Please find below the notes from GAM’s Weekly Investment Meeting on 6 June 2018 – this week’s speaker was Tim Haywood, commenting on recent events in Italy and the likely effect of the ECB ending its QE programme.
Friday, June 08, 2018
Absolute return fixed income
May was shaken by a sequence of events across a number of countries: Argentina, Turkey, Brazil and perhaps most memorably Italy, which towards the end of the month had a dramatic widening of spreads relative to bunds, particularly at the short end. That created ripples across markets, with the widening of spreads being faster than that seen in 2011 but not as deep, having moved around a third of the distance seen back then.
In our view, Italy is not a long-term buy for bond holders at present, although it can still have periods when it will rally. We have used recent shocks as an opportunity to top up a few areas. One economist said of Italy: “It’s a fine economy with the wrong currency” and it is notable that the capital stock in Italy has declined 10% in the last seven years, while at the same time it has grown by 21% in Germany. Italian productivity is quite impressive, but that alone is not a long-term solution for the country. Looking at nominal GDP, which is important when it comes to paying your debt, Italian nominal GDP is 5.4% smaller than it was 10 years ago and only 6.5% bigger than it was in 1999. With a debt-to-GDP of 132% and a current 10-year yield of 2.9%, Italy will require nominal growth going forward of around 3.8% just to keep its debt-to-GDP stable; over the last five years it has managed just 1.6%. We have had little to no exposure to Italy in our portfolio, and in particular almost no positions in Italian banks on the view that the ramifications have not yet fully played out.
Looking at markets as a whole for the year so far, a number of its constituents, such as investment grade credit and treasuries, have disappointed. There have been no major asset class moves that with hindsight one would like to have caught. Over the same period equities have been far more volatile but have delivered a similar level of return, so it is not just bonds which have been treading water.
So it has been a period of five or six months of disappointments for economists. Shocks and surprises are based on the outcomes relative to the expectations put by economists. Those can range from a positive outcome, where economists were mildly optimistic, to disappointments. Since November economists have perhaps become overexcited about the level of growth, however the heavy winter in the Northern hemisphere caused quite a decline across the world in the level of economic activity. More recently that has bounced back, mostly in the US but also in Asia. Europe has been a notable laggard, with more of a stagflationary backdrop; inflation is reasonably consistent and persistent, but the growth numbers are rather disappointing. Wages in both public and private sectors in Europe are quite robust but the growth is not coming through – so, at the margin, the return is to labour rather than capital. That remains something of a concern for the European bond market.
A further concern is the fact we now know the June meeting of the ECB will be discussing the end of quantitative easing (QE). Peter Praet, one of the key advisers to the council, has started to say the inflation mandate is being met and that one of the reasons why the ECB can contemplate stopping buying bonds altogether is that inflation target is getting close to what it wants to achieve. That would also be politically helpful for the Northern Europeans, who would no longer be obliged to buy Italian debt in ever greater size.
When QE does end, real yields (the level of yield minus future inflation) could become appealing. European bond yields are still low compared with inflation; we expect that yield measure to rise, which would be bad news for the price of bonds. The ripples from the Italian story extended beyond just Southern Europe, with the UK interest rate curve moving in lockstep despite no obvious reason why it should.
Volatility remains at a low level, although the outlook for the UK is troubled by a political logjam on Brexit. This low volatility provides an opportunity to rebuild some optionality against rising yields, particularly in the UK.
Within emerging market (EM) debt Brazil performed well in 2016 and 2017, but the recent shocks in the shape of the truckers strike, ongoing political problems and still quite low growth have caused a remarkable steepening between one-year and five-year rates, which presents an opportunity.
In recent months, and particularly in May, we have seen some distressed and semi-distressed assets in the financials sector in Europe. FX differentials can also achieve positive carry from bonds with negative yields depending if the destination currency has relatively high interest rates.
In our view, coupons on corporate bonds should be safe this year; we do not anticipate a significant number of defaults. Corporate bond prices could still come under pressure, but returns can be supported by income. The real skill is trying to ensure any capital changes are captured in a positive way.
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