The activity-cycle momentum continues to build in the Eurozone and in Japan, with the expansion stage still well-anchored in both regions. In the US, the picture appears to be mixed, as the probability of economic expansion continues to decline, but economic indicators appear to be positive and unemployment figures are still low. The consequences of the disaster caused by Hurricane Harvey as well as the progress around the much-awaited tax reforms and fiscal stimulus are important factors on which to base conclusions about the state of the US economy, which remains unclear as we appear to be nearing the end of the expansion phase of the activity cycle. The other developed countries are a mixed bunch, as Australia and Canada (continuing its acceleration) are in the expansion stage, while the UK and Sweden are experiencing a downturn.
On the debt-cycle front, the slowdown in US credit creation – weakened by lower M&A activity and weaker loan demand due to US policy uncertainties and higher leverage – continues. In spite of the stability exhibited by European and Japanese debt dynamics, the overall debt-cycle index is declining. This is an important factor to be taken into account, as the debt cycle is a leading activity-cycle indicator. Hence, while we do not foresee any immediate declines, this indicator does call for a cautious stance.
Elsewhere, the monetary cycle does not appear to be excessively restrictive, as the pressure for rate hikes is subsiding in the US and the UK. In the US, where we expect most of the rate hikes to come from, we await the nomination of the new chairman of the Federal Reserve, which should be announced in the coming weeks. Should a more hawkish chairman come on board, they might accelerate tightening on the back of the currently loose financial conditions. This, combined with the unwinding of the Fed balance sheet, could speed up the normalisation process and have a significant effect on the markets’ anticipation of US rates, which, we believe, is a risk that needs to be monitored.
The curve-flattening strategy on implemented US treasuries has been profitable in recent months. However, there remain a significant number of market positions on the long US 10-year rates trade. Furthermore, the recent rise in US treasury yields took place in spite of the fact that trend-following strategies in the market (CTAs) remained heavily invested in the US curve-flattening trade. As these funds start selling, the rate markets are bound to suffer and there will remain room for an additional rise in yields. With our cautious view on US rates (the Fed hiking and its stockpile reduction), we prefer to remove our long position on the higher maturities of the US curve, while maintaining a slightly negative duration towards US rates. It is important to highlight the fact that we remain flexible and moderate on this position in an environment where inflation and macro-economic data remain uncertain. In Europe, on the other hand, the continuous rise in the activity cycle and the probable additional tapering of the ECB QE, which is increasingly approaching its limits, has made us maintain our short position on the EUR curve. Valuations continue to be at extreme levels, especially on German rates, thereby comforting us in our strategy.
Non-core European bond markets continue to be supported by the ECB, and flow dynamics are also positive. Furthermore, investor-positioning remains close to its record lows. Political risk, however, seems to have made its way back into the European continent in the form of the referendum for the independence of Catalonia from Spain. Both sides are unwilling to compromise at this stage and, while intentions are clear, the outcome is not. The Catalan regional parliament, facing pressure from multinationals, which are already moving their headquarters elsewhere, also faces the suspension of its authority (Article 155). Temporarily, a confrontation has been averted, as the Catalan president announced that he would be seeking talks with the government in Madrid over the future of his region, paving the way to a possible dialogue. The referendum, however, has resulted in increased uncertainty and volatility in Spain. In this context, Spanish yields have widened slightly (not entirely reflecting the political risk premium) and, while increased ECB purchases could partially mitigate selling, we believe the volatile context is a good reason to sell off exposure to Spanish sovereign bonds. We are now slightly underweight on Spain and no longer have exposure to Spanish regional debt. This is a tactical position, as we remain confident about Spanish economic fundamentals and about the country’s strong economic recovery since 2014 (more than 10%), since when its outperformance of most of its Euro-area peers mooks like continuing, as highlighted by recent PMI’s. Spain’s external imbalance also corrected, turning from a more-than-9% deficit in 2008 to a surplus of 1.5% of GDP. Unless the current political turmoil lasts and derails growth, we shall not reassess our positive economic view on the country. Among non-core countries, we currently favour Portugal, which has been upgraded back to investment grade by S&P (from BB+ to BBB-), citing better growth prospects and the “solid progress” it has made in reducing its budget deficit and the receded risk of a marked deterioration in external financing conditions.
The overall framework for inflation-linked bonds is pointing upwards as our global scores on breakeven protections have turned more positive, balancing out a mixed inflation cycle indicator. That said, the asset class did perform better last month, especially in Japan. The combination of rising commodity prices, signs of wage pressures (see IG Metall in Germany) and still-improving economic dynamics supports our positive view on Euro linkers. The positive carry environment both in EUR and US adds to the equation. Valuations also remain attractive while our break-even momentum model is positive both on EUR and US linkers. In the UK, on the other hand, valuations are more expensive. In this context, and in spite of some caution on the inflation cycle, we hold a favourable view on breakevens in the US and in the Eurozone.