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Weekly Manager Views

14 February 2020

At GAM Investments’ Weekly Investment Meeting held on 12 February, the speakers were Adrian Owens, who discussed interest rates and currencies, and Jonathan Stanford, who commented on the outlook for convertible bonds.

Global rates

Adrian Owens

  • While it is too early to gauge the lasting impact of the coronavirus on global supply chains and activity, we believe that the disruption caused by the outbreak is likely to be temporary. We believe much of the hit to growth in Q1 is likely to be reversed in the second quarter and, for now, policy makers are likely to look through the growth volatility. In terms of policy more generally we note a growing recognition that ever more easy monetary policy is not without its issues and expect further calls for more expansionary fiscal policy. As the bulk of the distortionary effects associated with quantitative easing (QE) are mow largely priced and with more emphasis on fiscal policy we expect fundamentals to become more important drivers of markets.

  • Our focus on discretionary, relative value macro themes has historically enabled us to withstand periods of fixed income market volatility. In line with our relative value approach, this has typically been achieved with minimal net duration exposure. Against this backdrop, we have identified several relative value opportunities that we are currently emphasising.

  • First, we believe that US inflation expectations (as priced by 10-year breakeven inflation) are overly muted given the impact of easy policy, tight labour markets and wages that continue to drift higher. The 10-year breakeven inflation rate is currently around 1.8%, while we see the US inflation measure used in breakeven inflation remaining above 2%. Given this backdrop, we believe that Treasury Inflation-Protected Securities (TIPs) (versus conventional US treasuries) represent an attractive opportunity at current levels.

  • By contrast, we believe the inflation expectations currently priced into UK RPI inflation swaps seem overdone. These are pricing in an average RPI inflation rate over the next five years of around 3.5% - which seems rather high given that latest inflation indicators suggest that inflation is hovering not much above 2.0% and recent soft activity data suggests inflation is likely to remain muted in the near term. More broadly, we question whether valuations across UK fixed income as a whole are looking overly rich. UK fixed income has seen strong inflows over the last few years amid Brexit-related uncertainties. But we believe it may struggle to maintain its relative richness as we start to gain greater clarity on the Brexit endgame, see fiscal easing and a bounce in economic activity. As a result, we see better opportunities in euro area and Canada interest rates versus the UK.

  • We continue to favour Mexico. The central bank has already pared back interest rates a little, but we anticipate more aggressive easing to come as inflation continues on its downward trajectory. Under such a scenario, we expect Mexican rates to continue to do well. Meanwhile, we believe the Mexican peso should continue to benefit from the support of a strong real interest rate differential.

  • In our view, the currencies of both Sweden and Norway remain cheap. Sweden’s krona weakened on the back of the Riksbank’s decision to venture into negative interest rate territory. Now that Sweden has ended its experiment with negative interest rates, we expect the krona to recoup some of its losses. Relative growth, relative inflation, relative policy rates, flows and technical all, in our view, support the Swedish krona. We also believe Norway’s krone has scope to appreciate significantly as it is cheap relative to most of its fundamental and historic drivers.

Convertible bonds

Jonathan Stanford

  • Given the ongoing challenges in earning decent yields from traditional bond investments, alongside the risk of further equity market volatility, the potential asymmetrical benefits of a convertible bond (CB) allocation may be worth considering.

  • On the one hand, CBs have the potential to offer highly attractive upside 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 a selection of CBs are yielding more than their ‘straight’ bond counterparts. As such, their option to convert is not only free but CB holders are effectively being paid to own these options.

  • Over the last 20 years, CBs have outperformed both equities and their fixed income counterparts in Europe, the US and Japan. CBs have also demonstrated over time a lack of sensitivity to rising interest rates. We have seen this in periods following the interest rate bottoms of August 2010 and July 2016, as well as the more recent low in August 2019.

  • CB valuations hit a low in September last year and remain below their long-term average, hence these do not seem stretched and there is high revaluation potential. The current low levels of volatility also mean high convexity, which is a positive for CBs and their asymmetric return profile.

  • While there has been little M&A activity of late, primary issuance has seen a good start to the year in both Europe and the US. We have also observed, perhaps somewhat surprisingly, some issuance in euros from Chinese companies.

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. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or advice. Reference to a security is not a recommendation to buy or sell that security.
February 2020