FOR PROFESSIONAL CLIENTS ONLY. NOT TO BE DISTRIBUTED TO RETAIL CLIENTS. FIXED INCOME AND CURRENCY REVIEW AND OUTLOOK

Transcription

1 FOR PROFESSIONAL CLIENTS ONLY. NOT TO BE DISTRIBUTED TO RETAIL CLIENTS. FIXED INCOME AND CURRENCY REVIEW AND OUTLOOK Q3 2016

2 CONTENTS US GOVERNMENT BONDS // 3 EUROPEAN GOVERNMENT BONDS // 4 UK GOVERNMENT BONDS // 5 GLOBAL INVESTMENT GRADE CREDIT // 6 US INVESTMENT GRADE CREDIT // 7 EMERGING MARKET DEBT // 8 SECURED LOANS // 9 HIGH YIELD // 10 ASSET-BACKED SECURITIES // 11 CURRENCIES // 12

3 US GOVERNMENT BONDS MIXED MESSAGES FROM THE FED Isobel Lee Head of Global Fixed Income Bonds Treasury yields rise amid uncertain Fed policy Rate expectations dependent on domestic data and international events Pace of rate-hiking likely to be slower than Fed forecasts US treasury yields modestly increased between 12 and 18bp over the quarter between one and 10 year maturities. The market notably underperformed UK and German government bonds. The timing of the next rate hike from the Federal Reserve came into increasing focus over the quarter. The implied market probability of a policy rate hike by December was 0% following the surprise outcome of the UK referendum in June. However, strong employment data in July and hawkish rhetoric from Federal Reserve (Fed) members such as William Dudley and John Williams in August helped push the probability above 25%. In September it surged to over 40% when the typically dovish Eric Rosengren of the Boston Fed said there was a reasonable case for a hike. However, market expectations fell after Lael Brainard, in a much anticipated address, highlighted caution. Although the Fed held policy rates steady at the September meeting, three officials dissented, favouring a 0.25% hike. In its statement the committee upgraded its assessment of the balance of risks to the economy from nearly diminished to roughly balanced, with the implied market probability for a December hike rising to almost 60%. For 2017, the median projections indicate two hikes, down from three. Over the longer term the median policy rate forecast fell from 3% to 2.88%. This led to a flattening bias towards the end of the quarter. Inflation expectations increased in the US, supported by the strong labour market and a stabilisation in commodity prices (especially oil). 30 year breakeven inflation rose from 1.61% to 1.75% over the quarter. Looking ahead, we expect policy rates to increase at a steady rate over the next few years. The Fed is likely to raise policy rates at their December meeting with one to two hikes each year over the following two years. However, there remains potential for yields to sell-off given valuations, particularly at shorter-dated maturities given further hawkish rhetoric from Federal Reserve members. The Fed may come under pressure to increase the pace of tightening if labour market pressure feeds through to wage pressure. Figure 1: Federal Reserve policy rate expectations Fed funds rate Now One year ago Source: Bloomberg, as at 30 September Dot represents median FOMC member forecast. 3

4 EUROPEAN GOVERNMENT BONDS ECB DISAPPOINTS ON QE EXTENSION Gareth Colesmith Senior Portfolio Manager, European Fixed Income The ECB disappoints markets by not discussing a QE extension German yields largely stable Periphery outperforms core Core European government bond curves ended the quarter modestly steeper, barely changing overall at intermediate maturities, falling just 3bp to 6bp at maturities below 5-years and increasing just 6bp to 12bp at maturities 15-years and over. As markets recovered from the surprise outcome of the UK referendum in June, peripheral debt outperformed the core, particularly Spain, with its spread to Germany tightening by around 30bp at 10-year maturities and above. Looking ahead, we do not expect the ECB to cut its policy rates further or adjust the deposit floor that prevents it buying bonds that yield lower than -0.4% (currently true of all German bunds 7-years or less to maturity). However, given the scarcity of eligible government bonds it is more likely to adjust its capital key or expand the scope of its purchases further if it continues with the quantitative easing programme after March Some form of extension is widely expected, although it is less clear as to whether additional purchases will be made, or if the programme will begin to slow. Even if this were the case, we expect policy rates to be unchanged for the foreseeable future. At the European Central Bank s (ECB) September meeting, Mario Draghi disappointed markets by stating that an extension of the quantitative easing programme (currently scheduled to end after March 2017) had not been discussed. However, he acknowledged the growing scarcity of eligible bonds for the first time and revealed that the ECB has tasked relevant committees to evaluate all options for redesigning its programme to ensure a smooth implementation. This together with similar discussions by the Bank of Japan as to the desire for a steeper yield curve has also supported the steepening in markets. Figure 2: Government bond yields Yield (%) US UK Germany Japan Source: Bloomberg, as at 30 September Sept 16 4

5 UK GOVERNMENT BONDS GILT RALLY CONTINUES Gilts continue to outperform Further monetary support likely Valuations nonetheless look stretched Andrew Wickham Head of Global Rates and Deputy Head of Fixed Income (London) It was another strong quarter for the UK government bond market, which outperformed German bunds and US treasuries during the period. The nominal curve saw yields fall around 20bp to 25bp between five and 30-year maturities. Index-linked yields fell even further, between 40bp and 50bp out to 30-years. Although the easing measures were not more substantial than markets had been led to expect, price action following the meeting indicated the market was positively surprised. Gilt yields immediately fell around 16bp across the curve. September was notably a weaker month, as a heavy supply calendar contributed to gilts retracing a proportion of their post-referendum gains despite the continuation of the central bank s government bond purchases. Looking ahead, we believe that, absent significant upside surprises in economic data, the Bank of England will cut rates further to 0.1%. However, beyond that the central bank has ruled out a negative interest rate policy. The gilt market remains expensive at current levels and remains at risk of a sell-off even if the central bank does not disappoint markets on future easing expectations. From the start of the quarter, the Bank of England provided a strong signal that it would offer additional monetary easing in response to uncertainty surrounding the UK s decision to leave the European Union. In July Governor Mark Carney stated some monetary policy easing will likely be required over the summer and at the August meeting the policy committee duly cut its base rate from 50bp to 25bp. In addition it restarted its quantitative easing programme by announcing 60bn of government bond purchases and a separate 10bn corporate bond purchase programme. Finally a Term Funding Scheme was also announced, providing cheap finance to UK banks with newly created central bank reserves to ease pressure on banks net interest margins. Figure 3: UK 1030s spread bp Dec 14 Mar 15 Jun 15 Sept 15 Sept 16 Source: Bloomberg, as at 30 September

6 GLOBAL INVESTMENT GRADE CREDIT CENTRAL BANKS OFFER FURTHER SUPPORT Peter Bentley Head of UK and Global Credit Sterling credit outperforms as BOE purchases corporate bonds Markets continue to recover from Brexit shock Italian and German financials come under pressure Following the UK referendum result at the end of June, risk markets continued to rebound. Credit markets enjoyed a particularly strong July and August, although September was weaker. Euro and US dollar credit markets delivered similar excess returns, but sterling credit outperformed, making up for its underperformance earlier in the year. The sterling credit market was supported by the announcement of the Bank of England s corporate purchase programme in August. The 10bn programme is, by our estimation, (adjusting for market size) equivalent to around two thirds that of the European Central Bank s (ECB s) corporate purchase programme. This positive technical factor support led to a rally in sterling credit and the central bank s purchases began in late September. The additional monetary easing of a 25bp base rate cut, 60bn of quantitative easing (gilt purchases) and a Term Funding Scheme offering support to banks was also positive for risk appetite globally over the summer. From a sector and issuer perspective European financials drew notable attention. Early in the quarter concerns surrounding Italian institutions resurfaced when Banca Monte dei Paschi di Sienna received a letter from the ECB ordering it to develop a plan to reduce its non-performing loans by 10bn by Plans for a private sector solution were later released. Towards the end of the quarter, Deutsche Bank also became a key focus after the US Department of Justice announced a potential fine of $14bn for misselling of mortgage backed securities in the run-up to the financial crisis. The uncertainty around the final figure weighed on spreads, with the market expecting the final figure to be closer to $5-7bn. Looking ahead, we believe that the issues in the financial sector will remain contained. Overall selective financial debt offers attractive valuations, although security selection is crucial. From a valuation perspective, we believe investment grade credit spreads generally offer attractive compensation for risks, particularly in US dollars. Strategically, corporate fundamentals are a modest negative as profitability is generally under pressure while balance sheets look less robust than they have been over the last few years. The long-term technical environment, however, looks strong given central bank accommodation. Figure 4: Investment grade credit spreads Spread to government (bp) Sep 14 Dec 14 Mar 15 Jun 15 Sep 15 Sep 16 Sterling-denominated Euro-denominated Source: Bank of America Merrill Lynch, as at 30 September

7 US INVESTMENT GRADE CREDIT GLOBAL DEMAND POSITIVE FOR EM Jesse Fogarty Senior Portfolio Manager Impressive quarterly performance amid a drop in volatility Commodity-related sectors lead performance again Foreign demand plays an increasing role After the brief bout of volatility and related spread widening subsequent to the unexpected Brexit vote at the end of the end of June, spreads regained their footing and moved sharply tighter during the period. Credit spreads ended September at their tightest levels in over a year driven by market perceptions of persistently low global rates with US credit offering relatively attractive yields. Central bank policy in both Asia and Europe continues to provide a positive tailwind for the US markets as foreign demand supports valuations. While policy has been a key driver of risk assets, spreads did lose some momentum during September on the potential for less accommodative policy from the world s central banks and near-term volatility rose as a December interest rate hike was increasingly priced into the markets. Ultimately, we believe that our view of modestly higher interest rates in the US will be constructive for credit as higher yields will draw continued institutional demand, specifically insurance companies and defined benefit pension plans. The search for yield caused higher-yielding sectors to outperform with dispersion within the investment grade market continuing to narrow. Energy and the metals and mining sectors were again amongst the top performers given stabilisation in commodity prices and management actions to protect their balance sheets. An ongoing theme in 2016, banks continued to underperform the broader market with concerns over Deutsche Bank and news of Wells Fargo sales practices pressuring spreads. Utilities also underperformed as investors favoured higher-beta sectors. Primary markets remained robust with greater-than-anticipated supply coming to market as August and September set records. The decline in yields and all-in cost of debt funding brought in further opportunistic issuance which was easily absorbed with most deals being heavily oversubscribed pricing with little to no concession. We continue to look at opportunities in the new issue market to source attractive deals that have resulted from M&A activity where we believe to be credible deleveraging credit stories with attractive valuations. We see strategic value in US credit as there is the potential for modest improvement in fundamentals. The earnings outlook is turning positive, and balance sheet leverage is stabilising thanks to a decline in debt financed shareholder remuneration. The technical picture is still strong but we are mindful of the dynamics that influence foreign demand including the cost of hedging foreign exchange risk, which can shift quickly. We see value persisting in the banking sector where creditors benefit from strong fundamentals and attractive valuations. Additionally, we see value in sectors with exposure to the US consumer and select midstream credits. Technology remains an underweight due to tight valuations and medium-term concerns on re-leveraging. Figure 5: US dollar investment grade credit spreads Spread to government (bp) Sep 14 Dec 14 Mar 15 Jun 15 Sep 15 Sep 16 US dollar-denominated Source: Bank of America Merrill Lynch, as at 30 September

8 EMERGING MARKET DEBT GLOBAL BACKDROP SUPPORTIVE Colm McDonagh Head of Emerging Market Fixed Income Global central bank action continues to support EM debt Valuations remain attractive given low interest rate environment Improving fundamentals in EM set to become key driver It was generally a strong quarter for risk assets, including emerging market (EM) debt, as sentiment remained buoyant, supported by central bank action and rhetoric. This came despite an attempted coup in Turkey early in the quarter and a sharp drop in the oil price in July. A positive outcome from the OPEC meeting in September where members agreed to the outline of a deal that would cut oil production for the first time in eight years provided an additional boost to EM assets, although some contagion from the volatility in European financials tempered overall gains into quarter end. We remain constructive on EM owing to improving fundamentals and the nascent growth recovery witnessed so far, which we believe increases the asset class s resilience to the noise generated by monetary conditions in the developed world. That said, we acknowledge that in the near term diminished confidence in the efficacy of G3 monetary policy tools could limit support for global fixed income assets in general and remain a potential source of volatility for EM in particular. EM and risk assets may also be tested in the near term by volatility arising from the US election. The Bank of England eased monetary policy further early in the quarter and increased its bond-buying programme. This, combined with supportive US economic data and signs of further stabilisation in China s economy, underpinned appetite for EM assets. Meanwhile, policymakers in the US noted that the labour market had strengthened and near-term risks to growth had eased but decided, for the time being, to wait for further evidence of continued progress toward its objectives. Towards the end of the quarter, the Bank of Japan launched a new kind of monetary easing as it set a cap on 10-year bond yields. Figure 6: Emerging market growth (%) % China Emerging markets - Ex China Developed markets Source: Bloomberg, as at 30 September

9 SECURED LOANS VALUE IN STOCK SELECTION Stronger quarter for loans Issuer repricings remain a concern Stock selection can unearth value Ranbir Singh Lakhpuri Portfolio Manager, Secured Finance The European loan market participated in July s strong rally in risk assets with much of the market hitting one year highs in July. By the end of the quarter returns for the period were the highest in three years according to S&P LCD. Risk markets generally performed well, recovering strongly from the Brexit shock and from continuing central bank support in Europe. As with high yield markets, the loan market continued to benefit from the on-going hunt for yield. In general BB-rated issues outperformed single-b names. From a technical perspective collateralised loan obligations (CLOs) continued to actively demand loans and this continued to provide welcome technical support. Supply was also particularly strong in July, and although this was a headwind repayments helped provide offsetting positive technical support. Looking ahead we continue to be constructive on the euro loan market. Greater demand from CLOs continues to be supportive. However, the primary market is expected to pick up. An important development has been the continuation of loan repricing, which was common during the quarter. Given the recent strength of the market and the demand for yield, the balance of power with regard to pricing has been shifting back towards the issuers. Achieving attractive allocations on new deals can also be challenging as a result. However, despite this we believe there is good value available in the market, but good stock selection will be needed to access it. Figure 7: Loan spreads (Credit Suisse Western European Institutional Leveraged Loan Index) Bp Sep 98 Sep 00 Sep 02 Sep 04 Sep 06 Sep 08 Sep 10 Sep 12 Sep 14 Sep 16 Discount margin/spread (5-year life) Source: Bloomberg, as at 30 September

10 HIGH YIELD FAVOURABLE DEMAND CONTINUES Uli Gerhard Senior Portfolio Manager, High Yield Issuance surges in September Markets look technically well-supported Caution warranted given political event risk It was a strong quarter for high yield in Europe and in the US. Risk appetite recovery strongly after the initial Brexit shock. This was helped by the Bank of England s commitment to further monetary easing. The introduction of its sterling corporate bond purchase programme was also supportive as was the on-going purchase activity of the European Central Bank. High cash balances in the market also provided technical support. The US market outperformed Europe and in both markets single-b bonds outperformed BB-bonds. Looking ahead, in the euro market although defaults have slightly increased they have been specific credit stories and not necessarily indicative of a trend. The market will continue to be indirectly supported by the central bank purchases in investment grade markets. Recent supply has also been well-absorbed. Although September was a weaker month we expect credit spreads to at least retrace back to their summer levels by the end of the year. Given the particularly strong run the US market has had this year, it is possible it could cool off, particularly as supply has also been strong with lower-quality deals successfully pricing. However, political event risk such as the US election and potential for a US policy rate hike this year mean caution is warranted in both regions. Although European issuance was muted during the first two months of the quarter, September was the busiest month of the year at 13 billion. Refinancings were a significant driver of supply, with some issuers notably refinancing bank debt in the high yield market, taking advantage of the ultra low rates. New issuance generally had weaker covenant protection for bond holders, with PIK toggle notes (equity-like instruments) returning to the market with bumper issues from Schaeffler ( 3.6bn) and Ardagh Glass ( 1.5bn). Figure 8: US and European high yield spreads 1000 Spread (bp) Mar 14 Jun 14 Sep 14 Dec 14 Mar 15 Jun 15 Sep 15 Sep 16 Europe US Source: Bloomberg, as at 30 June

11 ASSET-BACKED SECURITIES UK ABS REBOUNDS Shaheer Guirguis Head of Secured Finance UK, European and US asset-backed securities (ABS) markets enjoy strong summer Bank of England provides support Technical picture improves in Europe Following the market shock of the Brexit referendum, ABS markets rebounded during the summer. Although the European market stabilised in July, it initially continued to lag the strength of other risk assets, as has frequently been the case over the last 12 months. The US market in contrast got off to a stronger start with a broad based rally across all markets. sentiment and the technical picture. These conditions led the UK market to outperform for the rest of the quarter, allowing investors that had pinpointed particularly attractive value in the market to benefit. The US market also continued to performed well, with cash on the sidelines proving supportive across asset classes. Looking ahead, we continue to see impressive value in the UK mortgage market, which can offer credit spreads of 210bp for AA rated debt. Technical drivers such as the Bank of England s Term Funding Scheme and lower net supply have set an attractive environment for the assets. Elsewhere, we also continue to see value in the US single family rental market and the Australian mortgage market. The US conduit commercial mortgage backed security market, which lagged other US markets over the summer, may also present value. However, by the end of August, the European market was on significantly stronger footing. A key factor was the Bank of England s expansion of monetary policy, including its 25bp base rate cut, re-ignition of its quantitative easing programme and the introduction of a Term Funding Scheme. The latter is designed to provide cheap financing to financial institutions to stimulate new lending into the real economy. The same month, Aire Valley (a 3bn buy-to-let deal secured against loans originated by Bradford and Bingley before the financial crisis) was redeemed in full, surprising a significant proportion of the market. Both events provided support to the mortgage-backed market, improving Figure 9: UK RMBS spreads Spread (bp) Dec 14 Mar 15 Jun 15 Sep 15 Sep 16 UK prime RMBS Dutch RMBS UK non-conforming UK buy-to-let Source: JP Morgan, as at 30 September

12 CURRENCIES STERLING IN FOCUS Paul Lambert Head of Currency Trends remain dislocated, but expected to re-emerge Risk events may lead to volatility Environment supports tactical trading for now The outcome of the UK referendum and subsequent events remained a focus for investors over the quarter. In July, Theresa May was appointed as UK prime minister, removing the political uncertainty created by David Cameron s resignation following the UK s vote in June to leave the European Union (EU). The Bank of England (BoE) later announced a broad package of monetary stimulus measures, delivering the first interest rate cut in seven years while also resuming its programme of quantitative easing, extending it to include the purchase of corporate bonds. Moves in sterling were dominated by central bank action but often experienced periods of brief support as data releases following the UK referendum generally surprised to the upside. By the end of the quarter, sterling again weakened, with the trade-weighted index falling to its lowest level in nearly eight years. Signals from the Federal Reserve (Fed) broadly gave conflicting views over the timing of the next possible interest rate hike, causing further volatility in the currency market. While the Fed left rates unchanged over the quarter, it did continue to point to the possibility of a rate hike by the end of the year. The Bank of Japan also left rates unchanged, despite mounting expectation that it would act more aggressively, although it did make some changes to its policy framework to allow it to target the shape of the yield curve. In the UK, despite the recent better-than-expected data, significant longer-term political and economic uncertainty still exists as the process of withdrawing from the EU takes place. In this environment we continue to think that sterling will weaken. Elsewhere, economic data in the US will be key in determining whether the Fed does raise rates during the remainder of the year, and this in turn is likely to determine whether the US dollar can strengthen from here. Figure 10: GBP/USD exchange rate Dec 14 Mar 15 Jun 15 Sep 15 Sep 16 Source: Bloomberg, as at 30 September

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