Summer party not worried by Central Banks tapering concerns


31 Aug 2017


In July, US economic data continued to be positive. However, GDP, employment and home prices have still not completely recovered in all states, despite nine years of economic expansion. On the soft data side, the Institute for Supply Management (ISM) reported that factory activity accelerated at the fastest pace in almost three years and was accompanied by an increase in orders and higher employment.

On 26th July, the Fed kept its Fed funds target unchanged (between 1-1.25%) and reiterated its plan to shrink its $4.5 trillion balance sheet ($10 billion/month, including $6 billion of Treasuries and $4 billion of Mortgage-Backed Securities). The Fed however did not indicate the starting point of the programme. FOMC’s June meeting minutes highlighted that officials are deeply divided on when to start to shrink the balance sheet, with the range varying between “a couple of months” to the end of the year. Unexpectedly low price data suggests that inflation may not be on track to reach the Fed’s 2% target. 

In the Eurozone, industrial production, employment and housing data confirmed the continued growth momentum in the major countries and particularly in southern Europe. Regarding the ECB’s QE tapering, Mario Draghi did not indicate when to wind down the Asset Purchase Programme. He reiterated that inflation shows no convincing upward trend and that recovery is good, but conditional on the high degree of monetary accommodation, and stressed that it should not be put at risk. This suggests that stronger growth must be encouraged rather than restrained. 

In this context, the 2y US Treasury yield decreased from 1.38% to 1.35% (-3bps), the 5y from 1.89% to 1.84% (-5bps), the 10y from 2.30% to 2.29% (-1bp), while the 30y increased from 2.83% to 2.90% (+7bps). At the same time, the 30y inflation-linked Treasury yield increased from 0.98% to 1.0%, leading to an increase of the inflation breakeven from 1.85% to 1.90%. In addition, the 3 Month USD LIBOR increased from 1.30% to 1.31%, with market participants not expecting any more rate increases before the end of the year. 

In Europe, the 2y German yield decreased from -0.57% to -0.68% (-11bps), the 5y increased from -0.22% to -0.18% (+4bps) and the 10y Bund rose from 0.47% to 0.54% (+7bps), after having reached its highest yearly level at 0.60% on 13th July. At the same time, France, Italy and Spain continued to outperform the Bund due to a better economic outlook and the defeat of euroscepticism: The French 10y OAT yield decreased from 0.82% to 0.80% (-2bps), while the Italian BTP 10y and the Spanish 10y bond yields decreased from 2.16% to 2.09% (-7bps) and 1.54% to 1.50% (-4bps) respectively. 

On the credit side, the European iTraxx Main decreased from 56 to 52bps, its lowest level of the year, driven by the tightening of Euro Periphery corporate spreads. At the same time the US corporate CDX index slightly decreased from 61 to 57bps. With respect to Emerging Markets, the CDX 10y EM index decreased from 262 to 245bps (-17bps), supported by an increase in allocation and higher growth expectations.


During the month, the Investment Adviser took profit on Linde 2018. The Modified Duration slightly decreased from 1.15 to 1.06. In terms of portfolio diversification, the Fund held 34 issues from 34 different issuers. 


During the month, the Investment Adviser decided to increase the weight of US Treasury 2046, after its yield to maturity reached 2.90%. The modified duration slightly increased from 5.02 to 5.20. In terms of portfolio diversification, the Fund held 35 issues from 32 different issuers.  


During the month, the Investment Adviser added three new issuers to the portfolio, Myriad (South Africa, BBB-, investment vehicle of Naspers, media group which has the particularity of being 33.8% shareholder of Chinese Tencent), Pemex (Mexico, BBB-, one of the major world oil producers, 100% owned by the Government) and Vale (Brazil, BB, one of the four major world iron ore producers). 

In anticipation of new US economic sanctions against Russia, the Investment Adviser lowered the allocation to Russia by reducing Gazprom 34 and Norilsk Nickel 22 exposures and selling Sberbank 22 & Vnesheconombank 25 entirely. The proceeds were reinvested in Tata Motors 20, AngloGold 22, Fresnillo 23, Bharti Airtel 24, Pemex 27 and Vale 22. Consequently, in terms of geographical breakdown, the top 3 countries were Mexico (14.3%), India (12%) and China (9.3%). Russia was reduced from 16.6% to 8.0%. 

The rating allocation was 62% Investment Grade, 33.1% Crossover (BB+ and BB) and 4.9% cash. The breakdown of the portfolio in terms of market allocation was 91.6% Emerging Markets, 3.5% Developed Markets (i.e. Luxembourg/ArcelorMittal) and 4.9% cash. In terms of sector allocation, the Investment Adviser favoured Governments (28.1%), followed by Materials (25.5%) and Energy (19.2%). The modified duration increased from 5.08 to 5.33 during the month. In terms of portfolio diversification, the Fund held 36 issues from 36 different issuers. 


The Investment Adviser’s outlook remains tied to two major topics, inflation and Central Banks’ behaviour. In Europe and the US, inflation is historically low and is likely to remain below target. The current economic situation in the US is probably at a turning point, at which equities are becoming less attractive and Treasuries more interesting. The flattening of the treasury yield curve has paused for now, but will probably continue over the coming months when the Fed is likely to be more cautious. The market participants do not expect any more rate hikes before the end of the year.

In Europe, tapering remains the main concern. Should the growth momentum persists and be revised higher, the Investment Adviser may expect the ECB to announce a reduction in the monthly pace of the asset purchases to EUR 40bn for Q1 in 2018, with a potential 6 to 9 month extension. However, further EUR appreciation may slow tapering and push the start of the monetary policy rate normalization forward. In this regard, BBB spreads could widen significantly (both corporate and government) and the Bund curve could potentially steepen further. 

As a result, the Investment Adviser is very cautious in the European bond market but still believes that US Treasuries will become more and more attractive. They, especially the long dated ones, could be a top performing asset class in 2018, as an inversion of the slope of the 10-30y curve is not excluded. Any correction would be seized by the Investment Adviser as an opportunity to add positions for a medium-long term strategy. 

The Investment Adviser will continue to monitor the resilience of the global cyclical recovery closely. Moreover, the team will observe G3 Central Bank balance sheets tapering concerns and geopolitical risks in order to seize any opportunity to reinvest in Emerging Markets. The team thinks that the latter are still likely to offer the best risk-reward profile and continue to be supported by low defaults, attractive carry and low supply. 

In conclusion, the best performing asset class in a short-medium term horizon is still high quality Emerging Markets but in a medium term perspective (2018 and beyond) investors should start building positions in long dated US Treasuries.


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 14/08/17 and are based on internal research and modelling.