Global Weekly - Bonds: How low can we go?

News item -

The escalating trade tensions between the US and China resulted in fireworks on the financial markets this week. Markets thought there was a truce again until the next meeting in September between China and the US, but things escalated quickly, leading to fears of a currency war and weaker global growth, with the risk of a US recession increasing. As such, credit spreads widened.

Some market participants thought the Fed was not as accommodating as expected last week, as the bank did not commit to more than one rate cut of 25 basis points. With the trade war now further escalating, it becomes more likely that the Fed will probably (need to) cut rates further, which they can as they are not hindered by inflation fears. As such, US Treasury yield declined significantly.

In Europe, interest rates had already declined to historical lows, following expectations of a rate cut by the ECB, and probably a new quantitative easing programme. That does not mean, however, rates cannot go lower, as we have seen this week with rates diving further into negative territory. Who knows how much further this can go? With the loose monetary policy from the ECB, we are not backing away from our positive stance on duration, even at current levels.

For sure, the timing of escalating trade tensions seems as bad as it can be for Europe. European growth is already very weak, with especially the German manufacturing industry remaining vulnerable, while risks for the region continue to linger. The chances of a no-deal Brexit have risen significantly with new UK Prime Minister Boris Johnson filling his cabinet with hardliners and more prominently preparing for such a scenario. Meanwhile in Italy, Interior Minister Matteo Salvini is causing negative headlines again by explicitly stating Italy’s 2020 budget deficit cannot be below 2%, which should lead to a new clash with the European Commission. At the same time, he is threatening Prime Minister Giuseppe Conte that he will bring down the government if some ministers are not being replaced before Monday.

European investment-grade credit, the asset class benefiting so strongly from the ECB’s expected new quantitative easing programme and the search for yield, saw its spread widening. Albeit not as severely as for US credits or the riskier high-yield markets. This is in line with our thesis that the positive technical circumstances for the European investment-grade credit market should keep any spread widening limited in stressful times. Therefore, we hold on to our overweight in European credits.

As high-yield corporates are a riskier investment, this asset class has suffered more severely from the fear of weakening global growth. Justifiably so, as this could lead to an increase in default rates. Within the high-yield bond universe, we therefore hold on to our preference for emerging markets debt (EMD), especially hard currency sovereigns such as in US dollars or euros, over corporates. We do not expect EMD spreads to be immune for global trade tensions. Default risk is significantly reduced, however, due to IMF support measures and the fact that emerging economies are able to fund themselves more in local currencies these days. Furthermore, we think central banks in emerging economies will follow the Fed by cutting their interest rates, which should be beneficial for their bonds. Indeed, the central banks of India, the Philippines and Thailand have already cut their interest rates this week.

After all the fireworks this week, we are expecting markets to somewhat calm down, helped by China’s recent signalling that it will stabilise the yuan. But be warned, new panic is just one surprising tweet away.

Equities - Is the party over?

The earnings season in the US started quite promising. Perfect expectation management led to significant earnings surprises and also, the outlook delivered by the US companies hinted towards a stabilizing economy. But then, equity markets around the world took a big hit in the last couple of days, as US President Donald Trump tweeted again.

Obviously, there was no progress in the trade talks between the US and China. As a consequence, the US President lost his patience and introduced another round of tariffs. This time, the Chinese government was not willing to cooperate and tried another weapon from their arsenal: a devaluation of their currency.

Undoubtedly, this unsettled investors around the world as the probability increases that we do not see a solution in the tariff struggle. This could therefore increase recessionary risks.

Our current positioning mirrors the investors’ views, as we are slightly underweight in our equity position. For the moment, we do not subscribe to a recessionary scenario and as such, we do not think the party is over yet.