In February, safe haven government bonds continued to rally as fears over a coronavirus pandemic escalated. US long bonds, both nominal and real (TIPS), reached record lows as concern increased among investors, waiting for prompt action from the central banks.
As a result, many institutions revised down their growth and inflation projections for 2020, but risky asset classes, such as equities and high yield, did not really measure the huge impact of this black swan. Despite a significant correction from Wall Street at month end, high-quality bonds and equities did not tell the same story.
The Investment Adviser has been assessing the importance of the crisis since 22 January, progressively increasing the duration of the Strategic Bond Opportunities Fund. In February, the Team bought US Treasuries maturing in 2029 and 2049 against the sale of US Treasury 2023 and a few days later, this strategy was increased, buying US Treasuries maturing in 2030 and 2050 against a US Treasury maturing in 2020.
This strategy was to favour duration risk to the detriment of credit risk. However, the opportunity was taken to build positions in the euro hybrid corporate market, buying EDF 4% perpetual (call July 2024) and America Movil 6.375% 2073 (call September 2023) against the sale of Mondelez 2027, whose spread tightened dramatically.
The Investment Adviser’s outlook remains focused on two major situations – the macroeconomic situation (including growth and inflation) and Central Banks’ behaviour. Inflation risk remains contained in the US and substantially below the ECB’s target in the Eurozone. Global growth is expected to contract in the coming months as China, Europe and eventually the US may face a significant slowdown and probably a recession.
For now, markets anticipate the situation to be temporary and central banks remain proactive in order to avoid any financial crisis. In the short-term, the US yield curve could continue to flatten due to strong demand for safe haven assets, particularly US Treasuries, with the Fed’s purchases in the short-term US bills and notes markets continuing in order to increase the size of its balance sheet and fix the turmoil in the repo market.
In this context, the Investment Adviser believes that long-term US Treasuries are still attractive and may increase duration against escalating global trade tensions and recession fears, as a precaution against the virus having a more severe impact on global growth. As falling breakeven expectations have been limited for now, the Team will maintain a significant exposure to US inflation protection securities (30y TIPS).
The Team believe that the best strategy today is to invest in a timely manner, maintaining a selection of high-quality corporate bonds, combined with a barbell strategy on the US Treasury yield curve, with an overweight of 1-2y combined with long-dated US Treasuries (both nominal and real yields).
Facing potential risks on growth and global trade, the probability of rate cuts remain high. In this context, the Investment Adviser believes that the Fed will act promptly, before the next FOMC due on 18 March. The Fed is likely to continue to ease monetary policy in the coming months and increase its QE4 at some point if needed.
In Europe, the Investment Adviser is of the opinion that current macro conditions, Brexit uncertainties and the recent coronavirus outbreak support the recent accommodation measures from the ECB. In the Investment Adviser’s view, the ultra-accommodative monetary policy (negative rates in particular) has probably reached its limits and implementation by some major governments of a common fiscal policy may kick in sooner rather than later. Moreover, in the current ECB policy review, environmental sustainability goals could have an impact on its Corporate Sector Purchase Programme (CSPP).
As for Emerging Markets, the Investment Adviser will avoid investing temporarily, but will closely monitor the spreads’ patterns (both governments and corporates) in order to seize opportunities in the near future, once spreads have widened sufficiently.
In conclusion, the Team believes that in the current environment, the best performing portfolio is a mix of hybrid bonds issued by high-quality corporates combined with long-term US Treasuries, both nominal and real (TIPS). In the near future, the Investment Adviser may continue to increase the weight of US Treasuries, whilst reducing exposure to the three other pillars.
The views and statements contained herein are those of Banque Eric Sturdza SA in their capacity as Investment Advisers to the Funds as of 12/03/2020 and are based on internal research and modelling.