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Weekly Manager Views

25 October 2019

At GAM Investments’ Weekly Investment Meeting held on 23 October 2019 the speakers were Michael Biggs, who discussed his views on the macroeconomic environment and the outlook for emerging market debt, and Jonathan Stanford, who examined the unique characteristics of convertible bonds.

Macro / Emerging market debt

Michael Biggs

  • Two major themes emerged from the International Monetary Fund (IMF) Autumn Conference last week in Washington, DC. First, the US-China trade war is here to stay, and globalisation has peaked. Second, policymakers are currently in damage control mode.
  • Investors with a bearish view point to an aggressive slowdown in global growth driven by ongoing trade tensions. Moreover, after interest rate cuts by the Federal Reserve and European Central Bank (ECB), they argue that monetary policy is no longer effective and there is little room for further fiscal stimulus from policymakers.
  • A more bullish outlook, however, is that negotiators are working to nail down a ‘Phase One’ US-China trade pact which has delayed October tariffs. This alone represents a slowdown in global trade headwinds and is likely to be enough for growth to pick up, particularly in China. In addition, interest rates work with a lag, and the cuts in Q2 and Q3 are still likely to boost growth in the future. The situation in Syria appears to have calmed, for now, and there is hope of a resolution to Brexit.
  • We side with the latter view – global growth is adequate, and policy makers are providing significant stimulus to the global economy. If trade tensions ease, we expect global growth to accelerate and risk assets to benefit. Recent data releases that impact our macro view include the credit and activity numbers in China, the ECB bank lending survey, and EM trade reports.
  • In China, new lending was strong enough in Q3 to keep the credit impulse positive, and for the first time in a while we saw property sales growth pick up. Industrial production growth was weak in Q3 as a whole, but the strong September release and the pick-up in the China PMI point to a stronger Q4.
  • The ECB bank lending survey showed a slight improvement in credit supply, but a modest softening in credit demand. In our view the survey as a whole is consistent with GDP growth of around trend, which in the euro area is 1.0% to 1.5%.
  • Finally, early emerging markets (EM) trade data suggests a widening EM current account surplus in Q3. When EM runs a current account surplus, returns to EM FX tend to be high and stable.
  • All of those releases are, in our view, consistent with a more positive outlook for EM FX. Perhaps all that is required to trigger a rally from here is an improvement in the trade narrative and some US dollar weakness. However, there are still some areas of concern.
  • Dynamic random-access memory (DRAM) prices continue to fall, and these are crucial for the semiconductor industry. DRAM prices lead semiconductor sales, which in turn are well correlated with global industrial production and manufacturing surveys such as the ISM. DRAM prices need to head higher in order for the global industrial production cycle to pick up, in our view. If this were to happen, further opportunities could arise in EM local currency debt.

Convertible bonds

Jonathan Stanford

  • Given the severe challenges in earning decent yields from traditional bond investments, alongside the constant risk of further equity market volatility, we think it is worth considering the potential asymmetrical benefits of a convertible bond (CB) allocation.
  • On the one hand, CBs can offer highly attractive upside potential versus government and ‘straight’ corporate bonds. As their name suggests, convertibles are debt instruments with embedded options to convert into issuer shares, thereby offering significant participation in equity market appreciation.
  • And on the other hand, CBs’ fixed income characteristics (they are typically issued in nominal amounts, carry a coupon and have defined maturity dates) mean they offer valuable downside protection in the event equity markets sell off. As a result, the asset class has performed broadly in line with equity markets over recent market cycles, but with much less volatility. The European CB market, for example, has exhibited only about a third of the realised volatility of European equity markets over the last 25 years.
  • At present we have the somewhat unusual situation whereby many CBs are yielding more than their ‘straight’ bond counterparts. As such, their option to convert is not only free of the usual premium but CB holders are effectively being paid to own these bonds.
  • We favour a highly selective approach when looking at CBs. The CB market is relatively small and concentrated and its technicalities can be poorly understood - which means it can be vulnerable to sharp corrections on the back of negative news flow. We believe these reactions are often linked to over-benchmarking and herd mentality, rather than sound fundamental reasoning. For example, the market as a whole has recently been subject to some volatility following sharp sell-offs in the CBs issued by a German fintech and by a Luxembourg-based real estate firm on the back of negative news flow about the two issuers.
  • We firmly believe active management is needed to identify the most attractive CB issuance. Merger and acquisition (M&A) activity can open up particularly interesting opportunities. That is because CBs typically offer an M&A ratchet mechanism whereby CB holders are amply compensated if a takeover is announced while the equity options on their CBs are out-of-the-money. This ratchet kicked in, for example, on a recent acquisition in the pharmaceuticals sector, where holders of the acquired company’s CBs received an attractive premium on their original conversion terms. In our view, this M&A premium potential is a substantial benefit to the upside of the CB asset class.

Important legal information
Source: GAM unless otherwise stated.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. Reference to a security is not a recommendation to buy or sell that security.