As expected, Treasuries rally…


Fund Commentary
18 Feb 2016


In January, all eyes were focused on every bad news item that could deteriorate the political and economic climate in 2016: fears of hard landing in China (and renminbi devaluation), negative rates in Japan, oil prices and commodity prices in general, Emerging markets, the (too hawkish) Fed but also Brexit, Spain (with no Government), migrants in Europe, turmoil in Brazil, Donald Trump, Italian banks…

In this context, macro-economic data seemed peripheral to investors. In Europe, German growth reached its largest annual gain in four years and Spanish unemployment its lowest level in five years but France did not improve and European inflation is still worrying. In the US, the picture remained unclear with good news (the 5% unemployment rate, consumer confidence at 98.1) offset by poor industrial production (-0.4%), durable goods orders (-5.1%) and a weaker than expected Q4 2015 GDP (+0.7% QoQ annualized). Inflation data was mixed with headline CPI reaching 0.7% and core CPI 2.1% (headline PPI at -1%, core at 0.3%) and average hourly earnings reaching +2.5% YoY in December which is notable as wage growth is key to reach the Fed’s inflation target. The BoJ took the market by surprise, adopting a negative interest rate policy, but other Central banks did not change their key rates and policies in January however due to the mood of financial markets and very poor inflation (or possible deflation) pressures in Europe, Mr Draghi said that the ECB program will be reviewed in March with “no limits” on how far they can go. In addition, reducing interest rates further is still possible, according to the December minutes.

In this context, the 2y US Treasury yield decreased from 1.05% to 0.77% (-28 bps), the 5y yield from 1.76% to 1.33% (-43 bps), the 10y from 2.27% to 1.92% (-35 bps) and the famous 30y long bond from 3.01% to 2.74% (-27 bps). On the credit side, the US corporate CDX index kept widening from 88 to 102 bps due to continuing signs of recession in some sectors of the US industry and the European iTraxx Main widened from 77 to 92 bps, led by spread widening in the banking sector. Both investment grade credit markets also suffered from a “flight to quality”, investors favouring government bonds (Bunds and US Treasuries) despite their lower yields.

In January, the Investment Adviser did not change the strategy he has been following since June, favouring high quality and liquidity. The only Corporate bond transaction during the month was the sale of the remaining position in Mubadala Abu Dhabi 2021. Consequently, there is no longer any Middle East exposure in the portfolio. Regarding US Treasuries, the Investment Adviser implemented the following strategy: he switched 20% of his exposure to 30y Treasuries into 30y TIPS (i.e. Inflation Linked Treasuries) as the inflation breakeven was very attractive. In terms of duration and duration overlay, the Investment Adviser maintained the modified duration of the Fund above 4.

The Investment Adviser believes that the ECB will stay ultra-accommodative and that Mr Draghi will announce an increase of the ECB’s QE in March. The economic conditions are not particularly improving in the Eurozone with low growth and, more importantly (as it is the unique mandate of the ECB) zero inflation. Regarding the Fed’s policy, the behaviour of the FOMC in 2016 is unclear: inflation is low, international issues are growing (Emerging markets, China in particular) and the Fed is expecting four rate hikes (25bp/Quarter) while markets are not pricing in any hikes (the 2y Treasury note yield reached 0.77% which is too low compared to the Fed dot-plots).

The Portfolio Manager is still extremely cautious on corporate spreads and on liquidity in the credit market. He will continue to focus his investments on high quality corporates and government agencies. High beta names will be avoided except for very short maturities with a “buy and hold until maturity” strategy. High Yield and Emerging Markets will be avoided. The modified duration of the Fund may increase to around 5 and if the US curve does not flatten further, the 30y Treasury position could decrease in order to buy back the 2y and 5y US T-note short positions.

The Investment Adviser still believes that positive returns will be achievable as a result of the carry of government-owned bonds and 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 15/02/16 and are based on internal research and modelling.