Developed markets positioning
We made marginal changes to our rates, currency and asset allocation views at the London Fixed income team’s monthly investment policy meeting on 11 November 2019. The most significant changes were our shift in European periphery exposure to neutral and our reduction in US dollar (USD) exposure. We discussed market concerns that the September spike in repo levels was indicative of potential turmoil for year-end liquidity. But our view was more sanguine, given the Federal Reserve’s shift to purchasing USD 60 billion of Treasury bills per month and the significant expansion of its balance sheet through the use of short-term repo facilities. Our outlook on rates was more negative because of the recent run-up and econometric models displaying negative trends in valuation. However, it is worth noting that the US-China trade conflict continues to dominate the overall rates outlook. Several risk factors are resurfacing and US President Donald Trump’s impeachment hearings only serve as a temporarily distraction from the trade conflict.
For Canada, we maintained our underweight duration view and reduced our overweight FX view due to the lower price of oil. A development that came to our attention was that Canadian short-term rates are now trading with a yield premium.
For Europe, we reduced our allocation to the periphery countries due to the extreme valuation levels they face in the wake of rising political risks. We remained relatively positive on our Italian exposure given the pullback in valuation and relative carry within the periphery. For the broader eurozone, we are still negative on core rate exposure because of the recent increase in negative views towards rates, and as the European Central Bank’s (ECB) tiering program is seen to have put a floor under European rates markets. However, our cautious view was balanced by a significant slowdown in German economic growth. The country’s Q3 GDP rose only 0.1% QoQ, narrowly avoiding a technical recession.
For Scandinavia, we discussed the Swedish Riksbank’s forward guidance, with the central bank signaling another rate hike this December. Although a rate hike would result in divergence with eurozone policy, we acknowledged the central bank’s desire to move away from negative interest rates. We maintained our overall neutral view on rates while retaining our overweight view on the Swedish krona as interest rate differentials are expected to increase. For Norway, we held our long duration positioning as few, if any, cuts by the Norges Bank are priced in. We expect the Norwegian krona to ease due to the retracement in oil prices and inflation. But rates, on the other hand, are likely to rally on the lower inflation outlook.
For the UK, we maintained our positive shift on the pound on the back of an increasing likelihood that the Tories will gain an outright majority at the 12 December election. We see an increasing risk of a potential surge in the pound, to a range above 1.35 dollars or even higher, with rates expected to sell off in tandem. A Tory majority increases the likelihood of a final Brexit by 31 January 2020.
In Australia and New Zealand, we remained cautious on duration in the Australian rates market, considering the flatness of the curve and outright yield levels. We believe that the notable pickup in the housing sector ought to generate a modest pickup in consumer behavior; as such, a further rally in rates (particularly in the back end) seems limited at this stage. We further cut our underweight allocation to the Australian dollar, locking in decent gains, as the prospect for a positive resolution to US-China trade negotiations increased, in our view, reducing the currency’s downside risk. In New Zealand, we remained on the sidelines, maintaining our flat duration exposure and market weight allocation to the local dollar. We feel rates are likely to be range bound for the time being, with the Reserve Bank of New Zealand on hold; meanwhile, the dovish central bank will limit the upside potential for the New Zealand dollar stemming from an improving external environment.
From an asset allocation standpoint we continued holding a negative relative value view on US credit versus its UK and EU counterparts. UK credit appears especially cheap because of the political risks associated with Brexit and the upcoming elections. We are also relatively positive on MBS and covered bonds due to their valuation levels.
Emerging markets positioning
Following their strong gains this year, we reduced duration in emerging markets again this month, given that major central banks are likely to pause monetary easing policies. We nevertheless maintain a slightly long overall bias, as emerging market valuations are still attractive relative to developed markets. In FX, however, we are relatively neutral overall, focusing more on relative value opportunities as uncertainty regarding US-China trade negotiations persist despite apparent recent progress. We remain somewhat skeptical of the two countries reaching a broader truce due to the structural nature of the issues at hand.
In FX, we remained underweight in the Malaysian ringgit as the economy is highly exposed to global trade developments. Malaysian exports, particularly in the electronics sector, are under pressure due to weak external demand. Another source of concern is the lingering threat of Malaysian bonds being dropped from FTSE’s index amid liquidity concerns gripping the domestic debt market. We increased our underweight position in South Africa amid waning sentiment surrounding the US-China trade deal. In addition, Moody’s could potentially cut South Africa’s credit rating status to junk, which is also a concern. Meanwhile we retain a slightly overweight stance in Poland, as we believe that country’s central bank will buck the global monetary easing trend and retain its interest rate differential relative to the eurozone, which is at attractive levels. We also reinstated our underweight exposure to the Singapore dollar given its sensitivity to sentiment over the US-China trade deal.
In rates, we have moved marginally underweight in South Africa, given the uncertainty over Moody’s ratings action, even though its real yields are still at significantly attractive levels. We also removed our long duration in Singapore considering its strong performance of late, particularly relative to US Treasuries.