From DC to Sintra via Paris: a 1st half story

Mid-Week Bond Update

From DC to Sintra via Paris: a 1st half story

Global bond markets ended the first half of the year as they started it: prospects of fast growth, especially in the US, pushed sovereign yields higher, supporting spread sectors and the most equity-like fixed income assets such as...

High Yield (HY). But the first half has been everything but optimistic and steady: the risk-on mode took a turn as soon as the new US Administration started facing challenges, which reduced investors’ expectations of an imminent economic upswing. The rise of European populist parties also dragged down bond yields, although this changed after market-friendly parties won the Dutch and French elections, as well as a local vote in Italy. The period ended with a synchronised hawkish message from the US, European, British and Canadian central banks, following a summit in Sintra, Portugal. This roller-coaster period delivered strong fixed income gains, especially in growth-sensitive sectors such as Emerging Markets (EM), HY and mortgage-backed bonds. US Treasuries held despite two rate hikes as inflation expectations remain low.

European sovereign bonds suffered on the back of an improved economic outlook, which raised speculation about a potential tapering of the European Central Bank’s monetary stimulus. The euro surged 8.6% against the US dollar. However, the greenback faded as soon as the euphoria that followed Trump’s election victory in November started to fade. This helped EM currencies, especially the Mexican peso, which more than offset its post-US election loss. The Brazilian real, however, fell against the US currency amid increased political instability. Oil prices fell to US$45 per barrel, from US$52 at the beginning of the year, as increased US shale supply more than offset output cuts from other producer countries. Investors now look into active management o navigate through the second half of the year – watch what Legg Mason portfolio managers say.

 

ON THE RISE

Emerging Markets – first-half winners: EM sovereign and corporate bonds performed strongly in the first half, supported by a reflationary outlook. Concerns about a significant slowdown in China eased as the country continued to post annualised growth above 6.5%, and as Europe and Japan seemed to leave deflationary fears behind. The US Federal Reserve ignored weak inflation data and raised rates twice, reassuring markets it is on course to lift them once more this year as it expects the economy to pick up. EMs, once hit by rising US rates, have shown more resilience over the past six months, underpinned by their improving fundamentals: central banks, such as Mexico’s, have lifted rates to control inflation, while India has benefited from low oil prices to limit price growth. A lower US currency has also buoyed EM corporates as some have US dollar-denominated debt. Click here to read why Western Asset thinks EMs may offer opportunity to investors.

 

The unusual suspects: EMs shine in US rising rate cycle. 1st half performance (%):

Source: Bloomberg as of 5 July 2017. Non-A is non-agency, loc is local, sov is sovereign, USD is US dollar, EM is Emerging Markets. Treas. is Treasury, y is years, curr is currency, HY is High Yield, IG is investment grade, Corp is corporate, MBS is mortgage-backed securities, gov is government. Past performance is no guarantee of future results. Please find definitions in the disclaimer.

 

China – connecting with investors: It is no secret that China wants to increase the yuan’s international presence and that the country is in the process of opening up its stock and bond markets, still dominated by local investors. After unveiling a new platform that allows international investors to buy onshore Chinese equities, the Asian giant launched this week “Bond Connect,” a link between Hong Kong and mainland China, so offshore investors can participate in the country’s US$10 trillion debt market. Initially, the programme will only allow one-way flows into the world’s third-largest bond market. China’s 10-year sovereign yield trades at around 3.5%, with annualised consumer inflation at 1.5%. In the US, the gap is wider: the 10-year sovereign yield trades at 2.3%, while annualised consumer inflation is at 1.9%. At present, foreign investors only represent about 2% of the country’s bond market.

 

ON THE SLIDE

 

UK-EU manufacturing – oceans apart: The economic gap between Britain and the Eurozone continued to widen – leaving the separating island behind. June’s manufacturing Purchasing Managers’ Index data came in strong in the Eurozone, especially in Germany, while it faded in Britain. Challenged by a weak currency, rising inflation, stagnant wages and political uncertainty, the UK has just started negotiating its exit from the European Union, scheduled to last as long as two years. Whether Britain will keep access to the single market is yet to be seen, making some companies consider a move to the continent in order to have guaranteed access to the Eurozone’s 340 million consumers. The negotiations will have a price. Click here to read Brandywine’s “Around the curve” blog about Brexit and reports of a UK economic demise.

 

Britain, left behind?

Markit manufacturing Purchasing Managers’ Index (PMI) per country

Source: Bloomberg as of 5 July 2017.Please find definitions in the disclaimer. 

 

Yen – still dormant? The Japanese currency fell 0.7% percent against the US dollar over the past 5 trading days, as an improved global growth outlook cut safe-haven demand for the traditionally stable currency. Japan has been trying to reflate its dormant economy for two decades, for which it continues to add billions of yen in the system, pushing down the currency. But the two-decade effort may be starting to bear fruit: the country’s well-known Tankan survey of large company business conditions reached 17 in June, matching its level on March 2014, which had been the highest since 2007. Still, the country’s annualised consumer inflation is at a stark 0.0%.Green shoots?

 

Source for all data: Bloomberg and Barclays Capital as of 5 July 2017, unless indicated.

 

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Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

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