After the eerie calm of 2017, the first quarter was characterised by high volatility, especially in US equity markets.
We think fears for global growth and trade are overblown. The foundations for continued strong growth are intact and a trade war between US and China remains a tail risk. Our conviction that the global economic upturn is sustainable underpins overweight risk positioning, albeit with a bias to fade market swings and focus on high conviction and relative value trades. Emerging market credit and local currency debt as well as bank debt remain favoured asset classes reflecting our key investment themes of emerging market recovery and European bank healing. We have taken profits on US short duration positions and our current positioning in G3 rates markets is broadly neutral.
Tactical asset class perspective (3-6 month outlook)1
1 ‘Tactical asset class perspective’ summarises the broad short-term tactical asset allocation views of BlueBay’s Asset Allocation Committee and positioning across BlueBay’s flagship ‘blended’ asset class strategies. The solid boxes reflect weights across asset and sub-asset classes (these ‘weights’ are indicative and do not relate to specific funds). The arrows indicate a shift in our tactical asset allocation since the previous Asset Allocation Navigator (1st Quarter 2018 published in February 2018).
The acceleration in global economic activity that underpinned the rise in growth-sensitive risk assets over the last 18 months paused in the first quarter. But in our view it does not mark an inflection point for the global economy. Strong demand and full order books, falling unemployment and rising capacity utilisation is supporting a pick-up in capex necessary to sustain the global economic upturn. Fiscal stimulus will provide a further boost to the US economy, more than offsetting the recent tightening in financial conditions. Activity indicators continue to signal strong growth in China and EM while private sector credit demand is rising in the Eurozone.
US Treasury bonds provided limited diversification benefits to equity market drawdowns as the Fed continues to hike rates and shrink its balance sheet. In the transition to the post-QE investment regime, it is even more important to seek out alternative approaches and assets that offer greater risk diversification than the false security of passive benchmark fixed-income strategies.
The prospect that trade tensions between the US and China escalate and curtails the global economic upturn is a key tail risk. The Trump approach to negotiations is aggressive and high stakes, but the goal is ‘reciprocal’ trade and opening up rather than closing down opportunities for US businesses. As with the South Korea free trade agreement and increasingly likely NAFTA, prolonged negotiations and a ‘deal’ (of some sorts) is much more likely than an outright trade war that meaningfully dents growth.
Credit and emerging markets were relatively well-behaved in the face of equity volatility, anchored by solid fundamentals. Greater cross-asset dispersion as well as volatility will likely persist. Nonetheless, more balanced investor positioning after the euphoria of January as well as evidence that the global growth remains well above trend underpins the positive outlook for risk assets over the next quarter.
Developed market (DM) high yield spreads widened around 50 basis points (bps) from the cycle lows posted in late January and global investment grade spreads by some 20bps. European bank subordinated debt also re-priced by some 5% during March. Despite the broad widening in spread, more market sensitive and higher yielding credit did not under-perform ‘low beta’ credit, consistent with re-pricing in response to equity volatility, heavy supply and tight valuations rather than deteriorating credit fundamentals. We continue to prefer European over US investment grade. In our global high yield strategies, value-driven credit selection rather than geographic market is the primary driver of portfolio construction focused on alpha generation.
Fig 1: Global IG & HY credit spreads
Source: Bloomberg, as at 5 April 2018
Low default risk, rising rates and volatility renders leveraged loans an attractive source of carry despite the prevalence of ‘cov-lite’ issuance. Convertible bonds also out-performed over the last quarter.
In our multi-asset credit (MAC) strategies, we retain our ‘over-weight’ in the debt of European banks as well in emerging market and specifically local currency denominated sovereign and corporate debt.
Emerging market assets generally out-performed DM assets during the first quarter as more attractive relative valuations and improving fundamentals provided a buffer against higher US rates and equity market volatility. In corporate credit, we currently favour Latin America and commodity-related credits as well as banks. In longer US duration sovereign credit we prefer high yielding and ‘frontier’ markets.
Fig 2: Higher EM local bond yields
Note: Global Treasury yield is Barclays Global Aggregate Treasuries yield to worst EM local yield is JP Morgan GBIEM yield to maturity
Source: Macrobond Financial AB, as at 5 April 2018
High nominal and real rates, improving fundamentals and positive currency dynamics will continue to underpin strong performance of local currency denominated corporate as well as sovereign debt. Moreover, idiosyncratic and country-specific factors provide potentially rich sources of alpha on the short as well as long side.
The Fed raised its policy rates by 25bps for the fifth time in fifteen months in March and we expect another rate hike in June. From pricing little more than one hike in 2018 in September of last year, the market has converged towards our view of at least three hikes in 2018. Consequently the short US interest rate position across a number of BlueBay investment strategies, including MAC, were covered and profits taken.
The widening in the spread between the overnight indexed swap (OIS) rate and Libor is the consequence of the crowding out of private sector borrowing by the surge in Treasury bill issuance as well as recent US tax and money market reforms. It is not in our view a sign of financial fragility and the impact on the real economy is marginal.
Fig 3: Probability of 3 or more FED hikes
Source: Macrobond, BlueBay Asset Management calculations, as at 5 April 2018
We broadly share current market expectations for the ECB to ‘taper’ its bond buying into year-end and start to raise interest rates from the middle of 2019. And despite BoJ discussion of raising its yield curve target, they are unlikely to do so before 2019.
Relative to forward and futures markets, our current views on G3 rates are not sufficiently divergent to warrant meaningful active risk.