Super-Mario and the “whatever it takes” rule

BY ERIC VANRAES AND PASCAL PERRONE

Monthly Fund Commentary
17 Dec 2015

BY ERIC VANRAES AND PASCAL PERRONE

In November, the markets were looking for clues in central banks behaviour (their speeches in the media, in particular) before the ECB meeting scheduled on 3rd December and the FOMC decision on 16th December. With China remaining a major issue and Emerging Market economies still suffering due to record low commodity prices, global growth remained a concern. Terrorist attacks in Paris added stress in both markets and the European population. In this gloomy environment, the good news came from Argentina and its new President, Mr. Macri.

In the US, economic statistics were encouraging, led by the non-farm payroll number which reached +271k (unemployment rate 5%). In addition, the first signs of wage inflation appeared. PPI (-0.4% this month, -1.6% yoy) and CPI (0.2% this month and 0.2% yoy) were weak but ex-food and energy numbers were more in line with the Fed target (PPI +0.1% and CPI +1.9%). Q3 GDP (annualized qoq) reached 2.1%, revised up from 1.5%. The only disappointing data was consumer confidence, falling from 99.1 to 90.4. Consequently, the probability of a Fed rate hike in December increased dramatically (to above 70%).

In Europe, moderate German data was offset by the Spanish, Italian and French recovery (with a surprising Q3 GDP figure reaching +0.3% in France). Mr. Draghi and other ECB members confirmed that the ECB may expand its QE policy if current market conditions continue to weigh on inflation. As a consequence, the ECB is more than ever ready to increase (i.e. to expand or to extend) substantially its QE program and to reduce its deposit rate which is already in negative territory (-0.20%) at its 3rd December meeting.

In this context, the 2y German yield decreased from -0.32% to -0.42%, the 5y yield decreased from -0.08% to -0.18% and the 10y Bund yield fell from 0.52% to 0.47%. On the credit side, the US corporate CDX index widened from 79 to 84 bps due to the first signs of recession in some sectors of US industry and the European iTraxx Main stayed broadly unchanged, from 71 to 70 bps, led by the euphoria preceding the probable increase of the ECB’s QE in December.Bund yield fell from 0.52% to 0.47%. On the credit side, the US corporate CDX index widened from 79 to 84 bps due to the first signs of recession in some sectors of US industry and the European iTraxx Main stayed broadly unchanged, from 71 to 70 bps, led by the euphoria preceding the probable increase of the ECB’s QE in December.

In November, following the strategy implemented since June, the Investment Adviser continued to favour high quality and liquidity. He focused his attention on the decrease of the weight of bonds maturing between 2022 and 2023 in order to decrease the short future position in Bunds as a duration overlay policy as the long 10y credits/short Bund future position does not add value in the current environment. He sold Engie 2023 and Allianz 2022. At the same time, he bought the following high-quality short term corporates: Ford Credit Europe September 2016, Würth 2018, Siemens 2018, WoltersKluwer 2018 and Terna 2018. Finally, as planned in November he took profit on the position of 2 million EUR VW 2018, sold at 1.6% (when spreads were Bund +190 bps, ASW +168 bps). This position had been bought in September at 2.27% (when spreads were Bund + 250 bps, ASW +228 bps).Bund future position does not add value in the current environment. He sold Engie 2023 and Allianz 2022. At the same time, he bought the following high-quality short term corporates: Ford Credit Europe September 2016, Würth 2018, Siemens 2018, Wolters Kluwer 2018 and Terna 2018. Finally, as planned in November he took profit on the position of 2 million EUR VW 2018, sold at 1.6% (when spreads were Bund +190 bps, ASW +168 bps). This position had been bought in September at 2.27% (when spreads were Bund + 250 bps, ASW +228 bps).

The Modified Duration of the Fund has been held around 2.5 and the duration overlay policy has been maintained with a short position of 250 Bobls and only 60 Bunds (compared to short 280 in September and short 350 in August). In terms of portfolio diversification, the Fund held 51 issues from 46 different issuers.

The Investment Adviser believes that the ECB will stay ultraaccommodative and that Mr. Draghi will announce an increase of the ECB’s QE in December. Economic conditions are not significantly improving in the Eurozone with low growth and, more importantly (as it is the unique mandate of the ECB) zero inflation. Growth is a concern because the current conditions are disappointing despite the alignment of planets (low euro, low yields, low oil & commodity prices and ECB’s QE). Regarding the Fed’s policy, the FOMC meeting’s decision on 16th December is clearer: a first rate hike is likely but the perception of the markets is more important. A “dovish tightening” (i.e. a rate hike with no strong conviction) could be well received by the markets. More importantly, the key driver of markets (both bonds and equities) is Forex: the currency war is still in place as many central banks are still in ultra-dovish mode, including China and Japan. Consequently, the dollar index (Bloomberg ticker DXY) is more than ever the major factor to follow.

The Investment Adviser is still extremely cautious on corporate spreads and on liquidity of the credit market. He will continue to focus his investments on PSPP and high quality corporates. High beta names will be avoided except very short maturities with a “buy and hold until maturity” strategy. The modified duration of the Fund may be maintained around 2.5. The Investment Adviser will pursue this strategy during the following weeks and still believes that positive returns will be achievable as a result of the carry of PSPP bonds and high-quality corporates, their spread tightening potential, credit selection and active management of duration and yield curve

The views and statements contained herein are those of Sturdza Private Banking Group in their capacity as Investment Adviser to the Fund as of 11/12/15.