By Edouard de l’Espée and Sébastien Waefler, Quaero Capital’s Yield Opportunities team:
Bond markets have experienced a tough few weeks. In Europe, higher retail prices and an accelerating economic recovery sent long bonds lower but in the US weakness in inflation, in GDP statistics and in corporate investment provided some support for long bonds.
The Euro was strong against all currencies. Equity markets in Asia performed very well while developed market indices stalled. The current US economic slowdown has now been factored in by the bond and forex markets, and US growth stocks are being marked down for the same reasons.
What lies ahead? This is a mild slowdown, consistent with a transition period to a further stage of the economic upcycle. There are no obvious imbalances in the US economy right now, apart from financial asset valuations. Some re-acceleration in various sectors should become apparent soon, even with the Government unable to set up an expansive budget.
Meanwhile structural banking problems in Europe are being addressed. The bail-in of specific Banco Popular securities clarifies the rules, minimum capital thresholds are being lowered and the market in bank perpetual bonds is becoming more selective and rational. Further progress for the banking system will enable further economic recovery for Europe.
In the UK, the outcome of the general election now practically excludes a hard Brexit. We expect European castigation of a hapless UK government, and drawn out negotiations.
Exports from emerging markets should roll over soon, a delayed reaction to the US slowdown. Managers consider their global scenario remains on track, with world consumption growth leading to job creation in developed countries, emerging countries benefiting from synchronized economic expansion in major economic zones, and inflation still tame as both job markets and production capacity utilization rates show little tension. The US dollar is not expected to weaken much from its present level and could well recover with improving economic news.
Long interest rates are still expected to rise only moderately in developed countries for the next few months. The High Yield strategy has been geared to this changing environment. In anticipation of renewed US economic strength, US long Treasuries and interest sensitive REITS were sold, and exposure to the US dollar was resumed. It presently stands at 20%.
Chinese consumer stocks were sold, and overall equity allocation slightly reduced in view of excessive valuations and increasing cyclical risk. Indonesia and Brazil sovereign bonds were bought as a better opportunity on undervalued currencies, subdued inflation and high real rates than emerging stocks. European exposure to domestic stocks was increased.
The overall scenario of subdued inflation perspectives associated with global economic expansion is still valid. Managers are looking closely for any changes in macro conditions which may upset this current balance, and are regularly assessing valuations with a view to avoid excessive risk.