After over 10 months of positive performance in bond markets, February and March represented challenging months, in the wake of the sharp rise in yields that impacted bond markets across the globe. The recent bout of macro-economic improvement, combined with a sharp uptick in inflation, saw core rates move upwards, with the US 10-year widening to over 1.5% while the German Bund reached -0.3%. In this context, the other fixed income markets also suffered, with spread products bearing the brunt. Indeed, high yield and emerging markets were among the most impacted asset classes, in spite of commodity-market support. It is in the US that the acceleration in the activity cycle is most pronounced, with the country leading the other economic zones in the recovery phase. The high levels of fiscal support are the clear drivers of a rebound in macroeconomic data, with more stimulus to come, following approval by Congress of the $1.9 trillion package, $1.2 trillion of which is to be deployed in 2021 itself. Although the rebound in inflation from previously depressed levels is also more pronounced in the US, it is also present across the other G4 countries. While we do expect the increase in inflation to continue, we believe that it is unlikely to turn the current rise in rates into a rate hike from the central banks in 2021. This has been confirmed by the stance of the FED and the ECB, who have re-iterated their intention to continue their QE programmes and accommodative stance. The Fed in particular has also expressed its will to adopt a more flexible attitude towards inflation, allowing higher inflation levels to persist before acting. We hence recognize that the increase in core yields is likely to continue in the short term and prudence is warranted in this context. Should rates rise moderately, on the back of good macro data and the steady rise in inflation, we expect the “risk-on” mood to return to markets, which will continue to be reassured by the central bank backstop and be encouraged to “buy the dips”. However, if the rate rise is sharp, resulting from an overheating of the economy – which is not our central scenario – this could result in further dips on the IG credit, emerging-debt and high-yield markets.
Negative stance on US rates, with a steepening bias
The return of growth and inflation is welcome in the US, and could – on the back of the additional fiscal stimulus that has been approved by the House of Representatives – continue. Joe Biden’s agenda will be focused on additional fiscal stimulus and should hence provide vital and much-needed support. There is little reason to think that the Federal Reserve will not pursue its low-rate policy and bond-purchase programme. From past Fed moves, the first rate hikes typically come after considerable communication on a possible tapering of the QE programme as well as a number of FOMC meetings on the whole tapering process. It is thus unlikely that the central bank will engage in a hiking cycle just yet. In this context, we expect US rates to continue to move upwards. However, we also take note of the fact that technicals are quite negative, as the short positioning on US rates is quite strong. Indeed, the market appears to fear that the future strength of the economy might be so strong as to force the Fed into hike rates. Given the context, we hold a negative view on US rates. We also hold a positive stance on US inflation-linked bonds, on the back of a more supportive inflation cycle and favourable break-even carry. The inflation cycle is, further, benefiting from the strong base effects (the 1-year inflation rise is based on low levels in March and April 2020) and the oil-price rise. The break-even inflation carry for US BEI trades relative to Euro BEI continues to be more favourable.
On the other hand, we took profit on our long Australian rates position, and our view on the segment is now neutral. Our previously positive exposure to New Zealand rates has been reduced to negative, on the back of some positive economic data, the tapering of monetary support in the form of scale backs in central bank asset purchases and a less attractive carry.
In Europe, the focus has shifted to easing containment measures in a balancing act between public and economic health, while the vaccination race against the clock gains traction and encounters multiple obstacles.
Overall, cyclical indicators, both on economic activity and inflation, are supportive. In spite of the fact that the budgetary cycle is less supportive of core European countries, monetary support – driven by the asset purchase programmes – remains strongly positive. Over past weeks the ECB showed more concerns about rising real rates than the FED and the BoE. Therefore further verbal intervention and some increase in the pace of PEPP purchases can be expected in the coming weeks. This will continue to be a driving force of technicals for 2021, as net flows for Euro sovereigns will remain negative, also supported by EU issuance, which will also lighten funding pressure on sovereigns. In this context, we continue to hold an underweight position on core Eurozone markets (particularly in Germany). In our EUR funds, we are underweight duration via US rates as the latter have more potential to underperform in relative terms.
Peripheral sovereign markets continue to be supported by fiscal and monetary policies, with the strong presence of the European Recovery Fund and its sizeable grants for non-core markets. Supply could turn supportive from Q2 onwards and, in relative terms versus core, flow dynamics are also improving for non-core countries. Positioning remains a negative driver, with investors still mostly long on peripheral markets. The return of Mario Draghi as Italy’s prime minister has drastically changed the political landscape and comes with broad political and public support while offering political stability in the short term. We have further increased our exposure to Spain and Italy (against a reduction in EUR IG credit exposure).
Developed Market Currencies: Neutral USD
Our proprietary framework continues to point towards a negative view on the US dollar, on the back of rising twin deficits. The Fed’s rate cuts, QE programme and dovish stance also point to a weaker dollar. However, with the improvement in growth and the potential rise in economic activity, the Fed is likely to be more patient in the short term and not immediately add more stimulus. In this mixed context, the Dollar could see respite, following a period of weakness, thereby justifying our neutral stance.
Out short position in the AUD is tactical and we believe that the central bank (RBA) will keep its accommodative stance in the coming quarter. Trade relations with China are quite difficult at the moment, and this is a risk, as China is an important trade partner. Ît is also a good hedge versus other high-beta currencies in the case of a period of risk-off sentiment. Finally, we are maintaining our long NOK/short SEK. The Norges Bank has adopted a hawkish stance, on the back of better inflation prints, paving the way to a potential rise in rates. The Swedish central bank, on the other hand, has opted for quite a different approach, having extended and increased its QE programme in December and become more verbal on the strength of the Krona. It is really cautious on the impact on inflation.
Credit: Favouring European markets
Credit markets came to an abrupt halt in 2021 as a sharp rise in core yield credit, particularly in February, led to a negative performance of the asset class, a significant portion of which came from the rise in yields, as spreads remained relatively unchanged. While we continue to operate in a low-yield environment, it is clear that the substantial fiscal and monetary support and the vaccination programmes across the globe will lead to markets anticipating improvements in the macro-economic outlook. Furthermore, the rally in commodities has also driven inflation levels upwards, thereby supporting the increase in rates. A potentially stronger economic context and continued commodity-market recovery could lead to a further rise in rates and potentially affect credit markets. We, however, believe that this phenomenon is likely to be short-lived, as any yield-widening is likely to be capped by the presence of the ECB's QE programme, which will probably continue. Furthermore, as valuations become more attractive, investors are likely to continue to pile into the asset class. Fundamentals are looking better than expected for the asset class and the fiscal support provided across the globe could lead to spread-tightening.
EUR & US Investment Grade: Spreads are vulnerable to a modest rise in rates in the near term, as the long positioning and stretched valuation appear at risk. However, we do not expect this weakness to continue throughout the year. Higher yield will attract more buyers to the asset class. Improving medium-term perspectives – thanks to rapid advances in curative and preventive solutions against COVID-19, as well as ample monetary support – have decidedly weighed in the balance of risks. Issuer fundamentals, too, are improving and we expect more rising stars over the course of the year. Deleveraging is underway, as balance sheets – also! – are improving. In this context, we have slightly reduced our positive view on the EUR IG segment by moving to a neutral stance on EUR IG non-financials. The Euro financial sector should benefit from the rising rates and the steepening that has taken place. On US IG, we have moved to a negative stance, as duration is long (8 years). We expect a seasonal spike in supply in March, though, overall, supply should remain the same as last year.
EUR & US High Yield: The asset class suffered from volatility as a result of rising rates, but there are still reasons to be positive on high-yield markets, which should be supported by a relatively attractive carry in a low-yield environment. The macroeconomic picture is increasingly supportive and developments on the (moderate) vaccine roll-out front are positive, as are the rising oil prices. However, the stretched levels of yield, and rising rates (especially if the increase is sharp) do provide a challenging market. In this context, we prefer to adopt a neutral stance on the HY asset class.
Finally, we think EUR convertibles should benefit from positive dynamics such as the coordinated action from EU Next Generation Recovery Fund, positive surprises/better visibility from quarterly results, less political noise than in the US and some China economic recovery. However, once again, we have reduced our overweight view in the context of the recent correction, though we remain positive on the asset class.
EMD: Positive on emerging currencies
Overall, this month our Global Macro score is neutral-to-slightly-negative, mainly due to the risk of higher US rates. Global risk appetite looks overstretched and could reverse. EM risk appetite is less of a concern, being robust but not in overly enthusiastic territory. Global liquidity remains abundant, although rising US real yields are bringing about a de facto tightening of financial conditions. PMIs in China have turned, in line with the expected cooling-off of activity, with China leading the recovery from the COVID-driven recession. The credit impulse, although continuing to slow, remains positive. Oil prices should stabilize, on expected increase in OPEC output (which hasn’t materialised yet). Industrial metals to be supported by infrastructure spending, but more supply is coming on stream. Precious metals are pressured by the US real yields rise. Fundamentals remain positive for all segments, except for local duration, in line with the phase of the cyclical (recovery) we are in. Inflation has started to rise, with the exception of CEE, where it is falling from elevated levels. Fiscal revenues are surprising on the upside, mainly on the back of a higher commodity windfall. Monetary policy is signalling hawkishness but, after the recent sell-off, price hikes appear excessive. Growth is still held back by lower advances in vaccination, although EMs are participating in the global recovery. Subdued domestic demand and the fast recovery in DM are ensuring that external surpluses remain large. Technicals are more challenging for EM sovereigns, with high positioning, high supply and outflows, on the back of negative YTD returns. Valuation has deteriorated for local rates, with real rates and the spread vs the US having compressed. In HC, there is value versus equivalently rated US credits, supporting relative valuations, whereas absolute valuations are stretched. We hold a cautious stance on EMD LC rates while EMFX remains supported by cheap valuations and gains, in terms of trade, especially for commodity exporters, but we maintain a diversified funding base between the EUR, the CNY and the JPY. Corporates are preferred to sovereigns, due to higher spreads, lower duration and lower-than-priced-in default rates.