Source: Nikko AM
Please Note: Relative positions against the WGBI (Citigroup World Government Bond Index) Copyright © Citigroup Inc
Global growth remains desynchronized, with China, the Eurozone and Japan continuing to show further signs of moderation, while the US remains relatively robust. Despite a recent sell off in equity markets, global financial conditions are still generally benign, supported by highly accommodative monetary policy in the Eurozone and Japan, and additional stimulus measures in China, which ought to limit the extent of the global economic slowdown.
Firmer oil price, particularly in the former part of the year, led to a marked pick-up in headline inflation globally. However, the majority of the impact is now behind us and we expect global headline inflation to moderate in the coming months. More recently, concerns related to an excess supply of crude, has resulted in a significant correction to oil prices, which should lead to a disinflationary impulse in the coming months. Global core inflation, meanwhile, remains subdued, but the broad based improvement in labour market conditions across the globe is starting to put upward pressure on global wage dynamics. The still relatively robust outlook for real economic activity coupled with higher, albeit moderating, inflation ought to see major central banks continue to normalise their excessively accommodative policy stance over the coming quarters.
Nevertheless, there are also significant risks to global growth, the most prevalent being the threat to global trade via increased protectionism. The US recently initiated a further $200bn of tariffs against China, in addition to a previously announced $50bn, at a level of 10%, with an increase to 25%, and a broadening of the product range, still possible should bi-lateral trade negotiations fail. Encouragingly though, during the latest G20 meeting, the US and China struck a 90-day truce in the “trade war”, alleviating some of the concern, albeit temporarily.
On the domestic front strong US economic activity is keeping the Fed on course for a total of four interest rate hikes this year. The outlook for the coming year, however, has become less clear with Fed Chairman Jerome Powell suggesting that US interest rates are nearing neutral levels. As such, the pace of monetary policy tightening next year is likely to slow, with markets currently pricing in just one rate hike for 2019.
Growth momentum across the Eurozone continues to slow, driven by weakness in the manufacturing sector. The ongoing tightening of labour market conditions, has led the European Central Bank (ECB) to reduce its Quantitative Easing (QE) program, and will halt net purchases at the end of 2018. ECB president Mario Draghi has however tempered expectations for rate hikes, unlikely until late next year, or even beyond, as inflation is starting to moderate across a number of Eurozone Countries. Meanwhile, political risks remain elevated as the populist government in Italy has pushed back against fiscal austerity, which has seen the European Commission launch excessive deficit procedures against the country.
In Emerging Markets, downside risks to growth remain, with expectations currently standing at 4.8% y/y for 2018, slightly below 2017 levels. Chinese growth has been the main drag, as authorities focus on the quality rather than the quantity of growth, with particular focus on reducing financial instability and pollution levels. However, with growth softening more than expected in the third quarter, and trade conflicts continuing to pose the threat of a more meaningful slowdown, Chinese authorities have responded by resorting to a combination of front loaded fiscal and targeted monetary stimulus measures. EM ex-China should generally continue to recover, driven mainly by improving domestic demand. Idiosyncratic risks will, however, weigh on a few countries as balance of payments crises have engulf Argentina and Turkey. EM inflation has generally moved higher in 2018, but the increase has not be based. The end of disinflation has seen monetary policy divergence within EM. With a number of countries hiking their policy rates, on the back of rising DM rates, as they strive to maintain their higher real yield relative to DM. However, with price pressures now easing much of the normalisation in EM is now likely behind us.
Developed Markets Positioning
The Global Fixed Income investment team has reduced, but maintained its positive outlook on the US Dollar (USD). This is because of the robust outlook for the US economy, higher rates over the longer-term and the continued stimulus injection in both Europe and Japan will be positive to USD performance over the last quarter in 2018. However, the team has increased its long duration position based on the assessment that the significant declines in energy prices will likely translate into significant declines in headline inflation. Furthermore, recent equity market weakness will likely persist into year-end as the market reprices a lower growth outlook for 2019 as the Federal Reserve will likely shift to a dovish stance dialing back its recent aggressive forward guidance. Further north in Canada, the team has remained marginally negative on the Canadian dollar (CAD) due to increased energy market risk, the lack of refining capacity and an overly aggressive forward interest rates curve will remain key catalysts for appreciation against the USD. The team has conversely marginally increased its long-duration view on the correlation with US rates as well as our assessment that the forward curve is mispriced.
Looking at the Eurozone, the team has persisted with its negative view on the Euro as Economic momentum continues to slow. Interest rates remain low and Italy has now become increasingly problematic for any hawkish rhetoric from the ECB. The team has moved to increase core Euro duration relative to periphery noting that while Italy remains cheap, it does not appear there is a rationale for spread performance into a weak credit environment and a lack of progress on the deficit dispute with the EU. In Scandinavia, the team has moved to reduce its bullish outlook on the Norwegian Krona (NOK) given the historical correlation with energy prices despite its undervaluation based on interest rate differentials as it is a risk that the Norges banks will have to address the recent energy market weakness with a dovish monetary policy statement. In Sweden, the team remains negative on the Swedish Krona (SEK) given the overall correlation with the Euro despite the likelihood that the Riksbank will raise rates at either the December or February meeting as continued Eurozone weakness will be the key headwind in further rate hikes.
Pound Sterling (GBP) remains a special case for the team-view given the binary nature of a deal outcome with the EU. The team has decided to neutralize exposure on both its FX and duration exposure in light of the upcoming UK parliament vote on the deal that was agreed with the UK and EU this December.
In Australasia, the team continued to be positioned defensively with respect to the Australian Dollar (AUD), as uncertainties related to the ongoing China-US trade rhetoric are set to continue weighing down the AUD in the medium term. However, the team felt prudent to lock in some profits, by reducing the overall underweight position, as a relief rally of late saw momentum reverse. By the same token, we have increased our allocation to New Zealand Dollar (NZD), which effectively left our long NZD/AUD exposure intact.
In the rates market, we kept our active weights unchanged, with a small long duration exposure to Australia’s local bond market, on the back of subdued inflation dynamics domestically and largely elsewhere. In New Zealand, we maintained our flat duration risk for now as external backdrop continues to be contaminated by US –China trade war rhetoric; yet the team remains cognisant that domestically led price pressures in New Zealand will continue to build, with tightening labour market and rise to minimum wages at its core.
Emerging Markets Positioning
In Emerging Markets we have been generally cautious due to concerns over a tightening of US monetary policy and escalating trade tensions. However, we are turning marginally more positive given generally attractive valuations. We also remain selectively bullish on a number of EM rates markets as despite greater risks from the external environment inflation dynamics remain highly divergent with disinflation facilitating a more dovish stance in a select few countries. The lower oil prices of late should also generally pass through to lower headline inflation across most EM countries and elsewhere.
We continue to be underweight the Malaysian Ringgit (MYR) as the manufacturing side of the economy has slowed somewhat of late as global demand enters a soft-patch. We expect the MYR to continue to closely track the Chinese Renminbi (CNY) which may exhibit a slight weakening in order to maintain competitiveness. Given the lack of inflation pressures in the economy, we are likely to see an extended pause in monetary policy in Malaysia. The government’s decision to repeal the Goods and Services tax will likely cause a deterioration in the government’s long term fiscal position, though compensated in the near term by lower inflation for consumers. Hence, we remain mildly bullish on Malaysian rates.
We have maintained our market weight exposure to the Mexican Peso (MXN), as optimism regarding the agreement of the USMCA trade deal has begun to recede from investors’ minds, to be replaced with uncertainty regarding president elect Andrés Manuel López Obrador (AMLO)’s stance particularly towards energy reforms. However, overall we remain constructive due to its relative undervaluation and high carry, coupled with an increasingly hawkish rhetoric from Banxico. On rates, we decided to reduce our overweight duration exposure to Mexican local bond market, despite largely contained domestic inflationary pressures, as the latest set of market unfriendly initiatives by AMLO, have continued to put pressure on the domestic rates market.
We remained neutral on the Polish Zloty (PLN), as strong economic momentum observed year to date is unlikely to be sustained in the coming quarters, potentially weighting down the PLN. In the rates market we also kept our neutral duration exposure, as the National Bank of Poland is expected to maintain its dovish stance for some time still, despite tightening labour market conditions, as inflation (headline in particular) is starting to show signs of fatigue.
We remain neutral on the Singapore Dollar (SGD) as slowing external demand weighs on the electronic sector. However, with a focus on domestic demand the Monetary Authority of Singapore have increased the positive appreciation slope of the currency, which should still see the SGD outperform its regional peers. We turned marginally positive duration due to the high correlation with US Treasuries.
Finally, in South Africa, better risk on environment and generally positive market reaction to the appointment of Tito Mboweni as finance minister, continued to support the currency, despite fairly disappointing incoming macroeconomic data. The SARB also maintained its hawkish stance delivering a 25bps rate hike in order to anchor inflation expectations, further propping up the currency. Given the strong performance, the team felt it was prudent to lock in profits, bringing the currency exposure to market weight. In the rates space, we continue to be marginally overweight, as strong performance of the currency and lower oil prices, ought to see price pressure wane in the coming quarters in turn supporting local bond market.
Overall, globally we currently see value in the short-end of the corporate bond curve where it offers an enticing risk/reward trade off. For example, we have noticed in the current market that in 1-3 years space within US corporates you receive a breakeven spread of 100-150bps. We argue that this is appropriate amount of breakeven spread which can withstand further spread widening which is different if you go to the longer end where the margin for error is much smaller.
In terms of spreads, within global markets we currently see credit premiums moving sideways as the best outcome we can hope for in the remainder of 2018. As a result we don’t currently expect an instant rebound in spreads.
A recent investment theme we have currently implemented into the portfolio has been a sector rotation within European credit where we have moved out of cyclicals and into non-cyclicals. We felt that this rotation in sectors will allow us to avoid more negative sentiment and headlines regarding the trade war. This conviction was assisted through seeing attractive spreads in the non-cyclical sector. Valuation is becoming less of a worry globally and has improved from September onwards especially within Europe, given recent spread moves which has provided more attractive levels than compared to the rest of 2018. However, we would note that in Australian credit, valuation has been more stable. This may be viewed as a concern that we have not had as much of a reaction in Australia yet.