Poor liquidity and spread widening


Fund Commentary
21 Oct 2015


In September, all eyes were focused on the FOMC meeting and the Fed decision to raise or not its Fed Funds rate for the first time since the 2008 crisis. In Europe, economic figures were offset by the unbelievable Volkswagen fraud!

In the US, economic statistics were subdued. The strongest data point for the month was the record level of auto sales, which would be good news if these levels were reached without overly aggressive leasing offers (that could lead to another kind of “subprime” crisis). The month started with the publication of the Beige Book, mentioning that among the 12 regional Fed districts, 6 were arguing that growth was “modest” and the 6 others that growth was “moderate”. These comments tempered the publication of the Q2 final GDP growth, revised from +3.7% to +3.9% (annualized). The unemployment rate decreased from 5.3% to 5.1% but the change in non-farm payrolls was slightly disappointing at 170’00 instead of the expected 215’000. Inflation was still low, with a CPI at -0.1%, PPI at +0%. Retail sales were published at +0.2% (+0.6% prior month) and industrial production fell to -0.4% (+0.6% prior month). As expected, the FOMC’s decision was to keep rates unchanged (lower bound at 0% and upper bound at 0.25%). Ms Yellen’s comments were more surprising and disappointing. She explained that higher rates would be appropriate later this year but that international developments (i.e. emerging markets and the Chinese slowdown) lead them to postpone the first rate hike. By delivering such an unclear message, she added more uncertainty while the markets were expecting clarity and strong conviction…

In Europe, moderate German data was offset by the Italian recovery. M. Draghi unveiled a revamp of QE and confirmed that the ECB may expand its QE policy if current market conditions continue to weigh on growth and inflation. The ECB also raised the share of bonds it can buy to 33% of each issue instead of 25%, adding that it is ready to make more adjustments to ensure the full implementation of the ECB’s QE program. In addition, the ECB reduced its growth and inflation forecasts through 2017 due to a weaker global outlook. These actions and speeches make clear that the ECB is fighting to bolster growth in the Eurozone and that its inflation target is still threatened by the drop of commodity prices, the deflationary effects of the Chinese slowdown and the PBoC’s monetary policy. As a consequence, the ECB is ready to increase (i.e. to expand or to
extend) substantially its QE program in the coming weeks or months.

In this context, the German yield curve experienced a bullish flattening move, the 2y German yield decreasing from -0.20% to -0.25% (-5 bps), the 5y yield from 0.13% to -0.01% (-14 bps) and the 10y Bund yield from 0.80% to 0.59% (-21 bps). On the credit side, corporate spreads behaved in a similar fashion on both sides of the Atlantic: the US corporate CDX index widened from 82 to 94 bps and the European iTraxx Main from 71 to 90 bps. The significant widening of the European index, (+19bps instead of +12bps) was due to poor performance of the European Automotive sector following the Volkswagen scandal, pushing European car makers’ spreads higher (Volkswagen 5y CDS from 75 to 261 bps, BMW from 66 to 110 bps, Daimler from 57 to 100 bps…). Liquidity continued to decrease sharply in the low quality universe (BBB, crossover, high yield, subordinated debt and hybrid bonds).

In September, following the strategy implemented since June, the Investment Adviser continued to focus on high quality and liquidity. He also decreased the weight of bonds maturing between 2025 and 2026 in order to decrease the short future Bunds position as a duration overlay policy, long 10y credits/short Bund future, as it was felt that this does not add value in the current environment. He bought Siemens 2021 and the Dutch PSPP Nederlandse WaterschapsBank 2019. He sold the following 10y issues: Wal Mart 2026, BMS 2025, Roche 2025 and Nordea 2025. He also sold Telekom Austria (decrease of BBB exposure), Sanofi (profit taking), BHP Billiton (decision to decrease the mining sector to 0%) and the remaining exposure to Korea Gas (exposure to Korea totally sold). 

The Modified Duration of the Fund has been held around 2.5 years and the duration overlay policy has been reduced as 9-10y corporate bonds were sold. In addition, in order to optimize the hedging of the 4-6y bucket of the portfolio, some Bunds were bought back and a short 5y Bobl position has been built. At month end, the Fund was short of 100 Bobl and 280 Bunds instead of short of 350 Bunds on 31st August. In terms of portfolio diversification, the Fund held 54 issues from 52 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 the coming weeks. The economic conditions are not really 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 is 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 closely scrutinizing 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 the Eurozone GDP, compared to 25% of the US GDP for the Fed’s QE and over 50% of the Japanese GDP for the BoJ’s purchase program. M. Draghi will probably conclude that his QE is relatively small and could be increased to around 10-15% of European GDP.

The Portfolio Manager is becoming extremely cautious regarding corporate spreads and on liquidity of the credit market. At month end, 18% of the Fund were invested in bonds that are on the QE purchase list of the ECB (7% governments and 11% PSPP) and 20% were invested in government-owned corporates. He will continue to focus the Fund’s investments on these names and on very high quality corporate names. High beta names will be avoided except short maturities with a “buy and hold until maturity” strategy. Most of the long maturities will be sold in order to decrease as far as possible the short Bund position. The modified duration of the Fund may be maintained around 2.5; however the duration overlay policy will be reduced. The Portfolio Management team 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 the 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 15/10/15.