Italy and Emerging Markets push safe haven yields lower


Fund Commentary
25 Jun 2018


Despite the trade war between the US and China still being a matter of concern, all eyes were on Italy and Emerging Markets in May. In the US, the FOMC confirmed that a rate hike in June will be likely, with inflation being close to the Fed’s target of 2%. This target has been described as “symmetrical”, meaning that the US central bank will in future tolerate small fluctuations of the inflation rate slightly above or below 2%.

Reported unemployment figures were strong with 160’000 job creations and an unemployment rate reaching 3.9% in April, with the next target being the record low of 3.8% (April 2000). The YoY average hourly earnings stood at 2.6% in April, indicating that wage inflation is under control, with further inflation data showing that inflation fears were exaggerated at the beginning of the year. The PPI decreased from 3% to 2.6% (from 2.7% to 2.3% excluding food and energy) in April, with the CPI climbing slightly from 2.4% to 2.5% in May, remaining at 2.1% excluding food and energy.

Due to the weakness of the dollar in Q1, imported inflation was expected at +3.9% but finally reached +3%. On the back of strong growth figures in Q1, European markets started to fear a beginning of a slowdown for the rest of the year. Apparently, the ECB does not share this view and Mr Villeroy de Galhau, Governor of the Banque de France, took the market by surprise with his very hawkish comments, amongst others mentioning that the time between the end of QE and the first ECB rate hike will be counted in quarters, not years.

Nevertheless, the main event in Europe in May – as feared – was the outcome of political turmoil in Italy. The Italian yield curve was subject to a bearish flattening, a sign of a crisis. At the same time, another crisis, occuring in the periphery, has been relatively ignored. After the unveiling of a corruption scandal in his party, the Spanish Prime minister, Mariano Rajoy was replaced by the socialist Pedro Sanchez. As a result, the German Bund yield decreased in a “fly to quality” rally and erased its previous increase following Villeroy’s comments.

In Emerging Markets, Argentina became a source of concern. The Argentinian Peso led a sharp correction of several emerging market currencies such as the Turkish Lira. A higher dollar combined with higher dollar rates led to a large wave of outflows in EM funds and ETFs. As a result, the whole Emerging Markets universe including high quality countries, experienced a spread widening, also leading to a “fly to quality” rally into US Treasuries.


During the month, the Investment Adviser decreased the weight of Daimler 2019, RCI Banque 2021, 3M 2022 and Temasek 2022. At the same time, the team sold CTE 2024 and EDP 2025. According to the Investment Adviser, EDP (Energias De Portugal) could in the future be taken over by the Chinese Three Gorges, which already owns 21% of the Company, leading to a potential rating downgrade of EDP. Market participants still remember the single A rated Swiss Syngenta, taken over by ChemChina and downgraded to junk last year. The Investment Adviser added two new names to the portfolio in May, BP 2024 and Pemex 2025. As a result, the modified duration remained around 2.0-2.1. In terms of portfolio diversification, the Fund held 27 issues from 27 issuers.


In May, the Investment Adviser sold Cisco FRN 2018 as well as the remaining stake in EDP 2021, alognside selling the EDP 2025 issue in the Strategic Euro Bond Fund. The team added 1 million in US Treasury maturing in 2048 and, at the same time, sold 25 5y Note futures (flattening strategy). As a result, the modified duration increased slightly from 5.3 to 5.7. In terms of portfolio diversification, the Fund held 26 issues from 23 different issuers.


During the month, the Investment Adviser decreased the weight of the following issues: Tencent 2020, Tata Motors 2020, China Development Bank 2022, Pertamina 2022, Export-import Bank of India 2023, Codelco 2025, Poland 2026 and Mexico 2027. The modified duration reached 5.4 at the end of the month and, due to the widening of EM spreads, the average yield to maturity of the portfolio increased to 4.4%. In terms of portfolio diversification, the Fund held 35 issues from 35 issuers.


The Investment Adviser’s outlook remains tied to two major topics, inflation and Central Banks’ behaviour. Inflation fears however keep decreasing and the flattening of the US yield curve, combined with other topics such as the near-disappearance of liquidity in the High Yield market, suggest that recession fears will become a major concern rapidly. In addition, after the correction of Emerging Markets and the European periphery, the team is still convinced that high quality bonds, considered as safe haven, will attract more investors during the coming months.

In the US market, the Investment Adviser believes that long US Treasuries (10 to 30 years) are becoming increasingly attractive. The team thinks that they could be a top performing asset class in the second half of 2018 and that an inverted slope of the curve is not excluded at the end of the year. The Fed could make mistakes given that the markets cannot absorb other rate hikes. Currently, the Investment Adviser thinks that the best strategy is to invest in both, floating rate notes (FRNs), as the 3 month Libor dollar is already above 2.30% and short term corporate bonds yield 3% and above, combined with 30y US Treasuries.

In Europe, the Investment Adviser thinks that the Bund will follow the behaviour of US Treasuries and, in addition, will perform well due to large outflows from the periphery, Italy in particular.

In Emerging Markets, the Investment Adviser will continue to closely monitor the behaviour of spreads (both governments and corporates) and increasing volatility due to global risk aversion. The market has suffered in April due to US sanctions against Russia and the strengthening of the US dollar. In May, the market additionally suffered on the back of the turmoil in Argentina and Turkey. The team thinks that high-quality Emerging debt still offers a very attractive risk-reward profile, in particular after the recent spread widening, and continues to be supported by low defaults, attractive carry and low supply.

In conclusion, the Investment Adviser still believes that the best performing asset class could be long-dated US Treasuries. According to the team, Emerging Markets will probably stay volatile during the summer period, with high-quality EM however offering an attractive opportunity given the current levels.

The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 12/06/18 and are based on internal research and modelling.