Both markets and data show signs of spring promise, with Iceland a possible rising star as capital controls come to an end.
Expectations for a dovish ECB meeting saw Bund yields rally and European sovereign spreads tighten during the past week. We see the announced extension of TLTRO until 2023 is seen as supportive for European bank credit and assets in the periphery and this should help sentiment at a time when investors have been worrying about downside risks.
Pushing forward-guidance on interest rate hikes out to 2020 underlines a desire by the ECB to remain accommodative as far as they can realistically project. In this case, it strikes us that the market is wrong to initially react to the ECB by focusing just on downward growth revisions, which were more a function of the ECB playing catch up with reality.
Indeed, it may be ironic that these moves occur just at the time when economic data in the region is starting to stabilise. This week’s PMI data across the region all showed a bounce from the month before and there is a sense that some of the worst of the data from H2 2018 may now be behind us.
In the US, data remains robust with the ISM services survey heading back close to its highs and the ADP labour market report continuing to highlight strength in the labour market. Nevertheless, Treasury yields edged lower as the equity market retraced some of its recent gains.
Corporate bond spreads showed signs of some retracement from their recent strength, as heavy March supply weighed on secondary markets.
USD limits EM
Elsewhere, sentiment in emerging markets (EM) also turned a little more negative, with Argentine assets under pressure ahead of regional elections at the weekend.
A slightly stronger trade-weighted US dollar has also limited the performance of EM local markets over the past few weeks.
Although Trump would continue to want to talk the currency lower, it seems difficult to engineer any material dollar weakness at a time when the US economy continues to outperform and evidence builds of the US winning concessions in the trade war it has been engaged upon, turning trade terms in its favour.
Greece: short-term underperformance, long-term promise
In Europe, Greek government bonds underperformed during the week following the announcement of a new 10-year deal.
In many respects, Greece did not need to come to market with this deal, having recently issued a five-year transaction, and given the fact that it is already fully funded for the next several years.
However, this was more of a vanity exercise on the part of the government, wanting to demonstrate the ongoing rehabilitation of the sovereign to Greek voters.
It seems likely that Syriza will lose power to New Democracy later this year and they have been keen to demonstrate their track record for prudent economic management, which has seen Greek yields fall to a 10-year low.
We continue to see Greece as an improving credit and the two-notch upgrade from Moody’s at the end of last week will probably be followed by further positive ratings developments in the year ahead.
Over time, these should pull in new buyers of Greek government bonds, as we have witnessed in sovereigns such as Cyprus and Portugal.
In turn, this could drive spreads substantially tighter over time, as long as Greece continues to pursue an orthodox policy mix.
In this context, the weakness seen in Greek government bonds this week should be short lived; we have been using this softening to add to existing exposure, given our conviction in this view.
Upbeat in Iceland
Iceland also made headlines this week, announcing an end to capital controls in the country, which have been in place since the onset of the financial crisis 10 years ago.
Iceland has been growing strongly over the past five years; it runs a fiscal and current account surplus and moved from being a net debtor to a net creditor nation in 2018.
Further sovereign upgrades to ‘AA’ are likely, in our opinion, and in a market offering government bond yields >5% and a currency that looks cheap after falling by 15% in the past two years versus the euro, we don’t think it will be long before other overseas investors are looking at Iceland with interest.
We expect bond yields to rally by 100bps in the next 12 months with the currency moving 10% stronger over the same period. Incorporating carry from the bonds, we believe this infers prospective returns >20% could be possible in the year ahead, should these projections be realised.
Ultimately, we see a stronger currency pushing inflation down and leading to lower interest rates.
In the past year, inflation has risen above 3%, following past currency weakness – but if this is now reversed it will drop back down and make it possible for the central bank to lower interest rates towards levels seen in other developed markets, limiting the risk that carry trades lead to renewed bubble conditions in the economy.
EU in the Brexit driving seat
Elsewhere in Europe, we saw nothing new in the Brexit saga in the past week.
We have known for some time that Brussels is very unlikely to give May the concessions she might want with respect to the withdrawal agreement, and we continue to expect this to be rejected at the vote in the Commons on 12 March.
This would trigger a vote to apply for an extension to Article 50 on 13 March, but here the assumption that the EU will grant a further three-month period without imposing any conditions might seem to be a naïve one.
We sense that the EU is aware that another three months is not likely to yield much that hasn’t been agreed in the past three months, and may therefore demand a longer extension or conditionality, which the UK will likely find hard to swallow.
The EU knows it currently holds all the cards and this makes the UK weak and potentially unpredictable.
In this context, uncertainty may be even greater in the second half of March than it is now, and we feel that it remains appropriate to retain a defensive stance on all UK assets, looking for underperformance in the weeks and months ahead.
Our views have changed little in the past week or two. We continue to see building evidence that growth momentum is turning stronger after weakening at the end of last year and into January.
We don’t necessarily expect a V-shaped rebound in activity, but do see scope for growth estimates to be revised up, following a period when they had been revised progressively lower.
It strikes us that pessimism was excessive earlier in the year and fears for economic stagnation and recession continue to be overdone today. A relatively dovish ECB we feel is likely to be followed by a Fed that may pre-announce the end of QT later in 2019 – as early as its March meeting.
On trade, the growing suggestion that existing tariffs will be repealed, in addition to new tariffs being scrapped, should also be supportive for sentiment.
In this sense, there are a number of potential positive catalysts and although Brexit remains a risk, it seems highly unlikely that a ‘no deal’ hard Brexit will occur as early in March given our expectation that the UK parliament will vote to reject this. In this context, we remain ‘glass half-full’ not ‘half-empty’ in our macro view.
This is the time of year that we start seeing green shoots and we may expect to see more of these in data and markets in the weeks to come.
Certainly, we feel these green shoots – if they mature – offer a far more interesting investment opportunity at the moment than green bonds.
At BlueBay, we believe that the best approach to ESG is through fully integrating ESG considerations into the heart of the investment process.
On this point, we would note that our interest in Iceland is supported by a strong ESG score. Not only does the country benefit from abundant clean energy, it is also socially progressive and was voted the world’s best place to be a woman for the tenth successive year in 2018. Quite appropriate for International Women’s Day one might think.