Waiting for Super-Mario’s bazooka

BY ERIC VANRAES

Monthly Fund Commentary
16 Mar 2016

BY ERIC VANRAES

In February, all eyes were focused on the ECB’s next scheduled meeting on 10th March. In the global bond market, concerns about a possible Brexit impacted the GBP bond market (both yields and currency), uncertainty about the size of Italian banks’ nonperforming loans and about the exposure to the oil & gas sector on European banks’ balance sheets led to a drop in subordinated bank debt (including CoCos).

In addition, negative yields implemented by the Bank of Japan (BoJ) pushed the 10y Japanese government bond yield to 0%. In Europe, the amount of debt yielding less than -0.3% (i.e. not eligible for ECB purchases) reached EUR 1 trillion. In this context, European macroeconomic data seemed peripheral to investors: business confidence in the Eurozone and German data were particularly disappointing, offset by stronger GDP growth in France, together with a stabilization of the unemployment data. In the US, poor data, such as durable goods orders (-5%, -1% ex-transport), ISM manufacturing (48.2, still below 50), U-Michigan sentiment (91.7) and Consumer confidence (92.2 v. 98.1 previous month), were counterbalanced by an unemployment rate symbolically below 5% (4.9% despite a disappointing change in non-farm payrolls reaching +151k v. +190k expected). More interestingly, the average hourly earnings figure (+0.5% MoM, +2.5% YoY) showed signs of wage inflation and the CPI confirmed, with +2.2% YoY ex-food and energy, that inflation could reach 2% (1.4% YoY today) in the coming months. Regarding Central banks activity, the ECB meeting should be in line with investors’ expectations as Mr Draghi promised “no limit” and learnt from previous mistakes made in December. Consequently, the minimum expectation is for further stimulus and markets expect a positive surprise, i.e. something new and different from an already priced easing (from -0.3% to -0.4%) and a QE expansion (increase of purchases from EUR 60bn to 80bn per month). The Fed seems to be in a “wait and see” mode. Mrs Yellen said that due to economic conditions, only gradual increases would be implemented. She added that it is not necessary to cut rates but in saying that, she gives substance to the thesis that it is a possible scenario in the coming months.

In this context, the German yield curve experienced a bullish flattening again, the 2y yield decreasing from -0.49% to -0.57% (-8 bps), the 5y yield from -0.31% to -0.41% (-10 bps) and the 10y Bund yield from 0.32% to 0.11% (-21 bps). On the credit side, the US corporate CDX index kept widening from 102 to 107 bps (reaching a peak of 125 on 11th February when oil prices fell to $26) due to continuing signs of recession in some sectors of US industry and the European iTraxx Main widened from 92 to 99 bp, led by spread widening in the banking sector, not completely offset by the rally led by issuers that may be included in the ECB’s purchase list from 10th March. Both investment grade credit markets also suffered from a “flight to quality”, with investors favouring government bonds (Bunds and US Treasuries) despite their lower yields. 

In February, following the strategy which was implemented in June 2015, the Investment Adviser continued to favour high quality and liquidity and to decrease the duration overlay (i.e. long 6-10y A and BBB rated credit with duration partially hedge by short Bund and Bobl futures). He focused his attention on decreasing the weight of bonds maturing in 2021, reducing TenneT and Essilor and selling the remaining positions in Toyota, Rolls-Royce, AstraZeneca, PepsiCo, Siemens and Syngenta. He also reduced KFW and IBM 2020, Deutsche Bahn 2024, RTE-EDF 2023 and Nederlandse Gasunie 2022 (switch against the new Temasek 2022). He implemented a duration extension trade in FCE (Ford Credit Europe), selling the old issue maturing in September 2016, against the 1.875% 2019. On the buy side, two new issues were included in the portfolio: Schlumberger 2019 (strong AA rated Oil & Gas services Company offering a very attractive spread due to current weak oil prices) and Temasek 2022 (Sovereign Fund of the Singapore government, AAA rated, first issue in euro). Finally, the Investment Adviser, despite his strategy of avoiding bonds maturing in 2021, increased substantially Renault Crédit International 2021 as Renault’s recovery is impressive and deserves a rating upgrade. The timing of the purchase, on 15th and 16th February just after the publication of the earnings was optimal as Moody’s eventually upgraded Renault on the 18th.

The Modified Duration of the Fund stayed above 2 (around 2.4) and the duration overlay policy has been reduced dramatically with a short position of 140 Bobls compared to 250 in January, simultaneously with the sale of bonds maturing in 2021. However, the Fund stayed short 70 Bunds in order to hedge the whole 7-9y government-owned corporate position (Sagess 2023, Aéroports de Paris 2023, RTE-EDF 2023 and Deutsche Bahn 2024). In terms of portfolio diversification, the Fund held 44 issues from 40 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 March. The economic conditions are not particularly improving in the Eurozone with weak growth and, more importantly (as it is the unique mandate of the ECB) low inflation. In this respect, the ECB decreased sharply its forecast for inflation this year from 1.1% to 0.25% (and from 2% to 1.75% for its 2017 projection). Regarding the Fed’s policy, the behaviour of the FOMC in 2016 is still unclear: inflation is low, oil prices reached a bottom this month, international issues are growing (Emerging markets, China in particular) and the Fed is expecting four rate hikes (25bp/Quarter) while markets are not pricing in any hikes (the 2y Treasury note yield remained at 0.77% which is too low compared to the Fed dot-plots). Already 13% of investors think that the Fed could adopt negative rates in 2017 (potentially as a result of the Fed announcing that in the next bank stress tests, a new scenario will be added with a 10% unemployment rate and negative Treasury yields).

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 very 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 14/03/16.