Macro: Sandcastle economics
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Where to wait out the trade war?
Althea Spinozzi
Head of Fixed Income Strategy
Summary: Investors need to take a good, long look at where they want to park their money while the China-US trade war plays out against an already weak macroeconomic backdrop.
The rapid and startling decline of trade negotiations between China and the US have investors worried. Part of the rally seen since the beginning of this year can be attributed to markets pricing in a successful resolution based on positive messaging from the Trump White House. Now that the market is turning, however, many are wondering whether relying on Washington’s word is wise.
Political noise of this type makes it very challenging to take on long-term positions, particularly in a market where valuations are high, inflation is subdued and growth appears to be slowing.
We believe that the trade war will likely escalate from here. After all, while China wants to proceed with planned structural changes, the US is pressuring it to remain as-is – i.e. purchasing vast amounts of Treasury bonds and exporting low-priced consumer goods. This is not an easy status quo to hold in place when China is moving towards reforms geared at making the economy more focused on domestic innovation, consumption and services.
It is therefore necessary for investors to consider where they want to be invested while the US exercises its power and the Chinese economy changes. Beside considering which sectors are more or less sensitive to the trade war, investors must also look at the threats and opportunities presented by their base currency.
Base currency: USD
If your base currency is the dollar, you have plenty of choices. Investors can look to Treasuries as a safe-haven and still get more than 2% across the yield curve. The big question, however, is where value can be found in the midst of an escalating trade war? In the past, we have been keen on short-term maturities; now, although we still like short-term yields, our attention has shifted towards the mid-long part of the yield curve with maturities from seven to 10 years.
There are several reasons for this. First, escalating the trade war means that longer maturities will rally. Second, the Federal Reserve has announced that it will be substituting mortgages with US Treasuries of matching maturities, which should correspond to 7-10 years. This is consistent with our view that we will come to see a full inversion of the yield curve that involves longer maturities as well, signaling that we are in the very last part of the late economic cycle and moving towards recession.
Political noise of this type makes it very challenging to take on long-term positions, particularly in a market where valuations are high, inflation is subdued and growth appears to be slowing.
We believe that the trade war will likely escalate from here. After all, while China wants to proceed with planned structural changes, the US is pressuring it to remain as-is – i.e. purchasing vast amounts of Treasury bonds and exporting low-priced consumer goods. This is not an easy status quo to hold in place when China is moving towards reforms geared at making the economy more focused on domestic innovation, consumption and services.
It is therefore necessary for investors to consider where they want to be invested while the US exercises its power and the Chinese economy changes. Beside considering which sectors are more or less sensitive to the trade war, investors must also look at the threats and opportunities presented by their base currency.
Base currency: USD
If your base currency is the dollar, you have plenty of choices. Investors can look to Treasuries as a safe-haven and still get more than 2% across the yield curve. The big question, however, is where value can be found in the midst of an escalating trade war? In the past, we have been keen on short-term maturities; now, although we still like short-term yields, our attention has shifted towards the mid-long part of the yield curve with maturities from seven to 10 years.
There are several reasons for this. First, escalating the trade war means that longer maturities will rally. Second, the Federal Reserve has announced that it will be substituting mortgages with US Treasuries of matching maturities, which should correspond to 7-10 years. This is consistent with our view that we will come to see a full inversion of the yield curve that involves longer maturities as well, signaling that we are in the very last part of the late economic cycle and moving towards recession.
Opportunities can also be found in the corporate space, but as the trade war heats as up, and given that we are approaching recession, credit spreads should widen. This should allow investors to pick up interesting names in the investment grade space, but we remain cautious concerning the high yield names as defaults may start to rise. For this reason, we favour shorter maturities among riskier assets.
Base currency: EUR
For EUR investors, things are a little bit more complicated. Not only do we face a volatile political environment, but Europe’s economy is weak and yields are depressively low, leaving little room to play investors looking for a reasonable pick up over their cost of funding.
Volatility in the European sovereign is currently at its historical low even as political developments in Italy rumble in the background.
Although many want nothing to do with Italian sovereigns, we believe the volatility of Italian BTPs can provide interesting opportunities, especially given Brexit’s advance and the EU’s inability to endure another departure (we see this as pushing Brussels to be more tolerant of the populist government in Rome).
The more dust is kicked up by Italian Interior Minister Matteo Salvini’s vocal willingness to break the 3% deficit rule ahead of the May 26 European elections, the further BTPs fall. As yield is increasingly difficult to find in even the HY euro space, we see 3% on 10-year BTPs as a very good entry point.
For EUR investors, things are a little bit more complicated. Not only do we face a volatile political environment, but Europe’s economy is weak and yields are depressively low, leaving little room to play investors looking for a reasonable pick up over their cost of funding.
Volatility in the European sovereign is currently at its historical low even as political developments in Italy rumble in the background.
Although many want nothing to do with Italian sovereigns, we believe the volatility of Italian BTPs can provide interesting opportunities, especially given Brexit’s advance and the EU’s inability to endure another departure (we see this as pushing Brussels to be more tolerant of the populist government in Rome).
The more dust is kicked up by Italian Interior Minister Matteo Salvini’s vocal willingness to break the 3% deficit rule ahead of the May 26 European elections, the further BTPs fall. As yield is increasingly difficult to find in even the HY euro space, we see 3% on 10-year BTPs as a very good entry point.
We do not believe that this is a good time to pick up risk in EUR corporates. Although the European Central Bank remains supportive of the economy, it is clear that the macroeconomic backdrop is not favourable for lower-rated corporates.
If the trade war escalates and/or the Eurozone enters recession, leveraged companies will be the first hit; as such, we believe it’s preferable to look at higher-quality names.
In the IG space, financials provide an extra pick-up compared to corporates, particularly on the periphery. We are looking at the senior non-preferred notes from Banco de Sabadell with coupon 1.75%, maturity May 2024 (XS1991397545) and a yield of 1.7%, as well as the senior non-preferred Unicredit 1% with maturity January 2023 (XS1754213947) and a yield of 1.75%.
In order to hit 2%, it is necessary to move into longer maturities such as the Intesa Sanpaolo 1.75% March 2028 (XS1785340172) offering 2% in yield. Many clients remain chary of the Italian banking sector, but we believe that the bigger names are much healthier than they were a few years ago and are now able to weather political and economic risk.
We cannot, however, say the same for the country’s smaller names.
Any escalation of the trade war will disproportionately weigh on particular sectors in the euro area such as auto manufacturing, technology and shipping. Ultimately, we believe that this could be a good opportunity for investors to see some repricing in a world that has seen too little volatility.
If the trade war escalates and/or the Eurozone enters recession, leveraged companies will be the first hit; as such, we believe it’s preferable to look at higher-quality names.
In the IG space, financials provide an extra pick-up compared to corporates, particularly on the periphery. We are looking at the senior non-preferred notes from Banco de Sabadell with coupon 1.75%, maturity May 2024 (XS1991397545) and a yield of 1.7%, as well as the senior non-preferred Unicredit 1% with maturity January 2023 (XS1754213947) and a yield of 1.75%.
In order to hit 2%, it is necessary to move into longer maturities such as the Intesa Sanpaolo 1.75% March 2028 (XS1785340172) offering 2% in yield. Many clients remain chary of the Italian banking sector, but we believe that the bigger names are much healthier than they were a few years ago and are now able to weather political and economic risk.
We cannot, however, say the same for the country’s smaller names.
Any escalation of the trade war will disproportionately weigh on particular sectors in the euro area such as auto manufacturing, technology and shipping. Ultimately, we believe that this could be a good opportunity for investors to see some repricing in a world that has seen too little volatility.
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