The markets’ over-reaction to one month’s rising inflation trend in the US has been a key issue as euro bond fund managers reassess their portfolios. The rallying of the 30-year bond brought the yield back under 6% at a time when many market observers had convinced themselves that the US stock market had peaked and that bond yields would continue rising amid fears that the Fed was behind the curve in its attempts to check inflation.
Some analysts did call the markets correctly in suggesting that the marked increase in US consumer prices in April would not be carried through into May. Accordingly, they questioned the need for an increase in interest rates under inflationary aspects. Fed chairman Alan Greenspan, testifying before the joint economic committee, sent a clear signal to the markets and stated that it is “useful to pre-empt forces of imbalance before they threaten economic stability”. He added that there is “no immediate evidence” of an acceleration in core inflation in the US economy.
The credit and equity markets were relieved that Greenspan did not sound the alarm about an upcoming series of aggressive tightening moves, while the dollar saw some potential support tied to interest rate differentials evaporate.
It is interesting at this point to see the differences in investment policy of euro bond funds. Marc Polydor at Union Banque Privée in Geneva suggests that he hasn’t been surprised by recent events: “Much of the data in the US already pointed to a slowing economic momentum so the interest rate reduction in October was not necessary to sustain the economy and we expect a reversal of that move over the summer.”
Daniel Knuchel, head of fixed interest at Credit Suisse Asset Management in Zurich, explains the changing European fixed income strategy thus: “Towards the end of May we moved to a slight overweight duration exposure and reduced our overweighting of the one to five-year sector and switched into the very long end of the euro yield curve. The major reasons for this move were the fact that the yield curve had steepened sharply over the preceding two months and we had reached our initial target. On the inflation side the stabilisation in the price of oil combined with weakness in industrial commodities suggested that we would not have a sustained uptick in the headline inflation figures. Finally market polls suggested that managers had cut back duration aggressively in May.”
With all the negative news in the price, UBP increased the duration of institutional portfolios and mutual funds in mid-June. “The same goes for Europe,” says Polydor. “The Greenspan speech confirms these aspects and reiterates that the Fed maintains a pre-emptive stance and is not behind the curve as the markets had extrapolated. In our euro allocation we are a bit longer in duration at 5.2 years.”
The question remains whether and when the Fed will take the full 750bp back over the medium term. That will depend on the tightness in the labour market, the behaviour of wage growth, and the behaviour of productivity growth. Investec Guinness Flight’s John Stopford comments that bonds have staged a rally - ostensibly because a move from the Fed would dampen credit demand, but in reality because too many people were. He suggests the bond rally may well continue, given that too much bad news is discounted, “but my suspicion is that bonds will continue to underperform other assets. At least until late this summer”.
Credit Suisse’s credit strategy remains defensive, in particular in view of the heavy issuance of corporate bonds and the relatively low spreads offered in this market segment. Knuchel comments: “Eastern European markets still offer value in the future, but we suggest that investments are made only after some more consolidation.”
Credit research from Paribas highlights the changing composition of the euromarket. Corporate new issuance since the beginning of the year has outweighed issuance by either of the traditional sectors of the eurobond market, such as sovereign/supras or financials.
Corporate issuance totalled E35.8bn and Paribas notes that the size of the corporate sector is particularly surprising when viewed against another emerging asset class, the sub-sovereigns. These state and local government issues accounted for only E2.2bn of debt this year. The handful that have come to the market are Ville d’Aubagne, City of Copenhagen, Metropolis of Tokyo, Communidad Autonoma de Madrid, Province de Buenos Aires, Region of Sicily, Land Hessen, City of Rome and Municipality of Sofia. The principal corporate sectors issuing euro-denominated bonds are autos, utilities, oil and gas, telecoms and tobaccos.
Richard Newell is a director of Forsyth Partners