Italy and the Fed - Two key drivers of the bond markets in September


In September, the trade war between the US and China, emerging markets (Turkey in particular), political tensions around the world (Iran and the impact on oil prices) and - to a lesser extent - Brexit continued to be a source of concern. This said, the Italian budget and the FOMC were the most awaited key events of the month.

In Europe, the ECB confirmed that asset purchases will decrease from EUR 30 to 15 billion per month in Q4, terminating, as expected, at the end of the year. At the same time, Mr. Draghi added that reinvestments will continue as long as they are needed, with the first rate hike not taking place before September 2019. The ECB lowered its growth forecast from 2.1% to 2% for 2018 and from 1.9% to 1.8% for 2019. At the same time, Mr. Draghi indicated that the surge of the underlying inflation in the Eurozone was vigorous, taking markets by surprise.

In Italy, the government finally unveiled its budget policy, indicating a budget deficit of 2.4% of GDP for 2019, 2020 and 2021. The European Commission as well as the markets reacted promptly, sending the BTP yield from 2.8% to 3.2% (with probably more to come).

In the US, the job data release would have been a non-event without the surprising spike of average hourly earnings, climbing +2.9% YoY, a level last reached in June 2009. On 26th September, the FOMC as expected voted unanimously for another hike of the Fed Funds rate to 2%-2.25%, with this year’s final hike expected at the last meeting of the year, on December 19th. The only unexpected news was the removal of the word “accommodative” from the Fed’s statement. On the one hand, this removal seems logical as the higher bound of the Fed Funds Rate (2.25%) now lies above core inflation. On the other hand, the central bank’s policy still appears accomodative in light of low inflation, solid growth and a very low unemployment rate. The Fed believes that growth will stay above average in 2019 and 2020, with its monetary policy becoming “slightly restrictive” from mid-2019 to the end of 2021 in order to manage a soft landing of the US economy.


During the month, the Investment Adviser increased the weight of Volkswagen hybrid, at the same time slightly decreasing the weight of Exor and Carlsberg which were close to the maximum weight of 5%. The modified duration stayed slightly below 3.4 during the month. In terms of portfolio diversification, the Fund held 30 issues from 30 issuers.


This month, the Investment Adviser reduced the Fund’s exposure to 30yr Treasuries when the yield reached 3.21%. Further, the team also sold the remaining stake in 10y Treasuries. The Investment Adviser continued to increase the weight of short duration corporate bonds yielding above 3% and added a new name (French Danone 2021 at 3.48%) to the portfolio. The modified duration has been lowered from around 4.6 to 4.3. In terms of portfolio diversification, the Fund held 26 issues from 24 different issuers.


In September, the Investment Adviser reduced the weight of South Africa and Indonesia substantially. The team sold South Africa 2027 and Anglogold 2022, reducing the weight of South Africa from 8.4% to below 4%. Further, Indonesia 2048 and Perusahaan Gas Negara 2024 were sold in order to reduce the weight of Indonesia from 9.7% to 4.8%. During the month, the Investment Adviser bought less risky issues in order to keep a low exposure to high beta emerging bonds, buying Alibaba 2027 and US Treasury 2020 (at 2.78%). The Fund’s modified duration decreased from 5.2 to 4.5. In terms of portfolio diversification, the Fund held 31 issues from 31 issuers.


The Investment Adviser’s outlook is tied to two major topics, inflation and the positions adopted by Central Banks, with inflation risk remaining subdued and the US yield curve continuing to flatten. In combination with other considerations such as an escalation of trade war risk, these factors suggest that recession fears will rapidly become a major concern. In addition, after the recent correction within emerging markets and the European periphery, the team are still convinced that high quality bonds, considered as safe havens, will attract more investors during the coming months.

In the US market, the Investment Adviser believes that long US Treasuries are still attractive, believing that they could be a top performing asset class in Q4 of 2018 and 2019. After the Fed’s potential rate hike on 19th December, an inversion of the curve’s slope is not excluded at the end of the year or in early 2019. According to the team, the Fed may be making a mistake by pursuing the normalisation of its monetary policy, with the markets not having the capacity to absorb additional rate hikes. The Investment Adviser believes that the best strategy today is to keep investing in short term corporate bonds, yielding around 3.5%, combined with 30y US Treasuries.

In Europe, the Investment Adviser thinks that the Bund will match the behaviour of US Treasuries and, in addition, will perform well in case of any resurging tensions in the periphery, particularly in Italy.

In emerging markets, the Investment Adviser will continue to closely monitor the behaviour of spreads (both governments and corporates) and rising volatility due to global risk aversion. With an increased performance dispersion, the team thinks that high-quality Emerging debt still offers a very attractive risk-reward profile, in particular after the recent spread widening, and continues to benefit from both attractive valuations and encouraging technical factors. In the short term, the team will remain very cautious, with the recent purchase of 2y US Treasury likely to contribute to a better relative performance of low beta investments.

In conclusion, the Investment Adviser still believes that the best performing asset class is a mix of short term Investment Grade corporates and long-dated US Treasuries. In the team’s opinion, emerging markets will probably stay volatile during the fourth quarter. This said, should either trade or rate concerns ease, current levels offer an attractive opportunity to invest in very high-quality emerging markets according to the Investment Adviser.


The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 12/10/18 and are based on internal research and modelling.

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