Brexit, High Yield, China

Tanguy Le Saout, Head of European Fixed Income, Pioneer Investments recapitulates the topics of last week.

1. BREXIT – Now the Bank of England Takes Sides

We wrote last week about how the upcoming BREXIT referendum was having an impact on UK economic performance, with Purchasing Managers Indices falling more than expected. Last Thursday, the Bank of England (BoE) finally nailed their colours to the mast, following their interest rate meeting and the publication of their quarterly Inflation Report. The word “referendum” appears 96 times in the May Inflation Report, compared to 2 times in February, highlighting the concern of the BoE’s Monetary Policy Committee (MPC) about the effect the 23^rd June referendum is having on activity. The problem for the MPC is that it is finding it difficult to decide how much of the recent slowing in activity is directly related to the referendum, and how much is a genuine loss of momentum that is reflecting what is happening in the worldwide economy (the BoE did revise down its growth forecasts for the UK economy). Nevertheless, the picture that BoE Governor Carney painted was stark – BREXIT could cause a significant slow-down in the UK economy, potentially even leading to a temporary recession. Sterling could fall sharply, which could lead to a pick-up in inflation just as the economy was nose-diving – a central banker’s worst nightmare. What would be the appropriate course of action for the MPC to take if such an outcome occurred? Higher inflation argues for higher interest rates, which would also support the currency, but an economy that is heading into recession needs lower rates, not higher rates. Governor Carney seemed to imply that the MPC’s reaction function would be driven more by the downside shock to the economy than the upside to inflation from the lower currency. But then earlier last week, the MPC’s newest member, ex-Citibank economist Michael Saunders, seemed to suggest that higher rates would be the appropriate response to higher inflation. All in all, a tricky situation, but we still believe in a short duration position in short-dated UK gilts as a potential hedge against a “LEAVE” outcome.

2. The Attraction of Higher Yields

Let’s start with a question – which major bond market set a record last week for the longest stretch of daily gains since Bloomberg started compiling data in 1989? Answer: the UK gilt market, which has now returned twice as much as its European peers so far in 2016, with 10-year gilt yields having dropped from 1.96% at the start of 2016 to 1.39% earlier this week. That is against the backdrop, as mentioned above, of significant economic and political uncertainty. Here is another question – which country’s investors bought the largest amount of U.S. Treasury bonds since 2005? Answer – Japan, where investors spent 4.8trn Japanese Yen (or US$4.5bn) in March buying U.S. bonds. What’s the common factor? Arguably the relatively high level of yields on offer. When 10-year Japanese government bonds yield -0.07%, and 10-year German government bonds yield 0.13%, then 10-year yields of 1.39% in the UK and 1.75% in the U.S. look very attractive. And when 10-year Australian government bonds, with a AAA-rating and a debt/GDP ratio of below 30% yield 2.25%, that’s even more attractive. Of course, many investors will hedge their currency exposure when buying these bonds, and the cost of that hedging will reduce the attractiveness and yield pick-up available. A recent visit to Australia by members of the European Investment-Grade Fixed Income team coincided with the release of a surprisingly-low Australian inflation print, which was quickly followed by a 25bps rate cut by the Reserve Bank of Australia. With the domestic Australian fixed income investor base generally short duration compared to their benchmarks (and consequently under-performing those benchmarks), expectations of further rates cuts will only serve to highlight the relative attractiveness of higher-yielding markets such as Australia, and to a lesser extent, the U.S. and the UK.

3. Chinese Renminbi – Ongoing Devaluation Pressures

It was a major topic for markets in H2 2015 and early January 2016, but concerns over the path of the Chinese Renminbi had faded from the market’s radar screen in the past few months. To recap, late in 2015 Chinese authorities tried to downplay the focus on USD/CNY by noting that they were managing the Renminbi against a basket of currencies (called the Nominal Effective Exchange Rate (NEER) and comprised the U.S. Dollar, Euro, Yen, British Pound and a few other currencies). As the U.S. Dollar depreciated, the pressure on the Renminbi had eased and it ceased to be a daily talking point in the markets. The weaker U.S. Dollar has also helped to reduce capital outflows from China in recent months, and even the latest “must-watch” number from China (the level of FX reserves) had stabilised over the last two months. But whilst the market was focussing on the U.S. Dollar and the Japanese Yen, the Chinese authorities had been allowing the Renminbi to slowly but steadily depreciate against the basket of currencies mentioned above – the NEER has fallen by 4% year-to-date. But this time the Renminbi has also depreciated against the U.S. Dollar, falling about 1% since the middle of April. With the U.S. Dollar looking like it may have bottomed for the moment, and weaker-than-expected data coming out of China, it could be that pressure will increase on the USD/CNY rate over the coming months, and further depreciation might be expected. We continue to believe that a long USD / short CNY position via options could add to performance over the rest of 2016.