Central bankers start the year with a more hawkish tone

BY ERIC VANRAES

Monthly Fund Commentary
1 Mar 2018

BY ERIC VANRAES

In January, US economic data was mixed, with strong consumption figures on the one hand and disappointing employment, industrial production and housing data on the other hand. The major driver in the US market this month (as at 13/02/18) has been Mrs Yellen’s last Federal Open Market Committee (FOMC) meeting on 31st January, in which she mentioned wage growth and implied that it could prompt an upward revision of inflation forecasts.

In Europe, economic data was strong, with the exception of Italy. Business confidence continued to improve, led by stronger economic activity and lower unemployment. 

The first ECB meeting of the year, held on 25th January, was watched particularly closely by the market. Mr Draghi just for once remained unclear when mentioning the ECB’s intention regarding the euro’s value against the US dollar. As a result, the EUR climbed above 1.25 against the Dollar, with the Bund increasing from 0.57% to 0.70%. The ECB has confirmed however that monthly purchases will remain at EUR 30 billion per month between January and September 2018.

In this context, the US curve has continued to flatten:

  • the 2y US Treasury yield increased from 1.88% to 2.14% (+26bps),
  • the 5y rose from 2.21% to 2.51% (+30bps),
  • the 10y climbed from 2.41% to 2.71% (+30bps),
  • and the 30y decreased from 2.74% to 2.93% (+19bps).

In Europe, German yields increased, led by the 5y Obl which made it back to positive territory:

    • the 2y German yield increased from -0.63% to -0.53% (+10bps),
    • the 5y rose from -0.20% to +0.10% (+30bps),
    • the 10y Bund increased from 0.43% to 0.70% (+27bps).

    On the credit side:

    • the European iTraxx Main hardly decreased from 45 to 44bps,
    • and the US 5Y corporate CDX index barely decreased from 49 to 47bps.

    In Emerging Markets:

    • the CDX 10y EM index continued to decrease from 196 to 189bps (-7bps).

    STRATEGIC EURO BOND FUND

    During the month, the Investment Adviser decreased the weight of BMW 2020 and sold the remaining stake in General Electric FRN 2020. Further, the team sold Eni 2020, Vodafone 2021, Telekom Austria 2021, Deutsche Telekom 2021 and Gas Natural 2025.

    At the same time the team increased the weight of Engie 2023 and bought two new issues: Enel 2026 (green bond) and Exor 2028 (both hedged by an increase in the short Bund position). As a result, the modified duration decreased sharply from 1.9 to 1.2. In terms of portfolio diversification, the Fund held 29 issues from 29 issuers.

    STRATEGIC GLOBAL BOND FUND

    Throughout the month, the Investment Adviser has been very active, managing the duration overlay. On 10th January, the team sold 10 long bond futures and 30 10y note futures. Later in the month, on 29th January, before the FOMC meeting, the team at first bought back 20 10y Notes and later sold 25 10y Notes. As a result, the modified duration decreased from 5.4 to 3.8. In terms of portfolio diversification, the Fund held 29 issues from 27 different issuers.

    STRATEGIC QUALITY EMERGING BOND FUND

    During the month, the Investment Adviser managed the duration overlay of the Fund in line with the strategy adopted by the Strategic Global Bond Fund. The team sold 10 long bond futures and 60 10y notes. The portfolio’s entire Brazilian exposure was sold following the country’s sovereign rating downgrade to BB-, despite higher issuer ratings held by the Fund. Vale 2022 (Ba1/BBB-), Embraer 2023 (Ba1/BBB), Fibria 2024 (Ba1/BBB-) and Suzano 2026 (BB+) were replaced through an increase in the weight of Bharti 2024, Enap 2026, Gazprom 2034 and Indonesia 2048. During the month, three new issues were bought: BDO Unibank 2023 (Bank, Philippines), OCP 2024 (Chemicals, Morocco) and Enel Americas (Utility, Chile). Finally, the position in Phosagro 2021 (USD 1 million) has been exchanged with the new issue maturing in 2023 (USD 1.5 million).

    In terms of geographical breakdown, the top 3 countries were Mexico (14.4%), Russia (11.5%, the weight was increased as the Investment Adviser believes Russia will be upgraded to Investment Grade soon) and India (11.2%). The rating allocation was 72.3% Investment Grade, 16.8% Crossover (BB+ and BB) and 10.9% cash.

    The breakdown of the portfolio in terms of market allocation was 85.2% Emerging Markets and 3.9% Developed Markets (i.e. Luxembourg/ArcelorMittal). In terms of sector allocation, the team favoured Materials (23.7%) followed by Energy (21.7%) and Governments (18.4%). The modified duration has decreased substantially from 5.3 to 3.8. In terms of portfolio diversification, the Fund held 33 issues from 33 issuers.

    OUTLOOK

    The Investment Adviser’s outlook remains tied to two major topics, inflation and Central Banks’ behaviour. In Europe and the US, inflation is historically low and is likely to persistently remain below target. Central bankers’ comments in January however suggested that inflation could be higher than expected in the months ahead.

    The Investment Adviser decided to substantially reduce the funds’ durations before the publication of the Non-Farm Payroll figures on 2nd February. Should Mrs Yellen’s expectations about wage increases materialise, the Investment Adviser would not hesitate to decrease the funds’ durations further. A potential decrease would thereby be a tactical rather than a strategic move, as the team still believes that the current economic situation in the US is probably at a turning point, at which equities are becoming less attractive and long Treasuries more interesting, despite increasing volatility due to lower Quantitative Easing policies.

    In Europe, tapering remains the main concern. As a result, corporate spreads could suffer substantially. The steepening of the Bund curve could persist, driven by inflation fears in the US and a too strong euro against the dollar.

    In the US, the Investment Adviser still believes that long US Treasuries (10 to 30 years) will become increasingly attractive. The team thinks that they could be a top performing asset class in 2018 and that an inversion of the curve’s slope is not excluded at the end of the year. Any correction would be seized by the Investment Adviser as an opportunity to add positions for a medium-long term strategy (outright and/or purchase of 30y bonds hedged by a short 5y future position).

    The Investment Adviser thinks that the major risk in the Treasury market does not come from macroeconomic data but from cash flows. Due to Mr Trump’s tax reform, the Treasury Department will need to issue more than USD 1 trillion of debt in 2018 (against 488 billion in 2017). Should an auction of Treasury notes fail, US yields could rise sharply. This case would depict a good opportunity for the team to purchase government bonds at very attractive yields. Going forward, the Investment Adviser strongly believes that US yields could climb higher. That being said, the team anticipates this increase to be rather moderate and short-lived, as too high 10y and 30y yields would lead to an economic slowdown, or worse, a recession in 12-18 months.

    The Investment Adviser will continue to closely monitor the behaviour of Emerging Markets’ resilience in order to seize any opportunity to reinvest in high beta names. The team thinks that the latter still offer a very attractive risk-reward profile and continue to be supported by low defaults, attractive carry and low supply.

    In conclusion, the Investment Adviser perceives the best performing asset class in the short to mid term to be high quality Emerging Markets, but in case the 10y and 30y Treasuries reach 3% and 3.2% respectively, long dated US Treasuries would constitute a strong buying opportunity.

    The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 13/02/18 and are based on internal research and modelling.