Wake-up! The US rate hike already took place via the $ 3 month Libor increase.


Monthly Fund Commentary
19 Sep 2016


In August, macroeconomic data was strong in Europe and in the US. In the Eurozone, the PMI index showed a recovery confirmed by the unemployment rate which reached 10.1%, the lowest in five years. Some disappointing data in southern Europe was offset by the French recovery. In the US, job creation reached 255k this month and hourly average earnings rose to 2.6% annualized (a major indicator of future inflationary pressures). Home sales were encouraging and home construction reached its highest level in five months.

As a consequence, market participants were waiting impatiently for the central bankers meeting in Jackson Hole in order to dispel prevailing doubts about their monetary policies and first and foremost, Ms Yellen’s speech since the Fed’s behaviour is the most unclear and unpredictable. (please see chart below, shown by Janet Yellen at the Jackson Hole conference on August 26th, source: Fed and Credit Suisse).

This indicates clearly that nobody really knows which direction the macroeconomic environment is moving, including the FOMC members! In Emerging markets, accumulating inflows and risk appetite have continued to drive the market as the Fed monetary policy normalization process is considered by the market to remain slow and prudent. In Brazil, as expected, President Dilma Rousseff was removed from office as more than two-thirds of senators voted for impeachment, leaving her successor the task of implementing difficult reforms to rescue the economy from recession. With positive technical factors and stable commodity prices, major credit markets performed well during the month with Turkish assets retracing most of the correction linked to the July Turkish coup attempt.

In this context, the German yield curve experienced a bearish steepening, the 2y yield increasing from -0.63% to -0.62% (+1bps), the 5y yield from -0.53% to -0.50% (+3bps) and the 10y Bund yield from -0.12% to -0.07% (+5bps). At the same time, Italian and Spanish 10y yields decreased from respectively 1.17% to 1.14% (-3bps) and from 1.02% to 1.01% (-1bps) reducing their respective spreads against the German 10y yield, while the ECB reduced the pace of its bond buying from the peripheral nations under its PSPP since July.

In the US, the 2y US Treasury yield increased from 0.66% to 0.81% (+15bps), the 5y yield from 1.02% to 1.20% (+18bps), the 10y from 1.45% to 1.58% (+13bps) and the 30y long bond from 2.18% to 2.23% (+5bps). On the credit side, both European iTraxx Main and the US corporate CDX index remained barely unchanged closing respectively. at 68 bps and 73 bps. In Emerging Markets, the CDX 10y EM index spread tightened from 295 to 279 (-16).


During the month, the Investment Adviser continued to favour high quality and liquidity. With yields having reached new lows post-Brexit, he took profit on most Government bonds, selling the remaining position in Finland 2020 and decreasing the French OAT position to EUR 1 million. In order to increase the average yield of the portfolio, he partially sold Linde (which was offering a very tight spread that could widen depending on the outcome of negotiations with Praxair) and increased the weight of Valeo. The duration has been maintained around 2.1 in the current low yield environment, with portfolio duration around 3.8 and a duration overlay position of -1.7. In terms of portfolio diversification, the Fund held 40 issues from 38 different issuers.


As with the Euro Bond Fund, the Investment Adviser did not change the global strategy implemented in June 2015, favouring high quality and liquidity. The modified duration of the Fund has been maintained between 4.9 and 5.0. The Investor Adviser was waiting for a correction in the 30y US Treasury yield but it did not materialize in August. Should this happen in September, he would increase the position in long bond and long TIPS (inflation linked) that could lead to a substantial increase of duration towards 6. In terms of portfolio diversification, the Fund held 35 issues from 31 different issuers.


In August, the assets under management of the Fund climbed significantly to reach $50 million. Due to the strong rally that took place year to date, the Investment Adviser took the decision to keep a substantial amount in cash (over 5%) and partially invest this new money in the safest names, such as Lithuania and China Development bank. He also bought a small position in Tencent 2020 and increased the weight of the existing investments in Norilsk nickel, Severstal, Eskom, Pertamina, Bharti Airtel, Namibia, Anglogold, State oil Co. of Azerbaijan, Pemex and Tata motors. In terms of geographical breakdown, the top 3 countries were Russia (17%), India (7%) and Brazil (6%). The rating allocation was 48% Investment Grade and 47% Crossover (BB+ and BB). The breakdown of the portfolio in terms of market allocation was 91% Emerging Markets, 4% Developed Markets (US Treasuries) and 5% cash. In terms of sector allocation, the Investment Adviser favoured Corporates (46%) followed by Sovereign & Government Agencies (42%) and Financials (7%). In reality, in terms of risk, this allocation to corporates is lower as most of these companies are partially or totally government-owned. The modified duration stayed around 6 during the month. In terms of portfolio diversification, the Fund held 36 issues from 35 different issuers.


Despite little evidence of material impact of Brexit on sentiment, production and consumption in the Eurozone, the Investment Adviser believes that the ECB will stay ultra-accommodative in the coming quarters. Indeed, there are substantial disparities between European countries and the outlook doesn’t point to any strong economic growth rebound in the next quarters. The economic conditions are slightly improving in the Eurozone but not enough for companies to increase investment and wages. In this environment the risk is that households will continue to hoard cash and spend less because of increased uncertainty. If necessary, Mr Draghi will not hesitate to implement new measures against deflation risk by either cutting rates or expanding QE. Regarding the US, the Fed will probably raise the Fed funds rates only once in 2016, probably after the November presidential election. However, concerns about consumer spending sustainability, persistent weakness of inflation and recent international issues (Brexit consequences, China growth momentum) may delay any rate increase. The Investment Adviser still believes that the FOMC behaviour is highly unpredictable (see chart above) but that the Fed needs to raise rates, not because the US economy is performing well, but because the US central bankers are scared by a possible slowdown in 12-18 months whilst their toolbox is empty. The main reason why they should vote for a rate hike is because sooner or later they will be obliged to ease their monetary policy. That is why many market participants describe this policy as a “dovish tightening”. The Investment Adviser will stay overweight 30y US bonds (both Treasuries and TIPS) and will seize any opportunity to buy dips. This US Treasury correction could occur in September or October, depending on central banks meetings (the Fed but also the ECB or BoJ) but also on uncertainty around the outcome of the US Presidential Election. The best indicator of the probability of seeing Mr Trump in the White house is to carefully watch the chart of the Mexican Peso against the dollar! Emerging Markets will stay volatile but technical factors (positive inflows, low net issuance) combined with the negative or low yield environment in most Developed Markets, higher commodities and oil prices, stabilisation of emerging currencies and a “wait-and-see” Fed suggest that the environment will remain supportive for further spread tightening. Any correction would be a buying opportunity.


The views and statements contained herein are those of the Eric Sturdza Private Banking Group in their capacity as Investment Advisers to the Fund as of 16/09/16 and are based on internal research and modelling.