C. Rendu de Lint (UBP) | The risk–return profile of so-called “defensive” segments within euro fixed income is less attractive currently and so it is worth optimising investments either with an absolute-return approach, or by using the enhanced liquidity benefits offered by CDS indices.
Using a metaphor from literature, the current macroeconomic environment has all the attributes of the confusing dualism of Dr Jekyll and Mr Hyde. On the one hand, we have Mr Hyde: the uncertainty that surrounds the US–China trade talks which is impacting world trade. On the other we have Dr Jekyll: world growth is holding up to the tune of 3% for 2019, which is close to its six-year average.
The uncertainty surrounding global trade is leading companies to reduce their capital expenditure, as this is the simplest and most direct means of trimming costs; however, this is a move that has weighed on business sentiment in the manufacturing sector. In contrast, services are holding up well, supported by generally healthy consumer spending and a firm labour market. In the absence of any real shocks, the central scenario remains one of stabilising growth.
Central banks synchronise easing but with varied scope ahead
Given these conditions, central banks did a U-turn at the beginning of this year, starting a new round of globally synchronised monetary easing, as highlighted by the recent rate cuts by the Fed and the ECB, along with the ECB relaunching its asset-purchasing programme.
That said, it is interesting to note that these two central banks don’t have the same amount of room for manoeuvre. The Fed was able to normalise its rates ahead of time between 2016 and 2018, whereas the ECB missed its window of opportunity to increase its rates. At 1.75%, the Fed Funds rate offers the necessary cushion should an economic deterioration demand any further reductions. This is a lever that the ECB can no longer really pull, as its rates are negative.
But how are these developments affecting the bond markets? In terms of valuations, both investment-grade and high-yield credit spreads are currently in line with their six- year averages. These last six years are a good reflection of what the “new normal” could be, given that weak growth, low inflation and low interest rates are likely to continue to prevail.
Active management and the search for liquidity
Yet core European sovereign bond yields are not attractive, as the current climate considerably alters their risk-adjusted performance profile. This means that it is vital to reconsider the euro-denominated “defensive” bond market segments, such as the aggregate market, and approach them with an absolute-return investment strategy based on the active management of exposure to interest rates (in the first instance) and to credit (secondly), with a focus on capital preservation.
A liquidity buffer that can absorb shocks has to be a priority irrespective of the segment: from this perspective, CDS indices continue to offer many advantages. Representing 80% of the volume traded on the European credit market, these instruments are more liquid than fixed-income securities. Since 2004, investment-grade and high-yield CDS indices have significantly outperformed their bond equivalents in these two categories, especially in periods of stress.
Finally, euro investors can once again look at dollar-denominated assets for returns. A fixed-income exposure in dollars hedged in euros offers greater yield compression potential relative to European exposure. The subsequent potential capital gain is coupled with the Fed’s broader room for manoeuvre in the event of a shock.