BlueBay: It is what it is

14 jun 2019

News that Trump was cancelling tariffs on Mexico helped to buoy sentiment, yet rate-cut speculation remained rife on the view that uncertainty around trade policy will weigh on sentiment in the months to come, with 65bps of easing priced between now and the end of 2019 in Fed funds futures contracts.

US core CPI was slightly softer than expected but remains at 2.0% – not inconsistent with the Fed’s mandate, though presidential interventions berating the Fed for keeping rates too high also seem to be seeping into the subconscious attitudes of investors. It will be interesting to see how the Fed responds to this when it meets next week.

We continue to believe that the Fed will underline its patient approach with a soft easing bias to act should the data point to a material slowing of activity.

However, for now, we remain encouraged that a healthy consumer will continue to support the domestic economy and so the FOMC should want to see more evidence of a loss of momentum before signalling a more decisive change in direction.

In that context, we maintain our view that the market is too pessimistic on the growth outlook and that rate-cut projections should be faded.

Italian risks look overexaggerated

In Europe, a week of supply saw a rally in the periphery take a pause. However, we continue to see strong demand for investments offering incremental yield against the backdrop of record-low yields in core euro fixed income, with the ECB set to retain a dovish stance for the foreseeable future.

Following the EU elections, Italian policymakers have made more constructive comments with respect to adherence to EU fiscal discipline, though investors remain deeply suspicious, with international participation at very low levels.

In contrast, we continue to believe that BTPs offer compelling value. 10-year Italy spreads of 265bps compare to 155bps in Croatia, 130bps in Indonesia and just 88bps in Portugal.

Indeed, Italian government bond spreads are largely the same as the sub-index of BB-rated euro high yield corporate bonds – yet Italy is a zero-risk-weighted asset, benefitting from robust institutional support within the EU.

We maintain the view that Italian credit and EU break-up risks are over-exaggerated.

In this context, Italy makes comparable assets appear relatively expensive in our eyes, with the principal exceptions to this rule being Greece and subordinated financial debt, where we continue to believe that credit spreads materially over-compensate investors for the credit risks they are taking.

Tariff turnback lifts EM

Elsewhere, Latin American assets were helped by the cessation of Mexican tariffs during the week. Looking more broadly, a pattern of differentiation within emerging markets continues to characterise the current trading environment.

South Africa has been under some pressure as the fiscal situation deteriorates against a backdrop of stagnant growth, while some of the high yielders, including Turkey and Argentina, have enjoyed something of a relief rally in the absence of bad ‘new news’ for the time being.

Corporate credit spreads have largely tracked moves in risk assets of late, with the greatest volatility seen in some of the higher-yielding energy names in response to the recent weakness in oil prices.

Overall, default rates remain low, and with a record volume of European fixed income securities trading at negative yields, the reach for yields appears to be a resurgent theme – even if investors seem wary of adding to credit risk on perceptions that we are ‘late cycle’, with worries of slowing growth creating a perception of fear, which is offsetting any greed for the time being.

FOMC likely to dominate next week’s thinking

We believe that further rate hikes will be eliminated from the dot plot but we are disinclined to think that the Fed would signal future easing at this point (with the Committee exposing itself to criticism for delay, should it communicate a belief that lower rates will be needed in the future).

Consequently, we believe that Powell will reiterate that he will be ready to act should signs of economic deterioration manifest, but we believe that central bankers will always look for evidence before moving, so any cut before September would seem very unlikely, in our view.

If the economy holds up better, in line with our own thinking, then it remains highly debatable whether the Fed will need to ease at all in the months to come.

Arguably, equity valuations may now be relying on the Fed to deliver, so could risk being disappointed, though ultimately, we feel that it is the pace of growth in the economy and earnings that will determine where stocks trade through the balance of 2019.

Boris likely to score in Westminster

Meanwhile in the UK, the Conservative Party leadership contest is now officially underway as the country searches for its next prime minister. The field of 10 candidates is already being whittled down and for now, it seems hard to imagine that Boris Johnson won’t make the final two; the fate of which will be decided by Tory members.

In this context, he seems highly likely to be selected but we continue to observe that his hard Brexit agenda will be very difficult for him to deliver in practice, with insufficient support in the Commons.

We expect that he may embrace Nigel Farage and cut off the Brexit Party, and with a resulting bump in the polls, this could leave Johnson encouraged to go to the country to seek a stronger mandate to ensure that he delivers on his Brexit promises – yet it is interesting to observe how vulnerable Johnson himself would be to losing his Parliamentary seat in an election in a Remain-leaning constituency.

In this case, his likely tenure could yet prove very short indeed (some may be inclined to think that this could be some poetic justice).

Odds seem to favour a ‘no deal’ Brexit early next year – but with a general election a 50% probability as we see it, a Labour coalition, a second referendum and a decision to remain, are also still very much on the cards.

As for the Tory leadership contest itself, it seems like a bit of a sorry affair. The gossip, backbiting, infidelity and stories of drug-taking would frankly not seem out of place on a reality TV show.

In this sense, it almost seems to resemble the TV series Love Island, with the main differences being that there isn’t much love to be found in Westminster and this version isn’t as easy on the eye.

It’s hard to escape the conclusion that the British political system is pretty broken at the moment. However, in the words of the oft-used Love Island phrase, ‘it is what it is’, innit.