Many investors have yet to fully acknowledge the break higher in global growth and instead fret that central bankers are ignoring ‘lowflation’ as they gradually scale back monetary accommodation.
The drivers of the rally in risk assets – higher growth, rising corporate earnings and ample liquidity – remain in place. That said investors should not be lulled by low market volatility from being disciplined and selective. We believe that returns are likely to be lower and volatility higher in the second half of the year compared to the first. Stay vigilant but carry on investing.
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 (2nd Quarter 2017 published in April 2017).
The global economy enters the third quarter with strong positive growth momentum. Recent Chinese economic data has surprised to the upside, easing concerns that regulatory tightening on ‘shadow’ financing will lead to a sharper than anticipated slowdown. Global PMIs are elevated with European economic data in particular continuing to surpass expectations. Falling unemployment and rising asset prices underpin consumption growth and private investment is gradually picking up. Emerging markets are benefiting from the revival in international trade and rising global final demand.
Despite accelerating economic activity and falling unemployment, inflation has surprised on the downside. ‘Lowflation’ is in part due to structural factors such as technology and globalisation as well as transitory factors such as commodity price shifts. As economic slack is utilised, we believe inflation will drift higher.
In acknowledgement of the improving economic backdrop and diminished deflation risks, major central banks, notably the ECB and Fed, recently affirmed their willingness to cautiously scale back highly accommodative monetary policies. The subsequent spike in global bond yields led by the German bunds underscores that interest rate duration and volatility remains a key source of potential risk for investors.
The fundamental underpinning of the strong first half performance for risk assets remain in place: the break higher in global growth and corporate earnings as well as falling default rates. Despite elevated valuations across many assets by historic standards, the search for yield and improving fundamentals means that we expect these assets to out-perform cash and ‘core’ government bonds through the second-half, albeit total returns will likely be somewhat lower and market volatility somewhat higher than in the first half. ‘Excess savings’, including from a corporate sector that is still cautious on capex, as well as central bank asset purchases continues to underpin a global search for income.
In our multi-asset credit funds we remain fully-invested and ‘overweight’ higheryielding asset classes, notably emerging markets that are arguably the most attractive of global ‘risk assets’ from a valuation perspective along with European bank contingent convertible bonds (‘cocos’). There have been no meaningful shifts in tactical asset allocation, although we have realised gains on some high yield bonds to fund a greater allocation to emerging market local currency sovereign and corporate debt.
Market volatility is likely to pick-up as markets focus on the political uncertainties emanating from Washington, including the conduct of fiscal and trade policies. The timing and profile of ECB ‘tapering’ QE is uncertain while ‘China risk’ should not be wholly discounted. Geopolitical risks are also on the rise from the Gulf through to the Korean peninsula.
Credit proved resilient in the face of the recent albeit moderate steepening in core yield curves and rate volatility with long-term buyers, such as insurance companies, stepping in as yields moved higher. Even after the recent back-up, government bond yields remain low, the default outlook benign and credit will continue to benefit from the ‘carry-friendly’ environment.
Credit spreads are tight but the room for further spread tightening is not exhausted. Nonetheless, more of the return is expected from coupons than price appreciation over the remainder of the year. In our view, convertible bonds offer greater upside potential reflecting their greater equity component and very low interest rate duration, while ‘alternative credit’ asset classes such as distressed credit and direct lending offer income and diversification.
The ‘clean-up’ of the Italian banking sector and diminished political risk along with a significant yield-pick up over non-financial credit means that European bank contingent convertible bonds remain a favoured credit class in our multiasset credit portfolios.
Fig 1: European HY ex-fins vs cocos spreads
Source: Barcap; latest date as at 7 July 2017
Emerging market debt
We retain a bias to emerging market debt across our multi-asset credit portfolios and further raised our local currency debt exposure. Stronger fundamentals, better valuations and still ‘under-weight’ global investors render the asset class much better placed to absorb higher core rates and volatility.
Global growth rather than core rates is the key driver of relative performance of emerging market assets. The out-performance of emerging market over developed market assets in the first half of this year is expected to continue so long as global growth and trade remain strong.
High real rates and currencies that, in aggregate, have been stable against the US dollar since late 2015, along with idiosyncratic economic and political risk factors means that EM local debt, corporate as well as sovereign, offers what we view as an attractive risk-return profile and alpha opportunity set. In sovereign and corporate credit our bias is towards higher yielding and lower duration assets.
Fig 2: EM local real interest rates
Note: Real local rates calculated as difference bewteen JP Morgan GBI-EM index yield to maturity and IMF estimate of emerging market inflation.
Source: JP Morgan; IMF; BlueBay calculations; latest month April 2017
After an extended period of very low market volatility, a perceived ‘hawkish tilt’ in central banker rhetoric and extended long duration positioning by ‘momentum’ investors, especially in German bunds, resulted in a short and sharp rise in ‘core’ government bond yields and steeper yield curves.
We do not share the view of some market commentators of a fundamental shift in central bank policy reaction functions reflecting a greater weight on ‘financial stability’. The ECB in particular will err on the side of caution in terms of scaling back its monetary policy stimulus as the European economy is far from ‘full employment’ and core inflation remains stubbornly stuck at around 1%.
In contrast to the ECB, the Fed is much more confident that some ‘normalisation’ of monetary policy is warranted, including a gradual and predictable reduction in the size of its balance sheet. In our view, the market continues to under-price the likelihood that Fed rates will reach 2% by the end of next year, in line with the ‘median dot’ projections of the FOMC (the Fed policy-setting committee). Inasmuch as higher than expected Fed rates could prove a shock to risk assets, a short position in US short-term interest rate futures is retained as a hedge to the long-risk bias in our multi-asset credit strategies.
Fig 3: Market-implied vs FOMC media ‘dot’
Source: Federal Reserve, 14 June 2017; Bloomberg data, as at 11 July 2017