European bonds are (still) waiting for Super-Mario’s bazooka


Fund Commentary
23 Nov 2015


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 German yield curve experienced a parallel 7 bps decrease, the 2y German yield decreasing from -0.25% to -0.32%, the 5y yield from -0.01% to -0.08% and the 10y Bund yield from 0.59% to 0.52%. 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 liquid issues. He focused his attention on decreasing the weight of bonds maturing between 2022 and 2025 in order to decrease the short future position in Bunds as a duration overlay policy, long 10y credits/short Bund future does not add value in the current environment. He sold Airbus 2024, Robert Bosch 2024, GlaxoSmithkline 2024, Air Liquide 2024, SAP 2023, Investor AB 2023, Unilever 2023, Coca Cola 2023, Bayer 2023, Anheuser Busch Inbev 2023 (including SABMiller takeover issue), General Electric 2023, BASF 2023 and Cez 2021. He also switched the following bonds, selling TeliaSonera 2021/buying TeliaSonera 2017, Shell 2022/Shell 2018, Telstra 2023/Telstra 2017, BMW 2025/BMW 2020 and Enel 2025/Enel 2020. He bought the following PSPP names: Tyottomyysvakuutusrahasto 2019, KFW 2020, Snam 2016, Snam 2019 and Terna 2019. He bought the following high-quality short term corporates: Klépierre March 2016, LVMH 2018, Linde 2018 and Enexis 2020. Finally, due to the inversion of the Volkswagen spread curve, he sold the 3 million EUR position in VW 2023 at 2.59% (asset swap + 175 bps) in order to switch into VW 2018 at 2.27% (asset swap + 228 bps). A few days later, after VW’s spread rally, he took profit on 1 million EUR VW 2018. Consequently, at month end, the Fund held only 2 million EUR VW 2018 with the objective to sell it as soon as possible if the rally continues in November.

The two objectives of this intensive trading activity were reached at month end. First and foremost, the modified duration of the portfolio decreased from 5.5 to 4.3, allowing the Investment Adviser to cover the majority of the short Bund future position. Secondly, the average quality and liquidity of the portfolio increased sharply as 30% of the assets were invested in European governments and PSPP bonds, i.e. bonds included in the ECB’s QE purchase list. In addition, almost 22% of the assets were invested in government-owned corporates that may be included in the PSPP list sooner or later by the ECB. If this should occur, more than 50% of the Fund would be on the ECB’s buying list.

The Modified Duration of the Fund has been held around 2.5-2.7 and the duration overlay policy has been reduced as 8-10y corporate bonds were sold. In addition, in order to optimize the hedging of the 4-6y bucket of the portfolio, the short 5y Bobl position built last month has been increased. At month end, the Fund was short 250 Bobls (vs. 100 in September) and short only 60 Bunds (vs. 280 in September and 350 in August) In terms of portfolio diversification, the Fund held 50 issues from 46 different issuers.The Investment Adviser believes that the ECB will stay ultraaccommodative and that Mr. Draghi will announce an increase of the ECB’s QE 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 Portfolio Manager 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 ultra-dovish 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.

The Investment Adviser is becoming extremely cautious on corporate spreads and on liquidity of the credit market. He will continue to focus his investments on PSPP and high quality corporates. High beta names will be avoided except for very short maturities with a “buy and hold until maturity” strategy. The modified duration of the Fund may be maintained around 2.5. The Portfolio Manager will pursue this strategy during the following weeks and still believes that positive returns will be achievable as a result of the carry of PSPP 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 Adviser to the Fund as of 13/11/15.