Leaving a troubled summer behind

We are emerging from a particularly eventful summer in the markets. We have seen the Argentine peso tumble, falling 50% year-to-date together with the Turkish lira which lost 38% of its value against the greenback, provoking a deep sell-off in sovereigns of these countries. Although things appear to have started to stabilise again, the reality remains alarming. Turkish political uncertainty continues to daunt investors, while in Argentina the $57.1 billion credit line provided by the International Monetary Fund may not be enough to pull the country out of its political and economic difficulties.

At the same time, tensions in Europe have been growing between Italy and the European Union over the 2019 budget. Many are wondering whether the colourful dialogue between the European Commission and the Mediterranean country is now really about the size of the deficit or about a deeper discontent that could drive Italy to take exceptional measures against the EU, possibly including a referendum to leave the economic community.

Finally, in the US we are continuously witnessing an overconfident Fed chair in the form of Jerome Powell, who continues to tighten the economy. However, although US interest rates are rising, US corporate spreads continue to trade tight, leaving many to wonder whether this is the next bubble destined to burst.

The fragility and contradictions of the financial market are starting to surface, and although credit spreads will be put under considerable stress in the fourth quarter, we believe that we will not see an overwhelming sell-off until the US economy slows and gradually turns into a recession. This should give investors plenty of time to assess their risks and position themselves for a possible downturn in 2019-20. The current market still provides opportunities, especially in the short part of the curve, and investors can use episodes of volatility to enter solid assets at a better price.

EM: Debt bonanza must end

From the financial crisis of 2008 until today, emerging markets have taken advantage of low interest rates and yield-deprived investors to issue more and more debt in hard currencies, the majority of which is in US dollars.

Unfortunately, with the USD remaining strong and the Fed continuing to hike interest rates, the EM world is walking a fine line, and the equilibrium can be upset by two main risks: interest rate payments, which are becoming increasingly more complicated as local currencies are quickly devaluing against the USD, and the refinancing of existing debt, which is becoming more and more expensive as interest rates rise in the US, and particularly impacting those countries with a preponderance of short maturities, such as Argentina.

The volatility that hit Argentina and Turkey this past summer is just the beginning. Although the sell-off had two very different causes (a currency crisis in the first case and a political hiccup with the US in the latter), the result was the same: a violent sell-off of the local currency together with sovereign and corporate debt issued by these countries. This implies that regardless of where pressure is applied (politically or economically), EMs have reached a peak, and now they can only go in one direction: down.

These events were alarming enough, but the most troubling part is that while the local currencies rebounded modestly (but stayed weak overall reflecting the fragile economic conditions of these countries), hard-currency sovereigns saw a robust rebound. This means that investors remain confident that episodes of volatility, such as those experienced over the summer, are fixable isolated cases which represent buying opportunities, and they are putting their faith again into the hands of central banks that for years have propped up asset prices through their enormous balance sheets.

However, we believe it is wrong to assume that the low volatility environment of the past few years will last indefinitely and that the cases of Argentina and Turkey indicate that we might be approaching the end of the late economic cycle where more volatility is to be expected within the EM world.

A possible trade war could aggravate this event as a shift towards anti-globalisation measures could have serious repercussions for EM growth.

For all these reasons we are cautious towards EM until the end of the year.

 

Figure 1: Orange: CDX EM; Green:  CDX HY; Blue: CDX IG. Percentage change since beginning of the year. Source: Bloomberg

ECB ‘tightening lite’ amid political crisis

Finally, after years of quantitative easing, we see European Central Bank president Mario Draghi ready to slowly tighten the economy, confident that the euro area is recovering and that the support of the ECB is no longer needed. However, although economically things are better than before, political risks are arising from the same strategy that enabled the EU area to recover: austerity.

Populism in Europe represents a growing opposition to the austerity rules imposed by the European Commission, and this has come to represent the biggest threat to the euro area since the global financial crisis in 2008.

We believe that Q4 will see the performance of European sovereigns put at risk by the demands of the Italian government to the European Commission, which will not only be confined to discussion of the 2019 budget but could even see an escalation of tensions as Italy makes it clear that it is not willing to abide by Brussels’ rules.

Ironically, it is just when the periphery needs the support of the ECB that Draghi is halving the bank’s balance sheet, making movements in European sovereigns more intense. And even when an agreement is eventually reached on the Italian budget for 2019, Italian sovereigns will continue to be volatile as political tension with the EU will remain high.

In addition, if a downgrade from Moody’s arrives at the end of October, then the widening of the spread between Italian BTPS and Bunds could provoke a wider sell-off in Italian corporates and the periphery, more notably Greece and Spain.

Although the Italian government will be a tough cookie to deal with, we believe an ‘Italexit’ is not possible. The Italian economy is highly dependent on the euro area economy, and the single European currency complicates things regarding a possible exit. This makes it impossible for the parties to pursue this without losing the bulk of their voters, who would find themselves in a weaker position than they had while in the EU.

This is why a sell-off in the periphery constitutes a risk in the short term but an opportunity in the longer term. This space could provide interesting opportunities for yield-deprived investors as the value of quality bonds falls.

Figure 2: In grey, ECB asset purchase programme monthly; in blue: ECB balance sheet; orange: Italian 10-year BTPS. Source: Bloomberg.

US high yield: Time to exit longer maturities

As you can see from Figure 1, US high-yield spreads have widened the least of any in the investment-grade space and, of course, EM space, making junk bonds the top performers in the fixed-income market since the beginning of year.

This can be explained by a combination of investors’ confidence in the economy together with the fact that high-yield issuance is at its lowest level since 2010. But these are not good enough reason to sit on riskier assets while interest rates are rising, and it is not yet clear how long the strong US economy will last before a recession comes. Just as in EM, here we see debt refinancing as the biggest risk facing weaker corporates at the moment.

Although we believe that the risks are not immediate, we think it is time for investors to reconsider their junk bonds exposure.

Current default rates are still below 3% for high-yield credits, and this outlook should not change this year or in H1 of next year, making short-term high-yield corporate bonds still attractive. Bonds with longer maturities are a different story. While the remainder of 2018 will be underpinned by solid growth thanks to Trump’s policies, we can expect this to stop sometime next year as rising inflation will require the Fed to raise rates faster, producing a slowdown in the US economy.

We are negative on longer-term, lower-rated bonds, and believe that Q4 represents a perfect opportunity to reduce exposure in these instruments as valuations will remain supported by the current economic momentum, while the start of next year should already see a correction in this space (and a higher chance of defaults later in 2019), as Moody’s has indicated in one of its recent reports.

Figure 3: Bloomberg Barclays US corporate high yield average OAS. Source: Bloomberg

Conclusion

We expect the fixed-income market to stay volatile this quarter. But as the economic backdrop remains strong along with market sentiment, we can expect a rebound after various episodes of volatility. This does not mean that this represents an opportunity to enter new risky positions. As the economy moves into the final stages of the late economic cycle, periods of volatility are going to be normal before a bigger sell-off occurs. This is why we believe this is the perfect time to monetise riskier positions and re-evaluate current asset allocation.

In the long term, we are negative on EM and US junk bonds because as the US dollar remains strong, the economy is tightening and growth gradually slows, we can expect weaker EM to find themselves in a liquidity trap.

In the short term, we are also negative on sovereigns from the periphery which will also remain under stress as political and economic uncertainties arise in Europe. Italy will be a catalyst for a possible wider sell-off in this space as tensions remain at historic highs between the Mediterranean country and the EU. In the long term, however, we are positive on selected periphery banks and corporates which are repricing and trading more cheaply than their European counterparts due to the current political instability.

In short, we believe that Q4 is the perfect moment for investors to assess whether their strategy is sustainable in the medium term, and hence to start taking measures to navigate the late economic cycle once it slowly turns into recession.

 

By Althea Spinozzi, Fixed Income Specialist at Saxo Bank

 

Source: Action