Market volatility associated with quantitative tightening and US growth leadership were the dominant themes of the first half.
Divergence in the growth and rate outlook between the US and rest of the world, notably Europe, is the catalyst for the stronger US dollar that exposed weak links in emerging markets (EM). As we enter the seasonally illiquid third quarter with heightened uncertainty over European politics and US trade policies, our multi-asset credit strategies are more defensively positioned. In our view, market worries of a global slowdown and European political risk are over-done and there will be opportunities to deploy ‘dry powder’ at more attractive asset valuations. The escalation of trade conflicts into a full-blown global trade war remains a tail risk but one that is on the rise.
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 investment vehicles). The arrows indicate a shift in our tactical asset allocation since the previous Asset Allocation Navigator (2nd Quarter 2018 published in April 2018).
The third quarter is likely to be characterised by illiquid financial markets; further episodes of volatility; and heightened macro and policy uncertainty. The flexibility offered by our total return multi-asset credit strategies (MAC) is reflected in a significant increase in holdings of (US dollar) cash; reduced exposure to EM local currency debt; a relative value shift into EM ‘hard currency’ sovereign from corporate debt; and a paring of the ‘overweight’ in bank subordinated debt. In our view, the transition to the post-QE era is best navigated by strategies unconstrained by benchmarks dictating the interest rate and credit risks faced by investors.
European economic data continued to surprise to the downside during the second quarter along with some softening in activity in China and emerging market economies. In contrast, the US economy is accelerating on the back of fiscal stimulus and elevated consumer and business confidence. Divergence in the growth and interest rate outlook between the US and the rest of the world was the catalyst for a surge in the US dollar that exposed weak links in emerging markets. In our view, the divergence theme and bias to a stronger US dollar is likely to persist into the third quarter and consequently, exposure to EM local currency debt has been reduced across BlueBay’s MAC strategies.
Markets have become too pessimistic about the outlook for growth outside of the US in our view. Recent eurozone business surveys and confidence indicators have stabilised while recent China data is consistent with annual growth of 6½%. Corporate earnings growth remains positive; default rates are expected to remain low, and risk asset valuations are less stretched. As concerns over growth in the rest of the world dissipate, risk assets including EM will perform positively.
Fear that trade conflicts will escalate into a full-blown global trade war will continue to weigh on investor sentiment until there is greater clarity on the Trump ‘end-game’. Trade wars are stagflationary – it lowers growth and raises prices – constraining the diversification benefit from duration in traditional fixed-income. More flexible, multi-asset and global strategies are in our opinion best placed to preserve capital and generate positive returns in a more uncertain world and as the QE-era draws to a close.
There has been a meaningful re-pricing of developed market (DM) credit. From the tights in early February, investment grade credit spreads are almost 40 basis points (bps) wider and European high yield (EHY) some 100bps higher. Spreads on European bank contingent convertible bonds (cocos) have widened by more than 170bps from the tights of the year, though mostly after the formation of the populist government in Italy. US high yield (USHY) is the only credit asset class with spreads broadly unchanged year-to-date and in our view looks increasingly expensive on a relative value basis. Except for USHY and convertible bonds, the latter demonstrating the value of capturing equity upside in a rising US rate environment, DM credit has underperformed risk-free government bonds.
Fig 1: YTD spread changes
Source: Bloomberg, as at 30 June 2018
The widening in spreads is not signalling rising credit risk – corporate earnings growth is positive, corporate credit metrics are stable/improving and default rates are low and expected to remain so for the foreseeable future. Politics and policy uncertainty pose the greatest near-term risk to DM credit: in Europe the populist government in Italy and more broadly uncertainty over US trade policy and the implications for global growth. The overall level of credit risk across most portfolios has fallen, including paring back the relative ‘over-weight’ in cocos in our multi-asset credit strategies. Near record issuance, boosted by M&A, and reduced international investor demand is the motivation for our ‘under-weight’ in US investment grade. But in light of our global growth view and the re-pricing of credit that has already taken place, our current assessment is that modestly overweight credit ‘beta’ remains appropriate.
In our view, the risk of a ‘systemic’ emerging market crisis is low in light of more flexible exchange rate regimes, modest external financing needs (in aggregate) and improved credit fundamentals. Nonetheless, credit spreads on emerging market ‘hard currency’ sovereign debt under-performed corporate debt during the recent sell-off and spreads at c.370bps are higher than in the aftermath of the 2013 ‘taper tantrum’. In our multi-asset credit strategies, exposure to sovereign hard currency debt has been increased, mostly funded by a reduction in local currency and to a lesser extent corporate debt.
Fig 2: Wider EM credit spreads
Source: JP Morgan, as at 30 June 2018
Note: EM sovereign is spread on EMBI Global Div. index. EM corporate is spread on CEMBI Div. index
Although most emerging market currencies are ‘cheap’, FX is the point of most potential stress if global trade and growth worries increase. We expect the dollar rally to fade as the flow of economic data confirms that market pessimism on global growth is overdone, but our MAC strategies reflect a tactically more cautious stance on emerging market local currency debt.
The market is currently pricing a c.50% likelihood of two more Federal Reserve (Fed) rate hikes this year, somewhat lower than our assessment. But further episodes of market volatility and the flattening of the Treasury curve could prompt a more cautious Fed stance especially if accompanied by a further strengthening of the US dollar and an escalation of trade concerns.
Fig 3: Months to first ECB rate hike
Source: Morgan Stanley, as at 30 June 2018
The European Central Bank (ECB) strengthened its forward guidance on policy rates remaining unchanged “through the summer of 2019”. Negative rates anchor long-end bond yields, though an easing of market worries over Italy would likely lead to a modestly steeper yield curve. Yet European growth is also vulnerable to an escalation of trade tensions that would push Bund yields lower.
Although tactical opportunities to trade rates abound, in our view the balance of risks warrants a broadly neutral stance on G3 rates.