Asset Allocation: The big picture
As the US economy continues to recover, the hour when the Fed starts to tighten is approaching. That precise date is, of course, one of the (known) unknowns confounding investors, although it is all but certain that it will happen this year, and appears to be securely linked to macroeconomic fundamentals. Stronger US economic data – such as January’s employment figures – bring the date nearer, while economic worries tend to postpone forecasts.
Even the euro-zone has been enjoying improving economic health, with business sentiment remaining around the 100 mark. According to the EC, this positive development has been “fuelled mainly by more optimistic consumers”, no doubt buoyed by the benefits of the 50% drop in the oil price.
While not all agree with ECB President Mario Draghi’s enthusiasm for the growth picture in Europe, most forecasters concur that Europe is emerging from its long recession. This time it might have more significant implications for the pace of rate hikes from the Fed, as it has become clear over the past few years that the US is more sensitive to international influences than before 2008.
However, things may not be that straightforward. The ECB, and possibly the Bank of Japan too, are now easing pro-cyclically, adding liquidity to already recovering economies. Thus, the significant downward pressure exerted on US rates by international bonds (ie, Bunds) throughout last year is now lifting, and the Fed could find US financial conditions tightening rather quicker than previously forecast without doing much itself.
EM credit – an uncomfortable year ahead?
The first quarter of 2015 has been fairly tempestuous for emerging market (EM) credit on nearly every continent. It is an uncomfortable list and reads like something from the bad old days – involving, corruption, murky politics, defaults and military conflict and has involved some of the most significant EM economies.
Bond markets in Russia, the CIS and Ukraine have all been badly damaged by the conflict in eastern Ukraine, currencies have depreciated dramatically and the almost inevitable ratings downgrades have been announced. In fact most Russian issuers have now moved down into HY territory, and the almost decade-long trend of an ever-increasing investment grade share within the Barclays US EM index looks like coming to an end this year.
There have been other headline-grabbing downgrades too. Moody’s two-notch downgrade of all Petrobras debt threatens to send that company into high-yield status. Moody’s cited “increasing concern about corruption” for its action, as well as the fact that accountants had refused to certify the company’s accounts. And the ramifications could spread to the Brazilian economy at a time when recession could be looming, and its own investment grade status is under significant pressure.
Turkey’s sovereign investment grade ratings are also under pressure, this time because the independence – and credibility – of the central bank appears to be being compromised by murky politics.
The events surrounding China’s Kaisa Group, a property company, have also been damaging, engendering an uneasy sense among investors that the problems at Kaisa imply a wider problem, and not just within the beleaguered property sector, but perhaps elsewhere in the highly leveraged corporate sector.
EM today has moved on from its tumultuous past, and is less prone to panic and contagion. There is still plenty of good news, both at the macro level – India, to name one star economy – and from many well-run EM corporates. But defaults are sure to increase, and 2015 will certainly be a very challenging year.
US Treasury yields are more sensitive to economic influences, surely a healthy development from last autumn – as far as market participants are concerned – when they had apparently zero sensitivity to any economic data, good or bad, but instead a complete dependence on copious central bank liquidity. Longer-dated US bonds, without the anchor of immovable short rates, look set to exhibit more volatility, as the Fed continues to ready the market for its first rate hike.
Since the start of 2015 there has been a significant divergence between US long rates and those within the euro-zone. The clarification of the ECB’s QE, the Public Sector Purchase Programme (PSPP), appears to be aiding not only this trend, but also a convergence of long rates within Europe.
While there is a modicum of consensus on whether US long rates, in particular the 10-year, ought to rise further, the outlook for German 10-year rates seems less clear. The bond bulls argue that, despite some signs of reflation in the euro-zone economy and a notable increase in the euro 5Y5Y breakeven inflation rate, one effect of the PSPP will be to increase net aggregate demand at the longer end of the Bund curve – where yields remain over the -20bps lower limit for ECB purchases.
The bears, on the other hand, argue that 10-year Bund yields are much lower than where they ‘should’ be, based upon macroeconomic fundamentals, spreads with other major bond markets and technicals, even after factoring in the potential downward pressure from the PSPP. One bearish argument dwells on the very low prevailing interest rates: Goldman Sachs estimates that the duration of outstanding Bunds with remaining maturity greater than 10 years is now about 60% higher than its 1995-2010 average. And in its view, this suggests that the yields on long-dated Bunds offer a “remarkably poor” risk-adjusted return.
The euro has already fallen 20% in the past 12 months, a magnitude of decline similar to the 26% fall it experienced in the two years following its launch in 1999. However, despite the diminishing threat of deflation coupled with sustainable economic growth at last coming to much of the euro-zone, there has been little impact upon the consensus that the euro will weaken further.
It appears that although there are increasing international flows into European equities, most of the euro exposure is being hedged. And although it seems clear the PSPP will indeed support European bond markets as demand will outstrip supply (Europe’s net issuance is turning negative, particularly in Germany), it is possible that the quickest sellers of bonds to the ECB will be foreigners who will probably also sell their euro proceeds. European banks, significant owners of European government bonds, have actually been buyers of bonds this year, and it is not obvious whether they will turn around and become big sellers.
Two-year euro rates have been below both US dollar and UK sterling rates for many months, and now they are trading through Japanese yen rates. This trend is unlikely to reverse in the near term, so it makes sense to wonder whether the euro will be increasingly used as a funding currency.
Corporate America has been gradually increasing its offshore issuance in euros for several years and last month one US company issued the largest ever euro-denominated Reverse Yankee.