuts by the US Fed expected over the coming months and still-high real yields in many emerging local currency bonds. In FX, however, we remain cautious due to ongoing weakness in global growth, particularly in the export sector. And we remain skeptical regarding a potential trade truce between the US and China due to the structural nature of the issues at hand.
In FX, we remain underweight the Malaysian ringgit and Singapore dollar as both Malaysia and Singapore are highly exposed to global trade with exports, particularly in the electronics sector, and are under pressure due to weak external demand. We increased our exposure to Poland as higher inflation will result in its central bank bucking the global trend of monetary easing.
In rates, we remain long in high-yielding currencies such as the Mexican peso and the South African rand, and, to a lesser extent, the lower-yielding Malaysian ringgit, as real yields in Mexico, South Africa and Malaysia are still significant. Mexico, in particular offers considerable value with elevated real yields, currently almost 4% higher than the current rate of inflation.
In recent weeks we have become more cautious on European credit. We have observed that both macro and micro fundamentals have weakened, and that the micro deterioration in particular has been accelerating. As a result the team has been focusing on purchasing bonds that are not easily affected by this macro and micro data. We have noticed a trend that banks are making it harder for corporates to receive loans, while they have been more flexible toward consumers. However, net demand for loans has not changed. Additionally, we would point out that the focus on default rates which has emerged in the market is somewhat of a red herring. Technicals have shown encouraging signs and we have seen significant inflows into European credit this month. That said, the overall tone regarding European credit is significantly less constructive than in previous months and we expect Q3 to be a difficult quarter.
In Asia, we have seen solid performance in recent weeks. Since Trump’s announcement of the 10% tariff, spreads have widened. On the macro front, USD strength was a negative for Asia Credit and FX. In terms of broader economic data from the region, PMI numbers have trended downward and import/export numbers have been subdued, notably in Korea and Singapore. Elsewhere, we have seen central banks in India and Thailand cut rates. Perhaps the event which gained most attention because of its political risk was the protests in Hong Kong. We continue to carefully watch the situation and its effect on spreads. On the micro front, reported earnings so far indicate that earnings growth remains solid across most sectors. Leverage in the IG sector has remained stable, but HY debt levels remain high for Chinese property despite resilient earnings. On technicals, IG supply has picked up in recent months but has remained manageable with HY supply being strong and likely to continue. Overall, we see technicals turning more neutral. Regarding valuation overall, we expect spreads will widen with the escalation in trade war tensions. Sentiment towards HY is likely to hinge on broader market developments. Otherwise, we are taking a cautious approach on the region and reducing risk.
In Australia, we view the economy to still be quite resilient, with some improvement in sentiment since the surprise re-election of the Scott Morrison government. Despite low unemployment (5.2% with an increasing participation rate), the RBA cut rates by 25bps in each of May and June to spur the economy and ‘kick-start’ inflation. The Australian dollar is being pressured down to lower levels, as currency and trade wars come to the fore and expectations build for further rate cuts. On the micro front, there is little negative news or areas of concern regarding the impending reporting season. Australian corporates remain reasonably leveraged compared to their overseas counterparts. With regard to technicals, a broad array of issuers, both local and offshore, have come to the market and been well-received, with recent activity dominated by financials. Supply has been more than met by demand. In terms of valuation, cash and synthetic credit spreads had been tightening, but the start of August has seen a widening. Volatility has also risen. While current spreads provide some protection against widening, a sustained risk-off period could result in substantial under-performance.
For the US, current macro indicators appear on the surface quite negative, with heightened political risk and forward concerns on economic growth. Whilst we accept political risk has increased, we would be skeptical of any suggestion that growth is slowing given the healthy job market and record low unemployment, all while labour participation is increasing. High employment rates are significant, as they support consumers, who form an important part of the US economy. As a result, we are more balanced on our macro view in the US with regard to macro indicators. On the micro front, default rates are marginally ticking up, although the remain well below the long-term average. We have seen some larger issuers succumb to market pressure, which is either a sign of the stage we are at in the credit cycle or that time is running out on these credits. In terms of technicals, we have seen continued strong flows into both IG and HY. In IG, supply continues to increase, but larger credits are focusing on deleveraging. Meanwhile, the outstanding amount in HY continues to decline. In terms of valuation, the Fed is being particularly supportive of IG credit. We take the view that going down the capital structure, as opposed to credits, is the way to make smart spread enhancements.
Lastly in Japan, on the whole not much has changed. Fundamentals are still satisfactory, with a slight decline in earnings and valuation on the expensive side. We expect the Bank of Japan to accept a -0.25% range for the 10-year government bond, given other central banks are on an easing path. On the micro side, we expect worsening earnings for some credits, especially among lower-rated names. As such, we will avoid names that are prone to volatility, and will instead purchase corporate hybrids. The idea is that, instead of buying a corporate with a BBB rating, through a corporate hybrid bond you purchase a higher-rated name with the same return.