BY ERIC VANRAES & PASCAL PERRONE
US fixed-income markets performances in January exceeded expectations as economic data was disappointing in all segments except housing and consumer confidence. Weakness in the ISM Manufacturing index continued and improvement in employment paused. After having shifted to “patient” mode, the Fed indicated that it would not normalise its monetary policy before June, international developments being cited as the main consideration for not increasing interest rates.
Despite anticipation of further disinflation effects in the near term, the Federal Open Market Committee (FOMC) expects inflation to rise gradually to its 2% goal over the medium term. With most Central Banks becoming more accommodative and fears of prolonged incertitude in Europe, long end Treasury yields reached new lows. In addition, following sluggish global macro indicators, the International Monetary Fund lowered its forecast for global economic growth to 3.5% in 2015 and 3.7% in 2016. In Europe, the European Central Bank (ECB) announced its first Quantitative Easing (QE) program with EUR 60bn monthly liquidity injections in Eurozone sovereign, supranational and agency bonds form March 2015 to September 2016. This program will increase the ECB’s current balance sheet by almost 50% to more than EUR 3 trillion representing 10% of Eurozone GDP. Risk sharing will be limited to 20% as national central banks will be doing most of the buying. This QE will potentially ease further interest rates in sovereigns, supranationals and agencies but also already creates extra demand for corporate bonds. Should these measures prove insufficient then the ECB may opt for additional QE programs as in the US, or increase liquidity injections similar to Japan. The Swiss National Bank decided (ahead of the ECB QE announcement) to abandon its cap imposed on the Swiss Franc and lowered its deposit rate to -0.75%. This move saw the Swiss currency appreciate massively and sent yields to historical lows.
The US government yield curve resumed its bullish flattening. The 2y US Treasury yield decreased from 0.66% to 0.45% (-21 bps), the 5y from 1.65% to 1.15% (-50 bps), the 10y from 2.17% to 1.64% (-53 bps) whilst the 30y decreased from 2.75% to 2.22% (-53 bps). As a consequence, the 5-30y spread (strategy implemented in the Fund at 151 bps) tightened from 110 to 107 bps. On the credit side, the US corporate Markit CDX Index slightly underperformed the European iTraxx main Index due to the correction in the Oil & Gas sector. The CDX moved from 66 to 70 bps and the ITraxx Index tightened form 63 to 60 bps.
The US government yield curve resumed its bullish flattening
Assets further increased during the month from USD 115.7 to 123.7 million. The strategy of the Fund was significantly adjusted with a major diminution of credit risk and an increase of duration risk. Credit risk has been decreased with the sale of Emerging Markets government agencies (Development Bank of Kazakhstan) and Emerging Market Oil & Gas issuers (whole exposure to Pemex, Ecopetrol and Petronas-Malaysia, decrease in the weight of Cnooc and Sinopec). Jaguar-Land rover (rated BB-) has been sold in order to decrease the weight of crossover. Finally, the whole position in the Peripheral European countries (the Italian Enel, the Portuguese EDP and the Kingdom of Spain issue) was sold ahead of the ECB meeting. The Investment Adviser believes that the QE was almost fully priced but considers that the impact of the victory of Syriza in Greece could push Peripheral spreads wider. Consequently, the risk/reward was too asymmetrical.
Duration risk has been increased through a “barbell” strategy, reinvesting the proceeds in AAA/AA+ rated very short term and very long term government agencies and government bonds. KFW 2016, Nederlandse Waterschapsbank 2015, Rentenbank 2016 and Export Development Canada 2018 have been bought as short term investments and Temasek-Singapore 2042, US treasuries 2024 and 2044 as long term bonds. Finally, the excess cash has been invested in short term corporates such as Honda 2015, Export-Import Bank of Korea 2017 and an increase in the weight of RCI Banque 2016. At month end, the Fund held 44 issues and 39 issuers.
The duration overlay policy has been removed in its entirety as the short positons in 10y and 5y T-notes futures were closed, in accordance with the new strategy – lower credit risk/higher duration risk. Consequently, the modified duration of the Fund increased dramatically from 3.9 to 6.
With the ECB joining the global currency war, the potential deflationary effects are increasing on both sides of the Atlantic and should maintain demand for yields. US economic forecasts are still expected to be contradictory; sustained growth and labor market strength vs falling inflation. The Investment Adviser will maintain the current duration risk of the Fund during February, as weaker global growth, monetary easing and disinflation are supportive of duration and flattening of the yield curve. On the credit side, corporate bond selection will be driven by valuation opportunities in both primary and secondary markets. As a consequence, positive returns will be achievable as a result of the carry of corporates, their spread tightening potential and credit selection, but first and foremost in 2015, active management of duration and yield curve.
The views and statements contained herein are those of Banque Eric Sturdza in their capacity as Investment Advisers to the Fund as of 17/02/15 and are based on internal research and modelling.