BY ERIC VANRAES AND PASCAL PERONE
In October, all eyes were, again, focused on the FOMC meeting and the Fed’s decision whether or not to raise the Fed Funds rate for the first time since the 2008 crisis which would be the first rate hike since June 2006. In Europe, the ECB’s behaviour was also the key driver of markets. With China remaining a major issue and Emerging Market economies still suffering due to record low commodity prices, global growth remained subdued and led the IMF and the WTO to lower their forecasts for the world’s economic growth.
In the US, economic statistics were subdued despite improvement in the housing market with housing starts reaching +6.5% (vs. -3% in September) and existing home sales climbing to +4.7% (vs. -4.8% in September). The following statistics published this month were all negative: Chicago PMI fell from 54.4 last month to 48.7, ISM manufacturing fell from 51.1 to 50.2, ISM non-manufacturing fell from 59 to 56.9, retail sales fell from 0.2% to 0.1%, industrial production fell from -0.1% to -0.2%, durable goods orders came in at -1.2% but the prior month was revised from -2% to -2.9%. In addition the three major indicators (unemployment, inflation and GDP) published this month were disappointing. Non-farm payrolls reached +142k (vs. 200k expected) as last month’s number was revised down from 173k to 153k. Both PPI (-0.5% this month, -1.1% yoy) and CPI (-0.2% this month, 0% yoy) were negative. The Q3 GDP (annualized qoq) reached 1.5% (vs 1.6% expected and vs 3.9% in Q2). Consequently, the FOMC’s decision to keep rates unchanged (lower bound at 0% and upper bound at 0.25%) was not a surprise.
In Europe, moderate German and Italian data were offset by the Spanish and French recovery. Mr. Draghi confirmed that the ECB may expand its QE policy if current market conditions continue to weigh on growth and inflation, saying “the degree of monetary policy accommodation will need to be reviewed at our December meeting when new macroeconomic projections are available”. The ECB could also consider the idea of reducing its deposit rate which is already in negative territory at -0.20%. These actions and speeches make clear that the ECB is fighting to bolster growth in the Eurozone and that its inflation target is still under pressure as a result of the drop in commodity prices, the deflationary effects of the Chinese slowdown and the “wait and see” policy of the Fed. As a consequence, the ECB is more than ever ready to increase (i.e. to expand or to extend) substantially its QE program in the coming weeks or months (probably at its 3rd December meeting).
In this context, the US Treasury yield curve did not move significantly before the 28th October FOMC meeting. Then, as the door for a rate hike on 16th December was opened, yields rose sharply and the 2y US Treasury yield increased from 0.63% to 0.72% (+9 bps), the 5y from 1.36% to 1.52% (+16 bps), the 10y from 2.04% to 2.14% (+10 bps) and the 30y from 2.85% to 2.92% (+7 bps). Consequently, the 30-5y spread tightened from 149 to 140 bps. On the credit side, corporate spreads behaved similarly on both sides of the Atlantic: the US corporate CDX index tightened from 94 to 79 bps and the European iTraxx Main from 90 to 71 bps. The greater tightening of the European index, (-19bps against -15bps) was due to the partial recovery of the European Automotive sector after the September widening at the beginning of the Volkswagen scandal.
In October, following the strategy implemented since June, the Investment Adviser continued to favour high quality and liquidity. Attention focussed on decreasing the weight of bonds maturing between 2020 and 2022 in order to improve the barbell positioning of the Fund, i.e. overweight 0-3y and 30y vs. underweight 3-10y. The decrease of 5-7y positions was also an opportunity to lower the weight of Qatar and Abu Dhabi (potentially hurt by the drop in oil prices) but also Poland and Czech Republic. The following issues were reduced: Qatar National Bank 2020, Mubadala 2021, Taqa 2021, Republic of Poland 2022, and Cez 2022. Dolphin energy 2021 was sold. At the same time, the following high quality corporates maturing within 2 years were bought: General Electric July 2016, Orange September 2016, Engie 2017 and Nestlé 2017. Finally, the position in US Treasury 2045 was increased and the 10y Treasury position was rolled, selling the remaining position maturing in 2024 and buying the 2025 benchmark issue.
The Investment Adviser believes that, in Europe, the ECB will stay ultra-accommodative and that Mr. Draghi will announce an increase to the ECB’s QE program in December. The economic conditions are not significantly improving in the Eurozone with low growth and zero inflation. Growth is a concern because the current conditions are disappointing despite the alignment of planets (low euro, low yields, low oil & commodity prices and ECB’s QE) and the outlook has been revised down by many institutions including the ECB itself, the World Bank and the IMF. The Investment Adviser believes that the major Central banks are now scrutinising closely the Swiss and Swedish monetary policies with negative yields (-0.75% in Switzerland and -0.35% in Sweden) instead of massive QEs. But, in the case of the ECB, this solution is premature as the ECB’s QE represents only 5% of Eurozone GDP, compared to 25% of US GDP for the Fed’s QE and over 50% of Japanese GDP for the BoJ purchase program. Mr. Draghi will probably conclude that his QE is relatively small and could be increased to around 10-15% of European GDP. Regarding the Fed’s policy, the FOMC decision on 16th December is still unclear but the Investment Adviser believes that the probability of a rate hike is 50%. The Investment Advisor will pay attention to the currency market. If the ECB announces a massive QE on 3rd December, it could prompt the Fed to “wait and see” because the combination of more easing in Europe and tightening in the US could push the euro-dollar to 1.00 or even below parity. More generally, as many central banks are still in ultradovish mode, including China and Japan, the dollar index (Bloomberg ticker DXY) could extend its rally above 100 which could be a very negative signal for the US economy and for US corporates earnings.
In this context, the Investment Adviser will continue to favour the barbell strategy, favouring a flattening of the 5-30y slope of the curve with a target of 100 bps (it stood at 140 bps at the end of October). He will continue to be very cautious and will focus on high-quality liquid issuers, as liquidity is becoming a worrying issue. Depending on the development of the markets, the Investment Adviser may maintain the duration risk of the Fund around 5 but he is ready to decrease it if increasing probability of a rate hike pushes 2-5y yields higher. The Investment Advisor will pursue this strategy (lower credit risk offset by above-average duration risk with a significant exposure to 30y US Treasuries) during the following weeks and still believes that positive returns will be achievable as a result of the carry of high-quality corporates, their spread tightening potential, credit selection and active management of duration and yield curve.
The views and statements contained herein are those of Sturdza Private Banking Group in their capacity as Investment Advisers to the Fund as of 13/11/15 and are based on internal research and modelling.