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Political landscape: risks abound
Spooked by a slowing US economy, President Trump softened his tone on China. Markets reacted positively to the President’s announcement regarding the suspension of tariffs and his claim that a “phase-one deal” had been reached. China proved less optimistic, as state media did not even speak of a “deal” at all. We believe a real, structural solution to the trade war is unlikely. However, with tensions easing, we may see a temporary improvement in market sentiment.
In the meantime, an impeachment procedure has been initiated against President Trump because he pressed newly elected Ukrainian President Zelensky to investigate Joe Biden by freezing almost $400 million in US military aid to Ukraine. Although we consider it unlikely that the republican majority in the senate will vote for impeachment, the President may go into elections significantly weakened because of the procedure.
And there is more bad news for President Trump. While the more moderate Joe Biden is still ahead in the polls, Elisabeth Warren’s bid for presidency is increasingly gaining traction, too. As an outsider to the establishment, she might be more resistant to Trump’s anti-establishment rhetoric that worked so well in his 2016 campaign. Moreover, Warren does not shy away from taking on a more populist approach towards banks, big pharma and big tech firms.
Closer to home, the Brexit saga has entered a crucial stage. At the time of writing, Boris Johnson has reached an agreement with the EU, but he has yet to pass the bill through parliament. He has subsequently been forced to request a three-month extension. The vote will undoubtedly be tight: the Northern Irish DUP party is not keen on border controls between the UK mainland and Ireland, and Johnson will have to get Tory deserters and a number of Labour votes on board as well. Nevertheless, with the alternative being new elections and/or a new referendum, the risk of a hard Brexit has decreased markedly – causing the pound to soar. A confirmed Brexit deal would provide a further boon to the GBP and domestically-oriented stocks, contrary to the more export-oriented FTSE100.
Further East, tensions between Hong Kong protestors and China continue. Meanwhile, president Trump’s move to pull troops from Syria has paved the way for the Turkish military to hit Kurdish forces which are currently in control of several Syrian regions. The Kurdish troops have entered into a deal with Assad, who is, in turn, backed by Russia. As such, the US’ economic sanctions against Turkey may not be sufficient to prevent a civil war in Syria. The temporary ceasefire between the US and Turkey in exchange for an easing of economic sanctions on the latter is unlikely to stabilize the situation. Finally, tensions between Iran and Saudi Arabia are close to escalation, subsequently driving up volatility in the oil market.
Economic landscape: the limits of monetary policy
In early October, Mario Draghi, outgoing President of the European Central Bank, gave another speech calling for more fiscal stimulus, causing yields to bounce back from all-time lows. Earlier in September, he already said it was high time for fiscal policy to take charge, encouraging European governments to do more. With rates far below the zero bound, monetary policy has become less effective in battling slowing growth. Moreover, years of monetary stimulus have led to plenty of unintended consequences, such as inflated asset prices, rising inequality, increased savings and a potential loss of faith in central banks. We have reached a crossroads where monetary policy is at the limits of its power and fiscal stimulus will be needed to keep the economy from faltering. Germany, Europe’s strongest advocate of austerity, initially seemed to have made a move in the right direction, announcing a multi-billion climate plan. Soon after the initial announcement, however, Germany emphasised the plan would be budget neutral This implies that, for now, large-scale fiscal stimulus plans may not be in the works. It remains to be seen how Christine Lagarde, who begins her run as new ECB President, will tackle this problem.
Implications for investment portfolios
Given the global growth slowdown and various political risks that could impact markets, we remain cautious on equities. Thus, we are slightly underweight versus the benchmark. In general, we underweight risk assets (e.g. equities, high yield, credit) and maintain a neutral stance on real estate. For similar reasons, we are long on gold. Within fixed income, we have a high conviction position in global government bonds.
Fixed income: searching for cheap protection
The global carry trade
Within fixed income, we expect a further slowdown of growth, and have positioned ourselves accordingly. This means we do not shy away from taking up duration in the portfolio. In the absence of a clear fiscal stimulus plan and with geopolitical risks such as Brexit and the US-China trade war at the forefront, rates are bound to remain low. However, with EUR rates reaching their bottom limit, their expected returns are underwhelming to say the least. On the other hand, it would be ill-advised to load up on high spread instruments (such as high yield) at a time when we are underweight equities due to a slowdown in growth and an abundance of downside risks. An increase in leverage, low credit spreads, rating agencies’ prediction of additional defaults and a substantial underperformance of US CCC-rated bonds , offer more reasons why investors should be prudent when investing in high yield bonds.
In order to still generate an interesting return on the fixed income side and simultaneously improve the portfolio’s diversification ratio, we hold a significant position in global government bonds. With rates substantially higher in countries such as the United States, Canada and Australia, their government bonds have far more upside potential to offset the current trend of slowing growth and low inflation. In the meantime, high interest rates offer a higher carry.
10 year government bond yield
Source: DPAM 2019
Uncovered interest rate parity
Unfortunately, this global carry trade is not without risk. In return for a higher interest rate, the investor is exposed to currency risk.
Based on the efficient market hypothesis, the uncovered interest parity hypothesis postulates that the interest rate differential between two countries will equal the relative change between the countries’ currencies. Consider a European bond investor who sells a German 1-year government bond, which trades at a yield of -0.65%, for a Canadian 1-year government bond with a yield of +1.65%. According to the uncovered interest rate parity hypothesis, this trade will not be profitable, as the 2.3% extra interest earned by the transaction is expected to be offset by a 2.3% depreciation of the Canadian dollar against the euro. In other words, the market is perfectly efficient and European bond investors are stuck with low interest rates.
Luckily, an overwhelming amount of studies have highlighted the empirical deficiencies in the uncovered interest rate parity hypothesis. In practice the interest rate differential turns out to be a poor predictor of future exchange rates. In fact, over the short to medium term, the high-interest rate currency’s relative attractiveness generally causes it to further strengthen.
A strong dollar offers protection
September’s sudden rise of the US-secured, overnight financing rate, pointed to a significant liquidity shortage in the US economy. This has subsequently forced the US Fed to inject billions of dollars in order to calm down the repo market. This shortage of US dollars, enhanced by an overly-restrictive US monetary policy, protects holders of US government bonds from a depreciation of the currency. This is in accordance with the above-mentioned hypothesis. Furthermore, the strength of the US dollar relative to the Euro is further supported by the relative slowdown of the European economy and the ECB’s accommodating policies. In our opinion, there are plenty of factors that will continue to support the US dollar’s forward momentum. This allows us to go long on US bonds and profit from their higher carry and greater upside potential. Within our US Treasury exposure, we have a significant exposure to inflation linked bonds. These should profit from an increase in fiscal spending, which will protect the portfolio’s bond exposure from a consequent rise in interest rates.