Developed Markets Positioning
In the US, trade tensions with China continue to dominate risk sentiment, with an apparent respite in tensions seeing sentiment improve this month. The US and China resumed trade negotiations in October. As a goodwill gesture US President Donald Trump agreed to delay the imposition of an additional 5% tariff on USD 250 billion of Chinese imports (from 25% to 30%), scheduled to go into effect on 15 October. President Trump also said the two sides had reached a ‘Phase 1’ deal, which could take a few weeks to finalise, in which China would buy USD 40–50 billion of US agricultural products annually. The US Federal Reserve (Fed) cut rates by 25 basis points (bps) in September, as widely expected, yet continued to push pack against the aggressive easing cycle demanded by President Trump. Fed Chair Jerome Powell referenced the ongoing strength in the labour market and stable inflation expectations as a rationale against more aggressive action, insisting instead on data dependency in determining future policy actions. Meanwhile, a formal impeachment inquiry was ordered against President Trump by House speaker Nancy Pelosi following an alleged cover up of a phone call with Ukrainian President Volodymyr Zelenskiy. We still believe that recessionary concerns in the US are overblown as the yield curve, though concerning, does owe much of its flatness to global factors, such as quantitative easing from international central banks, and as US consumption remains resilient despite the global manufacturing slowdown. As for the positioning, the team decided to increase our overweight allocation to the US dollar, as economic activity remained resilient despite a notable deceleration among the other key trading partners. A sell-off in rates during the month, however, offered a tactical opportunity to marginally extend duration in anticipation of a pullback in the coming months.
Within the Eurozone, recent economic data suggests that activity continues to weaken, with the manufacturing PMI slipping to 45.7 in September as German factories experienced their worst month since the global financial crisis. Not surprisingly, industrial production also disappointed in July, falling 0.4% m/m and declining 2.0% y/y. Despite some moderation of late, services continue to be a relative bright spot, with the latest PMI index still indicating expansion at 52. On the inflation front, the early estimate saw the headline gauge slip again to a below-consensus pace of 0.9% y/y in September. The core measure ticked up to 1% y/y, yet remains subdued and well below the European Central Bank’s (ECB) official target of close to 2%.
Given the very weak domestic economic activity and lack of inflationary pressure, the ECB delivered further monetary accommodation by means of a 10bps cut to the deposit rate facility (to -50bps), at the same time reviving its asset purchase programme at a pace of EUR 20 billion per month for an unlimited period of time. The ECB also eased lending terms for the euro area banking sector, whilst also introducing tiered interest rates on banks reserves held at the ECB, in a bid to ease pressure on the sector's lending margins.
Italy's left-wing populist Five Star Movement's unlikely coalition with the more centrist and EU-friendly Democratic Party won the approval of the county's president Sergio Mattarella. Meanwhile, Spain is now set to hold a general election on November 10th, the fourth time in as many years, as the caretaker Socialist Prime Minister Pedro Sánchez failed to win the backing of other parties in order to form a workable majority coalition. We remained comfortable holding an underweight allocation to the EUR, given the ongoing slowdown in economic activity and a general a lack of inflationary pressures to speak off. We did, however, decide to reduce our exposure to Italian local bonds, locking in a decent profit, following a marked tightening in the spreads.
UK Prime Minister Boris Johnson and the EU agreed upon new Brexit terms in mid-October. Prime Minister Johnson is now tasked with finding support for the Brexit deal from the British Parliament. Momentum seemed to have continued slipping on the economic front, resulting in the team's decision to extend duration in anticipation of the ongoing support for the gilts market.
In Australia, following a marked loosening of financial conditions on the back of easier monetary policy, the latest set of economic indicators showed tentative signs of a pick-up in economic activity, notably in the domestic housing market. Lower mortgage rates, loosening in credit rules, and improved valuations have seen a recovery in auction clearing rates and a pick-up in investment lending, in turn putting upward pressure on house prices, particularly in the hotspots of Sydney and Melbourne. Inflation also remains subdued, despite the Q2 consumer price index coming in at an above consensus pace of 1.6% y/y. The latest labour market report showed further signs of strength, with a domestic employment expanding at an above consensus pace of 34,700 in August. Yet a marginal pickup in the participation rate saw the rate of unemployment tick higher to 5.3%. The Reserve Bank of Australia (RBA) lowered the official cash rate by 25 bps to a record low 0.75% early in October after the higher unemployment print fuelled easing expectations. Given a tentative recovery in the underlying economic activity in Australia, the team decided to pare back our long duration exposure, while reducing our underweight allocation to the Australian dollar (AUD) itself.
In New Zealand, recent data continues to show a mixed picture. The labour market remains tight, evidenced by solid employment growth, which led to a sharp drop in the rate of unemployed persons (3.9%) and, in turn, a marked pick up in wage growth. Inflation expectations, however, continue to ease, with 2-year forecasts dropping to 1.86%, lows last seen in late 2016. Following the larger than expected 50bps cut to the policy rate in August, the Reserve Bank of New Zealand (RBNZ) decided to keep rates on hold during its September meeting, allowing time for the lower policy rate to transmit to lower retail lending rates for both households and businesses. Despite the pause, the RBNZ reiterated that there "remains scope for more fiscal and monetary stimulus, if necessary, to support the economy and maintain our inflation and employment objectives".
In Norway, spare capacity has gradually diminished following a couple of years of solid growth. More recently, however, a weakening external environment has seen an easing of economic activity, with September Manufacturing PMI falling to a mere 50.4 from 53.9 the prior month. The key behind the decline in manufacturing activity appears to have been a significant weakening in new orders, which eased to 48.7, whereas production and employment remained in expansion. Headline inflation also eased of late, coming at a below consensus pace of 1.6% y/y. More importantly, however, underlying inflation remains above the central bank’s target of 2% y/y, thus leading the Norges Bank to raise the key policy rate by 25 bps to 1.5%, its third hike this year. Given the weakening of both the domestic and external environment, the Norges Bank will likely take a more cautious approach to interest rate setting in the forthcoming periods. A potential dovish turn justified the team’s decision to extend duration exposure in the local bond market, at the same time bringing the FX allocation back to m/w.
In Canada, trade restrictions introduced by China in retaliation to US tariffs are having a somewhat negative impact on the country’s exports. Still, the removal of steel and aluminium tariffs and the awaited United States-Mexico-Canada Agreement (USMCA) ratification are likely to boost the country’s exports and investment. As such, the Bank of Canada (BOC) expressed confidence that the slowdown in late 2018 and early 2019 was temporary and that a pick-up in economic activity is underway. The strength of the labour market also suggests that businesses perceive the recent weakness as transient. Tight labour market conditions continue to pass through to higher pay, with the average hourly wage rate for permanent workers growing at 3.8% in August. Despite weakening globally, domestic price pressures persist, with the latest reading of core inflation remaining slightly above the central banks 2% target. This led the BOC to ascertain that the degree of accommodation provided by the current policy remains at an appropriate level.
Emerging Markets Positioning
For Emerging Markets (EM), the general expectation at the start of the year was that the major central banks were likely to continue to tighten liquidity by hiking rate hikes or through balance sheet reduction (or a combination of both) throughout the year. However, the situation now looks materially different given the increasingly dovish turn by the Fed, culminating in a second 25 bps rate cut in September, with the possibility of more this year, as well as the ECB, with President Mario Draghi announcing a 10 bps rate cut coupled with a resumption of asset purchases in September. We see these developments as ongoing positives for emerging market bonds, particularly those that are supported by sound fundamentals, as they will continue to receive welcome support from international investors. The moderate growth slowdown of developed economies also makes growth in emerging economies look more attractive on a relative basis. Furthermore, the loss of momentum in China, which has fed its way through the emerging world, is already well accounted for. However, we still remain cautious regarding the prolonged US-China trade war and with tariffs now in place on the majority of US imports from China. Meanwhile, China continues to utilise a number of stimulus measures to help offset the impact of tariffs to a certain extent. Despite the August sell-off and hence improved currency valuations, we feel that near-term caution remains warranted given the ongoing trade uncertainty. Nevertheless, the medium-term outlook for EM remains highly compelling. Additionally, the team decided to include China in its coverage this month due to its increasing importance within global indices.
In Europe, pockets of deterioration remain in the macro side, particularly in PMI data, exports and consumer confidence. In our view, this trend is unlikely to reverse as we go into Q4, and our current scores and views on European Macro are at an all-time low. Additionally, the US is also expected to implement tariffs on European goods, including autos, in November, which again paints a bleak outlook for overall macro and spreads. Focusing on the micro picture, taking the credit universe as a whole, credit defaults are benign. For leverage we see a marginal tick up in investment grade (IG), but in the high yield (HY) space fundamentals are looking weaker. Distressed credits/bonds are trading well into default areas. Merger and acquisitions are down 22% for the year, and most activity is still funded by cash as opposed to debt and therefore creates little concern. Domestically lower gross supply in both IG (USD 1.1trillion gross FY19E, down 12% from 2017) and net HY running at its largest shortfall (-USD 91.5 billion) in recent years continue to generate a positive supply-demand dynamic. This is complemented by the primary market activity in European credit, where a number of issuers have tapped the market since the start of September with large over subscriptions. This has been beneficial to spreads, in addition to anticipation towards the second round of the ECB's Corporate Sector Purchasing Program. Lastly, on valuation we see that in the IG space primary deals are well inside of initial price thought (IPT), pulling the market somewhat tighter. HY spreads are just outside fair value range but are quite rich relative to historical levels. It is worth noting that the threat on valuation as a result of volatility is still a concern due to the rising risk of volatility on the back of political events.
In US credit, YTD performance has been strong with IG and HY through Q3 returning 12.9% and 11.5%, respectively, although the majority of the spread compression took place in January as credit markets retraced the sell-off in the 4th quarter of 2018. To that end, following the rally early in the year, spreads have been range-bound and ended Q3 close to midpoints (+122 for IG and +402 for HY). Although current spreads are near the midpoint for the year, the rally in Treasuries has driven yields below 3% in IG and 6% in HY, representing 3-year and 2-year lows, respectively. HY yields were slightly lower during a brief period in September, but current yields have not been this low since the beginning of 2018. With unattractive yields and strong YTD performance, we remain skeptical about market participants’ appetite for risk going into year end. It is through this lens that we evaluate the technical and fundamental backdrop to form our near term view on US credit.
Strong technicals remain the driving positive force in US credit. Continued accommodative central bank policies have reduced the amount of positive yielding, investable debt globally. And with central bank corporate bond purchases being renewed in Europe, US Corporate debt has become one of the few remaining market with the size and liquidity which offers investors some return for their investment. Domestically, lower gross supply in both IG ($1.1tn gross FY19E, down 12% from 2017) and net HY running at its largest shortfall (-$91.5bn) in recent years continue to present a positive supply-demand dynamic.
The US macro backdrop remains mixed, but positive in net terms. GDP growth continues, employment data remains positive and the US consumer remains robust. The global overhang continues led by trade disputes, Brexit and geopolitical turmoil, which has weighed on sentiment. Fundamentals also reflect a market deceleration, as S&P 500 3Q earnings expectations are down 4.1%, a continued decline from -0.4% in Q2 and -0.3% in Q1. Credit metrics have stabilized to some degree. Net leverage has ticked higher to 2.5x for IG and was flat for HY at 3.9x. Anecdotally, in IG we have seen more rational balance sheet management from the largest debt issuers. Thus one wants to stay invested from both a top-down and bottom-up perspective, but signs of caution cannot be ignored.
Given the length of the current expansion, market participants are receptive to signs that the US is nearing the end of the economic cycle and are thus positioning portfolios more defensively. This is evident in the credit markets with CCC's (+6%) underperforming BB's (+13%), the worst relative performance for CCC's in any non-recession year. Highly levered firms are unlikely to show strong demand for debt, and we expect firms with structural and secular issues to continue to seek restructuring. We expect defaults to continue, led by the energy and wireline industries. Current expectations are for the default rate to end the year around 3%. Our outlook is for a continued trading range in credit without a meaningful move tighter or wider, with little to no demand for the weakest credits. We are very constructive on the banking sector, which is at its healthiest point since the global financial crisis. We advocate for continued investment in higher quality defensive industries within both IG and HY. Our process has led us to focus on firms that are building necessary infrastructure, notably telecoms and utilities. Within this framework we are more comfortable moving down the capital structure into subordinated debt in defensive industries as opposed to taking risk in more cyclical industries. We think that this balanced 'constructive but cautious' approach is appropriate for the remainder of 2019.
In Asia, USD strength continues to be a negative for Asia FX and Credit and overall sentiment within the area is somewhat subdued due to trade war tensions. As a result, export-import numbers have been negative and PMI data within the region also continue to disappoint. Inflationary pressures in the region have been mixed. Headline CPI inflation prints in India, Singapore and Indonesia rose, while similar gauges of consumer inflation fell in South Korea, Thailand and the Philippines. Lastly, consumer confidence has been broadly stable, although this could turn weaker given the recent backdrop mentioned earlier. Moving onto Micro, earnings growth remains decent across most sectors, including Chinese HY real estate. Some moderation in earnings growth is likely in 2H 2019, but we do not expect an earnings recession in Asia. Leverage in the IG space remains broadly stable but leverage in HY is more of a concern, as debt levels remain high for Chinese property despite resilient earning. Additionally, HY default rates are likely to remain elevated in the 2–3% range and present an additional worry. Credit spreads have tightened, prompted initially by greater policy support from China and some positive developments on the US-China trade front. There has also been a meaningful increase in primary market activity. Issuance volume rose in September as risk sentiment stabilised. The high-grade space saw 43 new issues amounting to about USD 21.6 billion in September, including a three-tranche USD 2.5 billion issue from ICBC and a two-tranche USD 1.25 billion issue from CK Hutchison. Meanwhile, the HY sphere witnessed 36 new issues amounting to about USD 10.4 billion. As we enter the last quarter, there is still an overhang of uncertainties arising from renewed trade war tension, geopolitics, tight market liquidity and an increase in idiosyncratic noises from various credits. These factors, however, are offset by easy monetary policies and still supportive fund flow. Given the relatively strong YTD return, we believe most participants will be less willing to chase risk. Hence, the market is likely to be range bound, depending the outcome of the trade talk.
In Australia, The economy remains resilient although the outlook is less convincing. There is some improvement, however, in the Sydney and Melbourne housing markets after the RBA conducted a 25 bps rate cut in May and June. The RBA eased again in September, cutting the cash rate to a record low of 0.75%. The central bank highlighted downside global risks and structurally lower global interest rates, adding that geopolitical uncertainty has caused firms to hold back on investment. The Australian dollar continues to experience downward pressure, with currency and trade wars at the fore and as expectations are building for further RBA rate cuts. Despite a slightly negative tone in some sectors, the reporting season has not generated major concerns. Australian corporates remain reasonably lowly leveraged compared to their overseas counterparts. A broad array of borrowers has come to the market, being met with a positive response. Recent issuance activity has been dominated by financials, both local and offshore. Demand has exceeded supply. Cash and synthetic credit spreads have tightened this year although August saw some widening. Volatility has risen. While current spreads provide some protection against widening, sustained risk-off could cause substantial underperformance. The Aussie iTraxx looks to be in fair value relative to its offshore counterparts.
Lastly, we remain selectively constructive on LatAm, particularly relative to other regions. This is not too surprising, as in general LatAm is more focused domestically while other regions have US-China trade tensions have impacted other regions. Therefore we prefer to focus more the domestic orientated businesses instead of names influenced by global forces, in particular commodity producers. However, within this sphere we still favour oil producers that are able to gain market share given the sanctions impacting other regions—Petrobras being an example. Elsewhere, we still have an affinity for Mexican names that are leveraged into the US consumer and we continue to monitor this space for investment opportunities.