Fixed Income newsletter

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1 16 January 2016 Fixed Income newsletter The quarterly fixed income newsletter of Allianz Global Investors Editorial In 2016, euro zone fixed-income markets will remain under the heavy influence of the central banks. FRANCK DIXMIER GLOBAL HEAD OF FIXED INCOME After much hesitation, the Federal Reserve (Fed) at last began to tighten its short-term rates late last year. The Fed will demonstrate that there is life after quantitative easing and this is good news, given how uncertainty over US monetary policy was beginning to drag down the markets. In particular, the feeling that the Fed would switch from being data-dependent to market-dependent could have undermined the central bank s credibility in investors eyes. Against a backdrop of weak global growth and heightened geopolitical tensions in the Middle East, the markets need a compass more than ever and seeing the Fed get back ahead of the curve will, to a certain extent, restore some visibility. So for the Fed it s no longer a matter of when but how much and for how long. Given the outlook for moderate growth, weak inflation and the strong dollar, this cycle of monetary normalization is likely to be atypical and of a limited extent. In the euro zone, the European Central Bank (ECB) has chosen the opposite path in stepping up its quantitative easing policy; weak inflation combined with the de-anchoring of inflation expectations during the summer unsurprisingly brought forth a determined response from the ECB. Accordingly, the markets are entering an unprecedented environment with a real divergence in monetary policies on either side of the Atlantic. In this new environment, euro zone interest rates will be pulled in two directions upward, due to the likely but moderate increase in US long-term yields, while an stepped up ECB buying program is likely to keep rates low. The most likely scenario for 2016 would be a slight upward trend in core euro zone rates and weak returns on the fixed-income markets. While core yields, German debt for example, look overpriced and hard to justify on fundamentals, the euro zone fixed-income markets still offer some investment opportunities. The convergence trade between periphery yields Spain, Italy and Portugal and core yields has not yet played itself out and remains a key position in our portfolios; we are also investing in inflation-linked bonds, which have been hit hard by weak inflation and negative surprises on euro zone price trends. Inflation breakeven points around 1% on 10Y core yields look like a good medium-term entry point. The credit market, which has recently featured heightened volatility and an increase in specific risk, also offers selective opportunities for capturing additional returns. When excluding the energy and commodity sectors, which are relatively modest in Europe, companies offer solid and rather stable fundamentals. The banking sector, meanwhile, has strengthened with an improvement in asset quality and offers a strict regulatory framework. At early-january spreads of 130bp in investment grade and 540bp in high yield, default risk appears to be well remunerated by historical standards, particularly as rating agencies default rate forecasts for 2016 in Europe are stable at about 2%. All in all, active management will be essential for extracting value that the European credit market offers by identifying entry points and avoiding negative credit events.

2 Key macro trends & investment strategy Europe GDP growth in the Eurozone continues to maintain a positive momentum, as shown by the latest Eurozone Manufacturing PMI index data which ended 2015 on a high: all Eurozone countries are in expansionary territory (ie. above 50), Greece is catching up with its European peers. The PMI order to inventories ratio is rising. The recent fall in commodity prices, in particular oil and gasoline, should continue to provide support to the Eurozone economy together with the improvement in credit conditions and the low real effective exchange rate, thanks to the ECB s expansionary monetary policy. Eurozone composite PMIs Eurozone (Core) Inflation Volatility in fixed income markets has remained elevated in the fourth quarter of 2015 supported by central bank action: following the ECB s announcement in October that the degree of monetary policy accommodation would be re-examined, market expectations increased sharply into the December monetary policy meeting. However, for a change, the ECB did not manage to exceed dovish market expectations. The decisions of the governing council to cut the deposit rate by 10bp to -0.30%, extend the intended timeframe for the asset purchases by 6 months as well as to reinvest maturing bonds disappointed the market. Inflation data in the Eurozone has remained weak: the December flash HICP came at 0.2% yoy, missing market consensus expectations of 0.3%. Main reasons include the mild winter weighing Source: Thomson Reuters Datastream, AllianzGI Economics & Strategy 05/01/2016 on clothing prices, and lower food price inflation of 1.2% versus 1.5% in November. The energy component contributed with a softer decline at -5.9% compared to -7.3% previously. Core inflation also receded to 0.8% yoy with services lower at 1.1% vs 1.2% in November. In the meantime, lower than expected inflation data has sparked renewed market expectations of additional stimulus provided by the ECB. Continuing support from the ECB, the improving economic outlook as well as fiscal efforts and structural reforms should support government bond spreads of Eurozone peripheral countries. Italy has shown encouraging signs of strength: the latest Italian Manufacturing PMI was published at 55.6, the highest level since March 2011beating consensus of The production and new orders sub-indices in strong acceleration 2

3 point to improving industrial production ahead. On the political side the year ended with further uncertainty coming from Spain: general elections held on December 20th led to a political stalemate. Both a center right coalition (PP + Ciudadanos) and a center left (PSOE and Podemos), lack full majority leaving the outlook uncertain. If no Prime Minister is elected after two months, new elections will eventually have to be called. USA The US economy remains on track, but downside risk has increase due to weaker releases of indicators recently. The Citi Surprise Index (CI) has continuously declined since the mid-november high, now reaching a level of -34. Integrating the last ISM manufacturing and construction spending indicators, the Atlanta Fed GDP Now model has decreased and is presently forecasting an annualized growth rate of only 0.7% quarter on quarter for Q deviating from the current economist consensus forecast of 2.2%. The main areas of weakness in the US economy are unsurprisingly the mining and utility sectors (weather related). Core capital goods new orders are slowing as well as investment. Headline inflation at levels close to zero due to the fall of energy prices is boosting personal real income but real consumption is lagging. US consumers seem to prefer to increase their savings rate. The CPI headline was flat in November at 0.50% year on year, in line with market expectations. The core inflation rate edged slightly higher, matching the 2% target. We observe a continuing dichotomy between falling goods prices and accelerating service prices. Headline inflation remains constrained by falling energy prices and the base effect upswing could be postponed. The labor market remains very robust with a risk of rising wages in the near future. US non-farm payrolls for December increased by 292k, above consensus expectations of 200k. The unemployment rate was stable at 5% and the participation rate increased. Evolution of Atlanta Fed GDPNow real GDP forecast for 2015: Q4 Source: Blue Chip Economic Indicators and Blue Chip Financial Forecasts, January 2016 US GDP Growth Contribution Source: Bloomberg, January 2016 In December, the Federal Reserve announced the first increase on the Fed Funds Rate in more than 9 years. The considerable improvement in the labour market and the positive outlook on the economy finally led the committee to become reasonably confident that inflation will move back to the objective over the medium term. Following the final lift-off the market focus has now shifted on the number of hikes to be conducted in The so-called dot charts indicate 4 hikes (to a range of 1,25% 1,50%) which compares to current market pricing of only two further increases (to a 0,75% 1,00% range). It seems that a significant deterioration of the economic outlook, both domestically as well as internationally, would be needed to delay further rate hikes. 3

4 FOMC members assessments of the appropriate federal funds rate Fixed Income Percent Source: Federal Reserve, January Longer run Japan and Emerging Markets Japan GDP Growth The latest readings showed strength for the Japanese economy in the final quarter of Current business conditions, including capital spending, came out above consensus expectations, supported by weak commodity prices. However, narrowing profit margins due to a slower pace of the JPY depreciation could pose a potential downside risk for investment. A weak corporate outlook for prices may dampen the government s 2% inflation target and require the Bank of Japan to continue its reflationary monetary policy. We expect commodity weakness, Chinese growth and idiosyncratic risks will continue to impact emerging markets in However, the market is technically oversold, new issuance is limited and spreads are wide on a historical basis. Despite renewed weakness in commodities, with oil declining close to 23% during 4Q 15, hard currency sovereigns had a positive return for the quarter, with the EMBIG-D Index returning +1.25% for the quarter. Corporate bonds, too, had positive Source: AllianzGI, Bloomberg June 2015 returns with the CEMBI-BD returning +0.44% for the quarter. The local currency markets ended the quarter where they started off, down a mere -0.01% over the preceding three months. Most of the sovereign gains took place during the month of October, following weak trading in the seasonally illiquid summer market. As liquidity dried up, again, in December, and weakness in commodity prices resumed, the markets began selling off, again. Idiosyncratic risks played important roles in differentiating returns across sovereigns. Argentine debt outperformed as Mauricio Macri, a market friendly candidate, won elections. Venezuela saw gains as the government continued to honour debt payments, and the opposition party gained a super-majority in elections. Kazakhstan debt rallied as the state owned oil company bought back bonds. South African debt weakened when the President replaced a well-respected Finance Minister on questionable grounds. Terrorist attacks in Egypt and Tunisia reduced tourism revenues to negative effect for these economies. In December, a second downgrade moved Brazil into sub-investment grade status, joining Russia who had lost IG status earlier in the year. 4

5 Credit Within the volatile Q market environment caused by the expected Fed rate hike, the fall in commodity prices and the subsequent emerging economies crises, Investment Grade (IG) and High Yield (HY) credit assets proved to be resilient, both posting a positive +1.2% total return*. Going forward, volatility could prevail until the market get more visibility on world commodity prices and China health, as the world s growth engine. In High Yield, December saw the average yield turning back close to its highest level since 2013 (5.50%). Even though outflows in European HY mutual funds were moderate (-0.9% of assets under management by JPMorgan), the market has been globally impacted by the fragility of the US HY market and the emerging macroeconomics. The decent amount of available cash among investors, both in IG and HY, as well as a relative scarcity of available quality bonds however have not spurred investors to invest lower in the credit spectrum. As a sign of rising idiosyncratic risk, the Bank of Portugal decided to transfer three of its senior bonds to the former BES, in default since 2014, in an attempt to recapitalize Novo Banco at the expense of Institutional Investors. In this context, and for both asset classes, cash level has been kept above its average level to pass the year-end liquidity lull and prepare for new issue activity resuming in January This being said, fundamentals of European issuers, be it IG or HY, are good and default rates are expected to remain low. Currencies Monetary policy divergence will be a significant driver of currency returns in 2016, i.e. short-term interest rate differentials will remain important. We still hold on to USD long positions versus EUR, but think that the USD uptrend could be bottoming out due to feedback loops from currency moves and GDP growth convergence between the Eurozone and the US. USD/JPY has already risen more than 60% since late Against the backdrop of the undervaluation of the JPY and the improvement of the Japanese current account further upside potential looks limited. Political risks of an exit of the UK from the EU, slower GDP growth as well as a less hawkish stance by the Bank of England make the GBP gains seen in 2015 difficult to be repeated this year. * ER00 BofA ML Euro Corporate Index and HE00 BofA ML Euro HY Index 5 Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. Bond prices will normally decline as interest rates rise. The impact may be greater with longer duration bonds. High-yield or junk bonds have lower credit ratings and involve a greater risk to principal. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted. This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations. This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission (SEC); Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No Z]; and Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.