Business as usual
With the news that job growth is indeed happening in the US, it’s back to business as usual. “The market’s sell-off in response to the March payroll figures was logical,” agrees SGAM’s Paris-based head of fixed income Eric Brard. “Our strategy team has argued that the US economy was clearly in recovery mode and to not see job creation would have been most surprising.
“We have gone through this period where the fruits of recovery, ie, increasing employment, were not shared; it was more important for companies to repair and enhance their balance sheets before embarking on a phase of hiring. To see that 308,000 US payroll number indicates this economic recovery is ‘normal’, hence the big sell-off in US Treasuries these last few days.”
Johnny Debuysscher, fixed income CIO at Belgian group Petercam agrees that fairly reliable indicators of future job growth had already been seen. He explains: “Through the jobless claims data and ISM surveys, we have seen that employment should improve. And if we compare today’s trends with what happened in 1994 we see that the non farm payroll number lags the jobless claims.”
For other managers, the arrival of the first set of figures showing a rise in employment, even one as large as 300k, is not enough to completely persuade them that a US economic recovery is well underway. “To be honest, I do not really trust those numbers,” says Martina Kocksch, senior portfolio manager fixed income at Cominvest. She continues, “For sure the headline number was big, but within it we see the working hours and wages actually coming down. Though I do not disagree that the recovery is underway I remain sceptical about the job growth.”
“I think the Fed’s ‘missing link’ has been found,” asserts Debuysscher. “Although I agree with this idea that the market will wait a bit to see if it will stay. If next month’s payroll comes in around 200,000 then that would be reasonable, and helpful.”
Debuysscher, like many market participants, admits that although the large number was a bit of a surprise and that a figure nearer 200,000 was the consensus prediction, he remains sanguine as he and his colleagues were well prepared for it and their portfolios were comfortably short of their duration benchmarks. In fact it appears that the majority of asset managers did indeed take this particular market lurch in their strides having already positioned their portfolios short of their duration benchmarks.
Asset manager surveys such as those conducted by JP Morgan have highlighted for some months that managers have been duration-underweight. “So we and our peers were short duration, and on the other side we have all those Asian central banks who, as we are all very aware, have been huge buyers and who have been the strongest influence on Treasury yields over the last four to six months,” asserts Debuysscher. “There will also have been some playing of the yield curve, shorting at 1% and being long the 10-years for 4% and these guys, the hedge funds for example, would have been quick to unwind these carry-trades when this (jobs) news came out.”
“We have been underweight in Government bonds for the whole of this year,” says Kim Pessala CIO of Evli Investment Management in Finland. “Although we recognise that it may take some time until we will see any tightening in the key rates, we think that the fundamental set-up will speak for higher rates in the long run. The main factors pushing yields higher will be: employment growth in the US picking up; the Bank of Japan changing its intervention policy which will mean that some time in the future they will stop buying US Treasury bonds; the worsening US budget deficit situation; and the prospect that ultra low rates globally and synchronised global growth will push inflation up at some stage. The Fed just has to come out of its corner at some point and start tightening.”
Indeed the team at SGAM had taken the precaution of buying additional protection for their portfolios in the form of put options in the weeks before those now infamous payroll numbers. Brard argues the market may well continue to be quite jittery over the coming weeks and that he and his team have no current plans to move their portfolios away from their current duration underweight status.
“We have some issues that we would like to clarify before we change our direction,” continues Brard. “For example, what is the fundamental/macro economic environment of the market – will we see additional growth and job creation? And what about the reaction of the central banks – we think this is a turning point, but what will the Federal Reserve do if we do indeed have job growth?”
Even the payroll sceptics like Cominvest’s Kocksch were correctly positioned. She explains: “Yes we have positioned ourselves short of our duration benchmarks, not hugely so but enough. As I said we do believe that the US recovery is underway and that rates will be raised, but I am not convinced about the jobs’ growth. I strongly believe that we need more confirmation, one number does not help us.” Kocksch and her team are sticking with their forecast that the market will not get its first rate hike until end-December or maybe early next year. At the time of writing, the futures market was pricing in a Fed hike some time in the third quarter.
“Our key word this year with our bearish strategies in government bonds is ‘patience’, comments Pessala. “We have been only marginally short duration in our fixed income portfolios thus far. We want to ensure we benefit enough when yields eventually do start rising. When we see the trend in yields move higher and we start to challenge the levels we saw at the beginning of January, that will be our trigger to move more underweight.”
That the Federal Reserve will raise rates within the next nine to ten months is, argue managers, almost certain. What the ECB will do in the coming months is rather less clear. On news of the payroll figures in the US, the euro futures market moved away from pricing in as much as 50 basis points of cut in the near term to perhaps 25 bps. Even this is not taken for granted. Debuysscher explains why he feels that cutting now would not necessarily help the euro economy. “If the ECB pushes rates down from 2% to 1.5% is this really going to be good for consumption and the economy? The situation we have in Europe is very different to that of the US. Here we have high savings’ rates and if rates are nudged lower might this not push savings higher and consumption lower? This is clearly what we have seen in Japan with rates at zero – although it has been good for corporate Japan, it has been a negative for the consumer.”
There is general agreement that bond yields in the western world will continue to track those of the US, in spite of rather different economic conditions particularly in Europe. “We will certainly not be seeing such strong economic growth in continental Europe,” agrees Brard. “And there are more supports for the bond markets but not enough to break that strong correlation we have between US and European yields.”
So, underweight the bond markets of profligate governments, but what about credit? After such a strong showing in 2003, it seems unlikely that credit will offer so much this year. Investors, having enjoyed the ride in 2003, are not quite ready to bail out of credit even though spreads are so tight. Debuuysscher explains his reasoning, “Yes, credit spreads are very low. But is this a reason not to buy? Look at from 1993 until 1997 – spreads stayed low for a long time. We think they could also stay low now, perhaps for a really long time like 18 months?” Although still long credit, Debuysscher and his team have cut down on that overweighting.
Evli’s Pessala agrees, saying: “At this point we do not think that spreads will narrow any more against government bonds. We are still modestly overweight high yield bonds, as indeed we were throughout 2003. I agree that we could have a similar period to what we experienced in high yield bonds in the US in the mid-1990s. We will sit and get the high coupons from our high yield bonds in the ‘carry is king’ environment.”
Kocksch again puts in a word of caution. “There is this huge search for yield. I get uncomfortable when I see too much appetite for all these risky assets. I have this uneasy feeling that I have seen this before in the emerging markets.” And Kocksch may be better qualified than many, having been in Brady bond sales and trading in those scary years of 1997 and 1998.