Rich outlook, poor politics

Mid-Week Bond Update

Rich outlook, poor politics

Corporate bond markets added another week of gains, supported by rising US wage data, improved industrial and manufacturing output in Germany and the UK, and an upgrade of this year’s global economic growth forecast by the International Monetary Fund. That is as far as the good news went: partially...

offsetting this positive mood, escalating tensions between the US and Turkey and within Spain dented sentiment, hit the US dollar, sustained most developed market sovereign bonds and slightly punished Emerging Markets (EMs). Rising political risk also sprung in EMs: in Mexico, the peso lost 2.6% against the dollar over the past five trading days on growing speculation that a populist candidate could win next year’s presidential election; and in Turkey, the lira plunged 2.7% against the greenback on the back of a diplomatic spat with the US that resulted in the two countries suspending each other’s citizen visiting visas.

Far from the epicentre of those tensions, Wall Street equities reached yet another high, mostly boosted by the improving US wage data. US inflation expectations climbed to the highest since May, and market-implied expectations that the Federal Reserve will lift rates in December climbed to 80%. Credit spreads continued to tighten: the premium that investors demand to buy US Investment Grade corporate bonds over Treasuries fell to 1.06%, the lowest since 2014, while High Yield spreads dropped to 3.42%, also the lowest in more than 3 years. Oil and most commodities rose on the improved global outlook.



EMs: investors struck oil: The fact that EMs have been recently hit by the rising political uncertainty in Europe shows how much more integrated they are within the forces that traditionally spin the wheels of world finance – and less so with what used to drive them: commodities. As seen on the chart, EM currencies often followed the price of oil and copper, two of their main exports, but that correlation has dropped now. This has happened as some leading EMs have diversified their economies, improved their budget and current account deficits and adopted more independent central bank policies – less dependent on the moves of the US Federal Reserve. This has become possible after years of battling against inflation: Brazil’s annualised inflation rate, for instance, has dropped to 2.5%, down from 10.8% only last year. The market’s response has been stark: Brazil’s sovereign local debt has gained 18.8% so far this year, on an unhedged basis, the best-performer in the leading JP Morgan GBI Index of EM local sovereign debt. Now it’s investors, and not the country, who seem to have struck oil – click here to read Brandywine Global’s latest “Around the Curve” blog: Can Emerging Markets hold steady?


EMs: Not an oil, copper story any more


Emerging Markets - Copper and Oil

Source: Bloomberg Barclays 11 October 2017. RHS is Right Hand Side. USD is US dollar. Past performance is no guarantee of future results. Please see disclaimers for definitions.


China – defying gravity: While most EM currencies dropped over the past five trading days, the yuan strengthened almost 1% against the US dollar, following stronger daily fixings from the country’s central bank – which has been trying to curtail capital outflows for months. The People’s Bank of China governor Zhou Xiaochuan also recently called for looser capital controls as the country aims to make its exchange rate more freely determined by global markets. So far this year, China’s currency has gained 5.3% against the US dollar. The country, which is preparing for its twice-a-decade Congress later this month, is also defying investors’ doubts over its capacity to maintain economic growth: its September manufacturing data was the strongest in five years. Many of its supplier countries sighed in relief.



Corporate credit ratings – more down than up: Despite the gloss of Wall Street’s recent stock market records, the financial health of US companies shows a less rosy picture: the ratio of US corporate credit rating upgrades versus downgrades is still below zero as, so far this year, more companies (694) have been downgraded than upgraded (552), according to Bloomberg data. The resulting 0.8 ratio, however, is better than last year’s 0.62, but still a reflection of rising corporate leverage: the Standard & Poor’s 500 Index average total debt-to-total equity ratio, for instance, has climbed to a current 113.6, up from 105.4 in 2014. With both Investment Grade and High Yield spreads at three-year lows, some investors seeking yield and returns have fled to traditionally less explored parts of the market, such as Emerging Markets, High Yield or bank loans. Click here to read Western Asset Michael Buchan’s “Finding Value in Bonds Now.”


Less shiny than Wall Street: Up & Down corporate credit rating ratio


Source: Bloomberg as of 11 October 2017. RHS is Right Hand Side. The universe includes US companies, both rated Investment Grade and High Yield. Past performance is no guarantee of future results. Please find definitions in the disclaimer.


India: stagflation fears, rate cut hopes: After being an EM posterchild on the back of strong growth and expected reforms, India seems to have fallen out of investors’ favour. The national currency has dropped 1.9% against the dollar over the past 1-month period, while the country’s local sovereign bonds have lost 0.6% over the past three months, the worst performance within the JP Morgan EM GBI Index, which has gained 3.1% over the same period, on an unhedged currency basis. The Reserve Bank of India recently cut next year’s growth forecast to 6.7%, from 7.3%, while annualised inflation has risen to 2.5%, up from 1% in June. This has lifted investors’ concerns over potential stagflation, as well as hopes that the central bank may have to cut rates to spur growth.


Source for all data: Bloomberg and Barclays Capital as of 11 October 2017, unless indicated.



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