Global risks still abound, despite positive performance from risky assets
John Stopford, co-Head of Fixed Income, and the Investec Fixed Income team, outlines their current views on portfolio positioning across the asset class in the wake of recent economic data
Risky assets, such as equities and credit spreads, have performed better than the recent run of poor economic data would normally have suggested. They appear to be finding support from defensive investor positioning, and the expectation that central bankers are likely to expand their balance sheets again before too long. Furthermore, data surprises have stabilised of late, and there are good reasons to assume that we are due a run of better data later this year, helped by falling inflation and policy easing.
That said, it is still too soon to sound the all clear. A range of issues could cause risk markets to turn more bearish. In particular, Spain and possibly Italy are at risk of losing market access. The European Central Bank (ECB) buying up bonds and the limited European bailout funds may only provide a temporary stopgap if this were to happen, despite the ECB’s latest guidance suggesting more aggressive support. The apparent progress made at the June summit now appears to have papered over large remaining differences between what is acceptable to the eurozone’s creditor countries and the rest. A Greek exit remains a real risk, given there is little chance that the country will be able to meet the commitments on which its funding agreement is based. Away from Europe, we are concerned that the Chinese economy is proving disappointingly slow to respond to looser policy, and US businesses are potentially postponing investment and employment decisions ahead of a possible fiscal cliff. Consequently, we continue to be fairly defensively positioned.
In light of this economic framework, we outline four current themes for Q3 looking across the spectrum of the fixed income asset class:
1) Hopelessly low or negative yields in core markets have encouraged investors to reach for yield in emerging markets (EM), and flow data continues to illustrate additional capital moving into this asset class. Local EM debt saw further gains during July, though these were more subdued than those seen in the previous month. The performance provided by hard currency EM debt reached unprecedented levels, with yields here breaking below the 5.0% mark during July on aggregate. Yields are at record lows in absolute terms, but versus developed markets the spread remains around the long term average.
2) Corporate credit may be poised for further gains. On a macroeconomic level, the most recent economic data has disappointed. We have also seen the first signs of revenue growth slowing and we expect this trend to continue. However, profit margins remain at high levels, reflecting the steps companies have undertaken in the past few years to improve profitability. Default rates remain low, with default rates in Europe below those in the US. Rates are forecast to increase from these low levels, but only very modestly over the remainder of the year. Investment grade spreads once again posted a solid month of compression during July, with high yield spreads mostly going sideways after a good recovery in the previous month. Consequently, valuations have not improved here, but are not as stretched as in other higher-yielding markets. Many risk assets have become less sensitive to high-frequency fundamental developments. Rather, perversely flat sovereign yield curves, investor positioning and expectations surrounding central bank actions have maintained demand at a higher level than was possibly deserved. This broadly applies to corporate credit, suggesting that further gains appear probable in the short term. Given strong company fundamentals and low real interest rates globally, credit remains an attractive asset class over the medium term, although returns in the near term could be volatile. As such, we remain defensively positioned and a selective buyer of risk.
3) Government bonds appear to be priced for a more bearish backdrop than equities, with short-dated bonds in a number of core markets now trading with negative yields. Core bonds were universally bid up until ECB President Mario Draghi’s pre-Olympic speech. Thereafter, long-end yields mostly gave back approximately half of their gains on the month, before the likelihood of a substantial policy intervention from the ECB at the August meeting was questioned and defensive positioning returned. The primary risks to core bond yields – aside from excessive long-term over-valuation – continue to rest with unconventional policy interventions from the Federal Reserve and especially the ECB.
4) We continue to view short positions in the euro and commodity currencies as good hedges against more attractive positions elsewhere. Both cyclical and secular forces remain more tilted in the US dollar’s favour, than the converse, with signs of improved competitiveness and stronger housing data reinforcing evidence of a shortage of dollars in funding markets. We believe that it has scope to make further gains, and though renewed quantitative easing (QE) may limit the dollar’s upside this has to be viewed against easing elsewhere, especially in the euro area. Risks have arisen surrounding the near-term outlook for the euro, as the potential for more meaningful policy interventions lingers. Similarly, the same prognosis applies to the commodity bloc, although even less ambiguously.
