By Eric Vanraes and Pascal Perrone
In December, the main drivers of fixed-income markets were deflationary fears (and their spread into the United States), the sharp drop in oil prices, the strengthening of the US Dollar against major currencies (the Euro in particular) and Greece. In the US, economic data was very strong: GDP growth (annualised QoQ) climbed from 3.9% to 5% in Q3.
Unemployment figures were excellent with the creation of 321,000 jobs (versus a forecast of 230,000); the previous month saw figures revised from 214,000 to 261,000. The only cloud on the horizon this month was the Consumer Price Index (CPI): -0.3% MoM leading to a YoY decline for the index moving from 1.7% to 1.3%.
Consequently, it came as no surprise that the Federal Reserve (Fed) modified its monetary policy language; shifting from keeping Fed Funds rates low for “a considerable period” to being “patient”. Finally and against all odds, 30 year US Treasury yields continued to fall as a result of an accumulation of fears imported from Europe: deflation, another Greek crisis and the pursuit of the conflict in Ukraine with its consequences on the Russian (and possibly European) economy. In Europe, government bond yields continued to fall to all-time lows driven by speculation that the European Central Bank (ECB) will extend its asset purchases to sovereign debt in early 2015. European inflation dropped to 0.3%, its lowest level in over 5 years. The ECB confirmed its intention to increase the size of its balance sheet to EUR 3 trillion and Mr Draghi said that “all assets but gold are under consideration”.
The 2 year US Treasury yield increased from 0.47% to 0.66% (+19bps), the 5 year from 1.48% to 1.65% (+17bps), the 10 year from 2.16% to 2.17% (+1 bps) whilst the 30 year decreased from 2.89% to 2.75% (-14 bps). As a consequence, the 5-30 year spread (strategy implemented in the Fund at 151 bps) tightened from 141 to 110 bps. On the credit side, neither the US corporate CDX Index nor the European iTraxx main Index saw a significant move: respectively 62 to 66 bps and 58 to 63 bps. This modest widening was due to the correction of the Oil & Gas sector spreads.
Assets further increased during the month from USD 113.4 to 115.5 million. The Investment Adviser adjusted the Fund’s asset allocation; reducing exposure to Kazakhstan from 2.1% to 0.7% and exposure to the tobacco sector to zero with the sale of the remaining positions in Altria 2021 and 2022. The proceeds were reinvested in high quality short term bonds (less than1 year): Teva June 2015, Honda August 2015 and General Electric October 2015. At month end, the Fund held 44 issues and 42 issuers.
The duration overlay policy was in full effect in December. Corporate bond trades significantly decreased the modified duration of the portfolio from 6.4 to 6 whilst at the same time, the Investment Adviser decreased the modified duration of the Fund from 4.7 to 4.0 in order to adopt a more cautious stance during the year end transition. As a consequence, the short positions in 10 year & 5 year Treasury or T-notes have been increased.
The US economic forecasts are still expected to be contradictory, improved unemployment figures being offset by lower inflation. Depending upon market behavior in early 2015, the Investment Adviser expects to adopt a less cautious stance and will again increase the duration risk of the Fund in January. The Investment Adviser also considers that investment flows, rather than macroeconomic improvements, will lead the US Treasury yield reaction. The huge amount of worldwide liquidity and the stability of QE policies around the globe (the Fed being replaced by the ECB and the Japanese BoJ), combined with very low government bond yields such as the German Bund (0.5% or even lower), will fuel a flight to both yield and quality. Consequently, a rally in long term US yields (10 year and 30 year) is likely. On the credit side, corporate bond selection will be driven by valuation opportunities in both primary and secondary markets. As a consequence, positive returns will be achievable as a result of the carry on corporates, their spread tightening potential, credit selection and active management of duration and yield curve.
Commentary provided by Banque Eric Sturdza in their capacity as Investment Advisers to the Fund as of 16/01/15.