In September, all eyes were focused on the FOMC meeting and the Fed’s decision to raise or not its Fed Funds rate for the first time since the 2008 crisis. In Europe, economic figures were offset by the unbelievable Volkswagen fraud!
In the US, economic statistics were subdued. The strongest data point for the month was the record level of auto sales, which would be good news if these levels were reached without overly aggressive leasing offers (that could lead to another kind of “subprime” crisis). The month started with the publication of the Beige Book, mentioning that among the 12 regional Fed districts, 6 were arguing that growth was “modest” and the 6 others that growth was “moderate”. These comments tempered the publication of the Q2 final GDP growth, revised from +3.7% to +3.9% (annualized). The unemployment rate decreased from 5.3% to 5.1% but the change in non-farm payrolls was slightly disappointing at 170’00 instead of the expected 215’000. Inflation was still low, with a CPI at -0.1%, PPI at +0%. Retail sales were published at +0.2% (+0.6% prior month) and industrial production fell to -0.4% (+0.6% prior month). As expected, the FOMC’s decision was to keep rates unchanged (lower bound at 0% and upper bound at 0.25%). Ms Yellen’s comments were more surprising and disappointing. She explained that higher rates would be appropriate
later this year but that international developments (i.e. emerging markets and the Chinese slowdown) lead them to postpone the first rate hike. By delivering such an unclear message, she added more uncertainty while the markets were expecting clarity and strong conviction…
In Europe, moderate German data was offset by the Italian recovery. M. Draghi unveiled a revamp of QE and confirmed that the ECB may expand its QE policy if current market conditions continue to weigh on growth and inflation. The ECB also raised the share of bonds it can buy to 33% of each issue instead of 25%, adding that it is ready to make more adjustments to ensure the full implementation of the ECB’s QE program. In addition, the ECB reduced its growth and inflation forecasts through 2017 due to a weaker global outlook. These actions and speeches make clear that the ECB is fighting to bolster growth in the Eurozone and that its inflation target is still threatened by the drop of commodity prices, the deflationary effects of the Chinese slowdown and the PBoC’s monetary policy. As a consequence, the ECB is ready to increase (i.e. to expand or to
extend) substantially its QE program in the coming weeks or months.
In this context, the 2y US Treasury yield decreased from 0.74% to 0.63% (-11 bps), the 5y from 1.55% to 1.36% (-19 bps), the 10y from 2.22% to 2.04% (-18 bps) and the 30y from 2.96% to 2.85% (-11 bps). The spread 30-5y widened from 141 to 149 bps. On the credit side, corporate spreads behaved similarly on both sides of the Atlantic: the US corporate CDX index widened from 82 to 94 bps and the European iTraxx Main from 71 to 90 bps. The significant widening of the European index, (+19bps instead of + 12bps) was due to the poor performance of the European Automotive sector after the Volkswagen scandal, pushing European car makers spreads higher (Volkswagen 5y CDS from 75 to 261 bps, BMW from 66 to 110 bps, Daimler from 57 to 100 bps…). Liquidity continued to decrease sharply in the low quality universe (BBB, crossover, high yield, subordinated debt and hybrid bonds).
In September, following the strategy implemented since June, the Investment Adviser continued to focus on high quality and liquidity. He sold Korea Hydro & Nuclear Power 2022, Korea Gas 2024 and Hutchison Whampoa 2022 (decrease of Asia), WPP 2021 (decrease of BBB) and Bimbo 2024 (decrease of Mexico). He also sold the entire position in subordinated debt: Rabobank 2022 and EDF hybrid perpetual switched against the purchase of EDF senior 2019. He also bought short-term bonds such as Volkswagen 2016, Orange 2016, Pfizer-Wyeth 2016, Siemens 2018 and Linde 2018.
The Modified Duration of the Fund has been held between 5.2 and 5.5 and the exposure to the long end of the curve (30 years) has been maintained above 12% of the portfolio but above 45% of the duration risk. At month end, the Fund held 42 issues from 36 different issuers.
The Investment Adviser believes that the Fed will stay very accommodative. The first rate hike could occur before the end of the year or in early 2016 but the probability of a “wait and see” policy is increasing. Depending on the evolution of the US economy, which is weaker than anticipated and on the economic situation in Emerging Markets and first and foremost China, the probability of a QE4 in 2016 is increasing. The Investment Adviser believes that the major Central banks are now closely scrutinizing the Swiss and Swedish monetary policies with negative yields (-0.75% in Switzerland and -0.35% in Sweden) instead of massive QEs. In the case of the ECB, this solution is premature as the ECB’s QE represents only 5% of the Eurozone GDP but if the Fed has to ease its monetary policy in 2016, it could be tempted to experiment with negative rates instead of a QE4, as QE1, 2 and 3 already represent 25% of the US GDP. In this context, the Investment Adviser will continue to favour a flattening of the 5-30y slope of the curve with a target of 100 bps (149 bps at month end). He will continue to be very cautious in terms of corporate bond picking and will focus on high-quality liquid issuers, as liquidity is becoming a worrying issue. Depending on market developments, the Investment Adviser may maintain the duration risk of the Fund between 5 and 6. The Portfolio Management team will pursue this strategy (based on lower credit risk offset by above-average duration risk with a significant exposure to 30y US Treasuries) during the comings weeks and still believes that positive returns will be achievable as a result of the carry of high-quality corporates, their spread tightening potential, credit selection and active management of duration and the yield curve.