15 October 2015 Fixed Income newsletter The quarterly fixed income newsletter of Allianz Global Investors Editorial QE2 is an increasingly credible scenario FRANCK DIXMIER GLOBAL HEAD OF FIXED INCOME The US Federal Reserve (Fed) was once again able to test the strength of its influence over the markets in September. At the dawn of a normalisation cycle in the Fed s monetary policy, a forthcoming decision has rarely drawn so much commentary, or been so widely-anticipated, nor has the ensuing inaction ever been so devastating! The Fed has - exceptionally - erred in its monetary policy by leaving Fed Funds rate unchanged. The central bank of the world s leading economy effectively has several good reasons for initiating a rate-hike cycle. The economy is close to full employment, consumer confidence is driving domestic growth, the property market is healthy, etc. Inflation certainly remains at a low level, impacted by the fall in commodities prices, however in a context of almost full employment, how is it possible to believe that the Phillips curve should be discarded? As several members of the Fed committee have highlighted, it is highly likely that inflationary tensions will ultimately influence wages, according to the simple rule of supply, which is increasingly limited, vs. demand, which remains strong, in the US employment market. The reasons given for leaving base rates unchanged were also surprising, as it is unusual for the Fed to base its decisions on external considerations such as the risk of a slowdown in China and other emerging economies, whereas domestic issues have traditionally always been the main factors taken into account in determining monetary policy. Furthermore, muddled communication from certain members of the Federal Open Market Committee (FOMC) ensured that confusion reigned. Too much freedom of speech, combined with the clamour for transparency, can ultimately totally eclipse the so-called forward guidance which is meant to channel investor expectations. The context has confirmed our anticipation of an initial increase in Fed Funds during 2015. It is important to understand however, that the rate-hike cycle will adopt an atypical profile in terms of its duration, as well its amplitude. Given that the US economy is highly leveraged, it would not be surprising to see the Fed cap its rate hikes at a level below medium-term target inflation, while also avoiding at all cost an inversion in the yield curve, which in the past has always heralded an imminent recession. Recent events have therefore not caused us to change our opinion. We are reiterating our core scenario based on a future divergence in monetary policies, with on the one hand the Fed about to start normalising its monetary policy, and on the other hand, the European Central Bank (ECB) sending out a very clear message regarding its plan to step-up its quantitative easing programme (QE) if circumstances require. The ECB s credibility may potentially be undermined. The credit cycle has taken off in the Eurozone, which is good news and to the central bank s credit. However, the recent downgrade in inflation forecasts raises doubts over the efficiency of its policy. Our message is unambiguous on this point, affirming that the ECB has the will and the capacity to intervene, and is ready to do so. QE2 is thus an increasingly credible scenario.
Key macro trends & investment strategy Europe Political developments have continued to dominate the headlines in Europe: In August, a long-awaited agreement has been reached between Greece and its creditors with a 86bn 3rd bailout deal approved. In the general elections that followed on 20 September, SYRIZA won 35.5% of total votes, allowing it to form a new government with its former junior coalition partner the same coalition which has signed the memorandum. The lack of an absolute majority for the secessionist camp in the regional elections in Catalonia has sparked a relief reaction in the market: spreads of Spanish government bonds have recovered both vs Bunds and BTPs. Further evolution of this story will depend on the outcome of the general elections held in December. In Portugal, the incumbent centerright coalition won general elections at the beginning of October. However, the threshold for an absolute majority has not been reached. The outlook for further progress in the fiscal and structural reform areas looks uncertain, as a minority government will likely be less strong than before. EU Big 4 Manufacturing PMI Source: AllianzGI, Bloomberg, September 2015 ECB loans to Non-Fin Corporations and Households Aside from the political field, data releases maintain evidence that the Euro-zone recovery continues to be on track. The Composite PMI indicator has decreased from 54.3 in August to 53.6 in September but remains well in expansionary territory. The average Euro-Zone PMI for the 3rd Quarter of 53.9 points to a GDP expansion in Q3 Source: European Central Bank - Data Y/Y growth 2
2015. In its September staff macroeconomic projections the ECB forecasts Euro-zone GDP growth of 1.4% in 2015, and 1.7% in 2016. Chart: Euro-zone headline and core inflation The downturn in parts of the Emerging Market segment should not impose large effects on the economic recovery in the Euro-zone while improved credit conditions and lower energy prices will provide support to private consumption. Despite the weakness on the stock market and a potential extension of the ECB s asset purchase programme by maturity and/or monthly quantity, the strength of fundamentals in the Eurozone leaves bond markets vulnerable. Euro-zone headline inflation weakened in September with the flash estimate at -0.1%. However, core inflation has remained remarkably stable at 0.9% even though it is still subdued. Headline inflation in the Euro-zone is expected to pick up in Source: AllianzGI, Bloomberg, September 2015 the 4th quarter. The base effects from the decline of energy prices a year ago will materialize over the last quarter of the year and push up the inflation rate. Afterwards, a normalization is still expected to take place at a moderate rate driven by the on-going economic recovery. Governing Council members have reiterated in various speeches that the ECB remains ready to act if needed and if inflation expectations seem to de-anchor - by modifying size, composition and duration of its programme. USA The timing of the first rate hike in the US since 2006 remains the main cause of uncertainty. The decision by the Fed in mid-september to keep interest rates unchanged accompanied by a dovish FOMC statement led to increased volatility in markets for risky assets. FOMC speakers have subsequently attempted to clarify that one rate hike this year is the base case - in line with the September dot charts. Upcoming data releases and developments will be key to gauge the timing for the US: Appropriate pace of policy firming ( dot charts ) - september 2015 3 Source: FOMC September 2015
return to conventional monetary policy measures in the US. Overall, macroeconomic data in the US have remained positive with risks of surprises to the downside ahead. Private consumption remains strong and the labor market continues to be in a solid condition, with weekly jobless claims stably below the level of 300k. However, Non-Farm Payrolls in September were weaker than market expectations. While +142k still represents a decent print at the late stage of the economic cycle the momentum is negative, and adds to uncertainty casting doubts on the expectation for continued solid growth of the US economy. Further downside risk to GDP growth is linked to the high level of inventories which could contribute negatively to Q3 figures. On the other hand, real Personal Consumption Expenditures have been strong in August, increasing by +0.4% on a monthly basis. Evolution of Atlanta Fed GDPNow real Source: AllianzGI, Bloomberg June 2015 Employment Cost Index (ECI) vs Average Hourly Earnings Despite some adjustments to the downside, consensus forecasts for Q3 GDP growth remain at around 2.5%. The Atlanta Fed model is now trending in the opposite direction, posting a meager +1,1%, mainly due to a worse than expected trade balance and a correction in inventories which remain at historical highs. Source : AllianzGI, Bloomberg, September 2015 US headline inflation is close to zero (+0,2% yoy), due to the commodity price decline. Core CPI in the US remains relatively elevated instead (+1,8% yoy). The Owner Equivalent Rent of Residence, which represents around 40% of core CPI, continues to rise and has touched the 3.0% mark yoy. Average gasoline prices have finally reacted to the oil price decline which is positive for consumers. The Employment Cost Index (ECI) declined in the second quarter from +2.6% to 2.0% yoy, missing expectations of a further increase. The ECI trend is now more in line with Average Hourly Earnings which remained unchanged on a monthly basis in the September report (+2,2% on a yoy basis). Japan and Emerging Markets In the Bank of Japan s (BoJ) press conference in mid-september, governor Kuroda maintained an upbeat outlook on the economy. The tone was particularly positive on a recovery of domestic demand which could be further supported by the improvement of corporate earnings. On the other hand, negative growth in April-June has been followed by disappointing data in July on exports, production and consumption. This reinforces the case for further monetary expansion going forward. China continues to remain in the spotlight. In August, China abandoned its appreciation of the Yuan vs. the USD. It has now adopted a managed free float 4
meaning China will allow the Yuan to weaken in a gradual manner by still intervening. The Yuan devaluation resulted in faster capital outflows, which forced the People s Bank of China to support the currency by selling foreign exchange reserves. FX outflows reached new record highs in August, with PBOC forex reserves dropping USD 94bn, followed by a decline of USD 43bn in September. Chinese authorities remain committed to act to fix the situation but the overall scenario remains very uncertain. There are growing signs of a further slowdown in Chinese GDP growth. The government has taken steps to stimulate property demand and boost the auto sector, though it will take time for stimulus to be reflected in growth figures. The situation in other Emerging Market countries remains on a negative track, with larger countries such as Brazil needing fiscal adjustments, and Russia facing tough recessions exacerbated by the commodity price decline and consequent negative pressure on domestic currencies. Currencies The price action after the dovish September FOMC meeting revealed: 1) The theme of monetary policy divergence remains intact, even after a dovish Fed. Markets are looking for increasing pressure on the ECB (BoJ) to ease more; and 2) the bullish USD consensus and positioning is not as strong as suggested in the marketplace. Short-term interest rate differentials will remain important. Our bigger picture bullish USD view remains intact, with the case for monetary policy divergence still valid. In our view, USD strength will continue in the medium- to long-term, albeit Chinese FX Reserves vs Bloomberg estimated Capital Flows Source : AllianzGI, Bloomberg, September 2015 more gradually and with increasing volatility. As for the US, the timing of the first rate hike by the Bank of England is clouded. However, monetary policy divergence compared to the ECB might still increase over the next quarters, supporting a bearish EUR/GBP view. Credit Investment Grade After the usual summer lull and Greece-related turmoil, focus turned on increased issuer specific risk within the automobile, materials and consumer staples sectors. As we are entering the earnings season, this is likely to limit the fear of heavy new issue pipeline, thereby limiting the risk of over-supply and should help support bond prices. Valuation, when compared to the fundamentals, start to be attractive again. In this context, due to the overall solid fundamentals but less supportive technical support in the coming weeks (earnings season blackout period, reducing of banks balance-sheet around quarter-end ), we are still Neutral on the Investment Grade credit bucket. High Yield The European HY market has been stuck in a bear trend amplified by the very poor liquidity provided by banks. Outflows have been limited so far, especially compared to its US high yield counterpart, but investors are anticipating some and try to sell all the bonds which have not dropped yet, bringing the whole HY market space down. On top of that, two sectors were particularly hit over the last weeks, namely the Automotive sector due to issuer specific adversity, impacting the HY auto suppliers and the Cable issuers with the official end of some potential M&A activity. Apart from those two sectors every excuse was good to send bonds 1 to 3 points down. Within 8 days of trading (September 21st - September 30th), the HY market erased most of its gains with a cumulative negative return close to 2%. The consequence is that the average yield of the asset class topped 5, a level not seen since 2013. With OAS spreads around 500 bps, we are now back to summer 2013 levels with the Itraxx Xover trading at 380 bps compared to 480 bps at that time. We keep our neutral stance in this context. 5
Glossary Breakeven: See inflation expectations. Bund: German Treasury bond. Unless otherwise indicated, with a residual life of 10 years. Covered bond: A bond issued by a bank and this is backed by collateral, or a guarantee, most often mortgage loans. Duration: Average life span of a bond or a bond portfolio, including all related flows, i.e., coupons and partial or full repayments. The more a 10-year bond pays out high coupons and makes partial repayments, the shorter its duration. The lower its coupons and the closer its repayments are to maturity, the longer, or higher, its duration. Eonia (Euro OverNight Interest Average): Average euro zone overnight (see this term) money-market rate. Euribor: Benchmark money-market rate for terms ranging from one week to two years. Haircut: A haircut is a percentage that is subtracted from the market value of an asset that is being used as collateral. The size of the haircut reflects the perceived risk associated with holding the asset. Inflation expectation: This is the spread between the bond market yield on a certain duration and the real rate (ex-inflation) as results from the market value of a bond linked to inflation of the same duration. Inflation-linked bond: Bond whose principal is indexed regularly to inflation of the issuing country or the euro zone. The remuneration rate, which is based on the principle plus inflation, therefore offers a real remuneration (ex-inflation). Investment approach: In each region (US, euro zone, and emerging markets) we review the following variables over the medium and long term: growth potential, inflation risk, monetary policy, long bond yield potential, and risk appetite. Money market: Cash market. Banks place their short-term cash on this market or go to it to borrow the funds they need on a short-term basis. See also Eonia, Euribor, overnight rate. Overnight rate: Refers to a 24-hour loan that may be rolled over indefinitely. OAT: French Treasury bond. Unless otherwise indicated, with a residual life of 10 years. Spread: The difference in yield between two bonds with the same maturity, with the former often offering greater risk than the latter. Treasuries: US Treasury bonds. Unless otherwise indicated, with a residual life of 10 years. Variable: See investment approach. All data provided in this document come from the following sources: Datastream, Reuters, Boursorama. The variation listed are calculated from one month to the other. It concerns the indexes established by assessment organism commonly recognized unless stated otherwise (INSEE, IFO - Institut für Wirtschaftsforschung, ZEW - Zentrum für wirtschaftsforschung, GFK - Gesellschaft für Konsumforschung, etc.). 6 Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. Bond prices will normally decline as interest rates rise. 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