Eventually, there is only one source of concern: The credibility of Central Banks


Fund Commentary
18 Oct 2016


In September, markets were driven by China (non-performing loans), Japan (the slope of the yield curve managed by the BoJ), the US presidential election and the drop of Deutsche Bank shares (fears about the solvency of the European banking sector, mostly German and Italian banks).

Macroeconomic data was strong in Europe and softer in the US. In the Eurozone, Q2 GDP reached +0.3% and confidence indicators improved. In the US, the ISM indicators (both manufacturing and non-manufacturing) decreased and job creations reached 151k versus a consensus of 180k. Consequently, the Fed voted 7-3 to leave its rates unchanged and the ECB did not modify its policy. Regarding other major Central banks, another BoE rate cut is likely in the United Kingdom and a new wave of unconventional easing is possible in Japan. The main concern was mentioned by the Investment Adviser last month: 3 month US$ Libor has already increased by 25 bps and a Fed rate hike now would only be a readjustment of official key rates to align with the level of money market rates. This $ Libor increase is not anecdotal at all. Corporate loans and mortgages in USD are increasing; the cost of currency hedging has already increased (2% today to hedge the USD against the CHF), the cost of leverage for banks and hedge funds is higher. As a result, negative flows affected the US Treasury curve and should this trend continue, it would become unsustainable. In this environment, a Fed rate hike becomes less relevant than the evolution of money market rates.

In this context, the German yield curve rallied with all maturities declining by almost the same magnitude, the 2y yield decreasing from -0.62% to -0.68% (-6bps), the 5y yield from -0.50% to -0.58% (-8bps) and the 10y Bund yield from -0.07% to -0.12% (-5bps). At the same time, Italian and Spanish 10y yields behaved differently. The Italian 10y yield increased from 1.14% to 1.19% (+5bps) due to the uncertain outcome of the referendum and fears about the Italian banking sector while the Spanish 10y bond yield rallied from 1.01% to 0.88% (-13bp) after the regional elections in the Basque Country and Galicia.

In the US, the 2y US Treasury yield decreased from 0.81% to 0.76% (-5bps), the 5y yield from 1.20% to 1.15% (-5bps), the 10y increased from 1.58% to 1.59% (+1bps) and the 30y long bond from 2.23% to 2.32% (+9bps). This steepening of the curve is the immediate consequence of the tightening of the 3 month Libor. At month end, the slope 2y Treasury – 3m $ Libor was negative (-9bps). On the credit side, both the European iTraxx Main and the US corporate CDX index increased slightly, from respectively 68 to73bps and from 73 to 75bps. In Emerging Markets, the CDX 10y EM index barely widened from 279 to 283 (+4bps).


During the month, the Investment Adviser continued to favour high quality and liquidity. With yields having reached new lows post-Brexit, he sold the remaining position in the French OAT 2020. He decreased the weight of Wolters Kluwer 2018 in order to maintain the S&P score of the portfolio below 90 points. Finally, he switched Telstra 2017 into Telstra 2022 (a duration extension trade). The duration has been slightly increased from 2.1 to 2.3, with portfolio duration around 3.8 and a duration overlay position of -1.5. In terms of portfolio diversification, the Fund held 38 issues from 36 different issuers.


Similar to the Euro Bond Fund, the Investment Adviser did not change the global strategy implemented in June 2015, favouring high quality and liquidity. He increased the weight of TIPS 2043 (Inflation-linked US Treasuries) and US Treasury 2046 when the US curve steepened. He also invested in Shell 2019 and Korea Gas 2021 (switched against the sale of US Treasury December 2016) in order to keep the weight of corporate bonds above 50%. The modified duration increased from 5.0 to 5.4. In terms of portfolio diversification, the Fund held 36 issues from 33 different issuers.


In September, the assets under management of the Fund climbed significantly from $50 to $55 million. Due to the strong rally that took place year to date, the Investment Adviser took the decision to keep a substantial amount in cash (almost 6%) and to increase slightly the weight of US long bonds simultaneously with the Strategic Global Bond Fund ($1 million, half in TIPS 2043, half in US Treasury 2046). He increased the weight of the following holdings: Anglogold 2022, Norilsk Nickel 2022, Namibia 2025, Bharti Airtel 2024, Tata Motors 2020, Grupo Bimbo 2044 and Sberbank 2019. He also added a new name in the portfolio: Suzano 2026, a BB+ rated Brazilian pulp and paper producer. In terms of geographical breakdown, the top 3 countries were Russia (17.1%), Brazil (8.6%) and India (8.0%). The rating allocation was 46.6% Investment Grade and 47.5% Crossover (BB+ and BB). The breakdown of the portfolio in terms of market allocation was 89.4% Emerging Markets, 4.7% Developed Markets (US Treasuries) and 5.9% cash. In terms of sector allocation, the Investment Adviser favoured Governments (39.6%) followed by Materials (16.3%) and Energy (14.6%). The modified duration reached 6.4 during the month. In terms of portfolio diversification, the Fund held 38 issues from 36 different issuers.


Many risks can materialize in the coming weeks and before year end: the outcome of the presidential election in the US, the referendum in Italy in December, oil prices, China, a free fall of the GBP post-Brexit, a liquidity stress in Europe due to fears of insolvency of an Italian or German bank. The Investment Adviser still believes that all these threats will not lead to a crisis in the markets as long as market participants remain confident that Central banks will take action if necessary. Today, the credibility of Central bankers is the key component of the behaviour of financial markets. As a result, he is strongly convinced that the ECB will stay ultra-accommodative in the coming quarters. Regarding the US, the Fed will probably raise the Fed funds rates only once in December 2016 and Ms Yellen will probably stay dovish during the press conference in order to reassure investors. The Investment Adviser still believes that the Fed needs to raise rates, not because the US economy is performing well but because the US Central bankers are scared of a possible slowdown in 12-18 months while their toolbox is empty. The main reason why they should vote for a rate hike is because sooner or later in 2017 they will be obliged to ease their monetary policy. Emerging Markets will stay volatile but technical factors (positive inflows, low net issuance) combined with a negative or low yield environment in most Developed Markets, higher commodities and oil prices, stabilisation of emerging currencies and a “not-too-hawkish” Fed suggest that the environment will remain supportive for further spread tightening. Any correction would be a buying opportunity.

The views and statements contained herein are those of the Eric Sturdza Private Banking Group in their capacity as Investment Advisers to the Fund as of 14/10/16 and are based on internal research and modelling.