So far, we are witnessing a constructive recovery in developed markets after the Covid-19 and oil-price shock. We see this drawdown-to-recovery playing out in three stages:
The first stage was the mark-to-market shock.
The second stage was the recovery in higher quality investment-grade bonds.
The third phase is normalization, with high yield and some distressed emerging market investments beginning to recover.
The markets experienced a shock similar to 2008 but packed into just two weeks, so we could have 2009-2011 style recovery packed into six months. That is the trajectory of recovery we could expect.
In our view, the 500 billion euro EU stimulus plan announced this week is a massive game-changer. This leads us to conclude that Europe is likely to have a stronger recovery than the US, for example.
The Fed and ECB have been active in injecting stimulus, which is a positive. Furthermore, and not getting as much press, is that the IMF has been very active with regards to emerging markets, we are confident that this stimulus will help the construction and recovery of EM economies.
Overall though, the macro outlook is currently vague as there is not enough hard data to give a realistic view on what will be the overall global path of recovery as countries and their economies begin to open up after the coronavirus lockdowns.
Portfolio and positioning
We think US duration is more attractive than Europe in terms of valuation and portfolio construction. In particular, we see good convexity on the 5-year part of the curve. Currently the duration of the portfolio is 5.6 and we prefer to avoid exposure to the longer end as it is volatile.
In high yield, we are now seeing value. For example, Europcar received an injection of cash from the Spanish and French governments, and their main shareholder. It’s a sector that people are afraid of because of the effects of Covid-19. To use a comparison from real estate, in a bad neighborhood you buy the best available real estate in that neighborhood. For example the above mentioned Europcar. The car rental sector is a beaten up one, but Europcar is the best in that sector, in our view, with a good balance sheet.
We are active in the primary issue market. For example, Disney issued various maturities, we bought the long duration as that was the most favored part of the curve, the bond was issued at 280 bps spread, now trading 50 bps tighter within two weeks. By being active in primary issues and looking at every specific case carefully, we can find a good allocation of risk.
In corporate credit,we believe the premium is attractive in developed market cyclical papers.
In AT1s, we have switched between names that had high reset levels to lower reset bonds (referring to the spread that is paid after coupon reset) as they have a lower cash price so you have a higher upside convexity.
Currencies in terms of tactical positioning: Volatility remains low but erratic at times. The FX options book that saw drawdowns in March is recovering, the pace of recovery is slowing down, which is normal, but volatility is abating and we continue to have carry in these positions, so every week that passes we should be able to recover part of the losses.
In terms of strategic views: We are convinced that the euro is on a path to recovery and the US dollar has downside risks. Therefore, we are underweight US dollar (12% underweight) and overweight yen (30% overweight) and we built a long euro position (15% overweight).
The portfolio is skewed towards risk-seeking strategies because we see the long-term value in developed market credit and emerging markets. Before the crisis we had no exposure to investment grade in Europe, now it’s the opposite, because we see the fundamentals as solid and with attractive spreads. It is a “risk-on” portfolio positioning that should perform in a long-term recovery.
Our emerging market exposure is non-consensus, where we believe we could have the biggest pendulum swing when the recovery comes.
Exposure to duration in 5-year US Treasuries and the overweight in yen could help mitigate downside should there be a renewed spike in volatility.
Yield to maturity (YTM) is 5.8% in euro with a carry of 5.2%. The portfolio has broad granularity with over 200 positions with an average BBB+ credit rating.
In June and July, we will begin to see backward-looking hard data being published relating to March and April. This data will not be good, but it will give us an idea of the “bill” of the shock.
We will need to look at the upcoming soft data (e.g., confidence, PMIs, retail sales etc.) to get an idea of how strong the recovery will be.
We expect a rally in fixed income towards September, followed by volatility because of upcoming US elections, which will be a major event.
Normalization has started, but investors should remain specific, by choosing their bonds and duration very carefully. A portfolio with a high carry, built on solid names, should be able to ride the blips of volatility that will inevitably appear.
For further information on performance and investment considerations regarding funds included in this Insight, please click on the respective "Related Funds" below.