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«Euro periphery: our favorite for now Fixed Income Allocation Outlook Q2 2014 Italian Prime Minister Matteo Renzi Kommer van Trigt, Head Fixed Income ...»

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Second quarter 2014

For professional investors

Euro periphery: our

favorite for now

Fixed Income Allocation Outlook Q2 2014

Italian Prime Minister Matteo Renzi

Kommer van Trigt, Head Fixed Income Asset Allocation

Magiel van de Groes, Portfolio Manager

Paul van der Worp, Portfolio Manager



Main views and changes since last quarter

Main asset

Total Valuation Technicals Fundamentals


- ◄► - 0 0 German Bunds

-- ◄► - - US Treasuries

-- ▼ -- + JGB’s 0 ◄► 0 0 0 IG Credits 0 ◄► 0 0 0 High Yield

-▼ + - EMD local debt +▲ + + 0 EURO peripheral debt Our key themes

• Constructive on growth We believe the US economy is on a solid footing. Consumer demand is underpinned by rising house prices and equity markets. The labor market is recovering albeit at a moderate pace. Inflation is bottoming out and will head to 2% towards the end of the year. In the euro area economic activity data have surprised on the upside, but inflation has on the downside. Inflation will remain low for the remainder of the year.

• Decoupling of monetary policy between US and euro area The Fed is committed to end its bond purchase program in the autumn. Markets will speculate on the next phase in normalizing monetary policy. The belly of the US curve remains vulnerable. The ECB is under growing pressure to ease monetary policy further. The strength of the euro exchange rate and the persistently low inflation readings make further actions likely. The Bank of Japan will adopt a wait and see approach in assessing the need for extra stimulus depending on the impact of the VAT hike on consumer spending and economic growth.

• Strong preference for European fixed income over US fixed income Diverging monetary policy trends on both sides of the Atlantic argue for reduced interest sensitivity in US markets in favor of European markets. Especially for bonds with a maturity of around 5 years, we anticipate the interest rate spread to widen further. History teaches us that these trends can continue for a long time.

• Valuation of credits is becoming less appealing The credit spread tightening move is slowing down. Room for further tightening is limited. Especially when taking into account the higher percentage of lower rated credits in today’s universe compared with the past. Demand for credits remains solid whereas the market is not growing in size.

• Emerging debt not out of the woods yet Local political and economic uncertainties can put emerging debt under further stress. Fed tapering and rating pressure could add to this. In terms of valuation emerging debt looks more appealing now; this is more so the case for the rate outlook than for the foreign exchange outlook.

• European peripheral debt continues to do well Sovereign spread tightening in the European periphery has been fierce at the start of the year. We see room for more.

Euro periphery: our favorite for now | 2 In focus Euro periphery our favorite for now We are asked a lot whether the current rally in peripheral debt is sustainable. Our clear answer is yes, at least for the time being. Economic activity is coming back into the region, albeit slowly. Competitiveness is regained in countries like Spain and Portugal as shown in strong export growth. Current account deficits in the periphery have been closed (see picture below). The austerity drag is fading. The rating cycle has turned. Moody’s raised Ireland’s rating back to investment grade. Spain’s government bond rating was upgraded to Baa2 from Baa3. Portugal is heading for a bailout exit in June. Capital market access has been restored. Chances are growing that the country will opt for an Irish-style “clean exit” rather than go for a precautionary credit line. Even Greece is considering its return to the capital market, nearly two years after private investors agreed to write off 85% of the countries private debt representing the biggest debt restructuring in history. Capital flooding into the euro area seeking higher yields or safety from the turbulence in emerging markets is also supportive. Valuation wise it is striking that in many peripheral countries yields on corporate bonds still trade through their sovereign bonds. Even more so in the light of the ECB’s Outright Monetary Transactions (OMT) program which resembles a credible backstop facility for the sovereign debt market. Is all fine then in the euro area?

Surely not. Further improvements to the institutional framework are inevitable. In many countries more labor and product market reforms are needed to bring structural growth to a higher level. Stronger growth, fiscal discipline and a return of inflation are prerequisites to bring public debt on a sustainable trajectory in the peripheral countries.

When to get back into emerging markets?

It is less than a year ago that Mr. Bernanke shared his intention to taper the Fed’s bond purchases later in the year. Ever since, emerging local debt markets have been under pressure. The looming end of easy money triggered a reassessment of the asset class.

Chinese growth concerns and political turmoil in several countries were not helpful either.

Currencies depreciated significantly and bond yields climbed. In valuation terms this has increased the appeal of emerging debt. The average yield of the universe currently equals around 7%; many EM currencies have depreciated significantly. But valuation calls always run the risk of being too early. The technical picture remains worrisome given consistent outflows out of both emerging fixed income and equity funds. From a fundamental point of view economic growth in most countries is still on a downward trajectory. Current account deficits in many economies have yet to turn (see picture below). Appetite to push through structural reforms is absent due to upcoming elections in many places.

Current account/GDP comparison between peripheral and emerging economies Source: Bloomberg

–  –  –

Valuation negative: not much value left in core markets Forward curve analysis shows that US 10-year yields are expected to remain below 3% this year. We argue that this is too conservative in the light of a US economy that is gaining strength and a Fed that is open to policy normalization. Markets expect the Fed to start hiking its official target rate in the second half of 2015 (we agree) and continue tightening at a gradual pace in the years after (we disagree, it will be faster). Last quarter’s decline in German yields is fueled by deflation fears and expectations that the ECB will opt for Quantitative Easing (QE). Real yields are close to zero again. In Japan real yields are negative across almost the entire curve.

Technicals: it’s all about the central banks We live in an era in which the footprint of central banks on their respective government bond market is huge. The BoJ’s share of JGB holdings almost doubled in the first year of QQE. Its purchases have been equivalent to 70% of monthly issuance. Although the Fed is tapering its purchase program, it now holds more than one third of the outstanding long Treasuries. The size of the BoE’s asset purchase program is stable, but continues to be huge at GBP 375bn, also equal to one third of all the Gilts. All eyes are on the ECB now.

Will they at some stage embark on full scale QE? Even after the SMP, OMT and the LTROs (apologies for the acronyms), the ECB’s balance sheet is not yet stuffed with government bonds on a similar scale as with the other central banks. Although not our base case, outright QE by the ECB would be a big positive from a technical point of view.

Fundamentals: decoupling across the Atlantic Divergence between the US and the euro area is growing. For the US we expect inflation to have bottomed and move to 2% towards the end of 2014. In the euro area inflation will remain at uncomfortably low levels of around 1%. In the US unemployment has fallen from 10% to now below 7%. In the euro area unemployment is at a record high of 12% and at best stabilizing. Also in terms of monetary policy divergence is apparent. When will the Fed start tightening? When and in what way will the ECB loosen its policy stance?

Divergence between the US and the euro area Source: Bloomberg, Robeco

–  –  –

From a valuation perspective credits have become less attractive The average yield on euro credits is still about double the German 7-year bond yield (comparable duration) and at 100bps the spread is about double the spread before the financial crisis. However, most of this differential is explained by the implicit sovereign risk and the overall low yield environment. Italian and Spanish corporates, which on average trade at even with their sovereigns, make up about 15% of the euro corporate credit market. Italian government bonds still trade around 170bps over Bunds, and a similar picture holds for Spain. Credit markets are different from the past. In the US and Europe the percentage of lower rated credits increased (doubling in Europe to over 40%!) Whereas some index constituents are the same, they operate in a different (regulatory) environment with more investor awareness and less support, warranting higher spreads.

Demand for credits remains solid whereas the market is not growing in size For many bond investors credit remains the place to be in the current low yield, low default and high cash liquidity environment. This is reflected in heavily oversubscribed new issues and continued inflow in credit funds, both investment grade and high yield. While strong demand is a positive, the drawback is the loosening credit standards and the declining credit protection covenants. This year we see a pick-up in issuance of high beta instruments like corporate hybrids and bank capital in the form of AT1s. These instruments feed yield hungry investors, but are typically also more sensitive to a change in sentiment for the worse. Market liquidity remains poor and investors should be aware of what to buy!

The fundamental picture has changed little, but we remain cautious Leverage slowly creeps up, but so do corporate cash balances. There is no imminent change to increased shareholder focus either. The dividend pay-out only increased at a moderate pace last year and so far there is no broad trend of increased stock buybacks.

M&A activity is largely related to consolidation in certain sectors, in particular the communications sector, but companies are willing to pay up and the cash (debt) component is increasing. The regulatory changes – European banking sector related – should work out positively over the medium term. The measures agreed upon have been softened though and leave the domestic angle in place. Ahead of the AQR results, the capital issue will be addressed to increase the credibility of the banking sector.

Euro corporates versus Italian and Spanish government debt – spread distribution Source: Barclays POINT

–  –  –

Valuation is positive, but less so when adjusted for volatility The total return of EM was almost flat (slightly negative) but intra quarter volatility and dispersion between different emerging markets continued to be large. Due to this volatility several EM central banks were forced to raise their official interest rates. The current average bond yield for the EM local debt category (as measured by the JP Morgan local currency debt index) is around 7%. No asset class in the fixed income universe offers such a high running yield (e.g. HY is just at 5.6%). This is particularly striking when considering that out of the 15 countries in the index 13 are rated investment grade. Nonetheless, this additional yield hardly compensates for the currency volatility in local EM debt.

Technicals are negative, challenges ahead Technicals are not favorable for EM as Fed tapering is a fact and the Fed exit strategy becomes increasingly concrete as communicated by Fed chair Yellen in her first testimony.

Flows out of the asset class in the first quarter underline this view. In contrast to other fixed income asset classes, both local and hard currency debt outflows continued in 2014.

Similarly, outflow out of EM equity continued in the first quarter and was almost as large as in June 2013, when “Fed tapering worries” popped up. Nonetheless, despite Yellen’s relatively hawkish testimony in March, most emerging markets kept up surprisingly well in the aftermath of her first speech.

Fundamentals are moderately negative, structural reforms necessary Emerging markets are still battling weakening economic growth. Imbalances have to be corrected (e.g. Chinese leverage in the private sector, Turkish reliance on external capital, Brazil’s commodity dependency). Elections in many EM countries this year will complicate any progress with structural reforms in the short term. A turning rating cycle with more downgrades for EM countries would not surprise us. Brazil was already downgraded from A- to BBB+ by S&P in March. After years of export led growth, easy liquidity and low cost competitiveness, it is important for emerging markets to demonstrate added value in the supply chain of the global economy. Northeast Asian countries like Taiwan and Korea are the role models for such a development.

Emerging markets fund flows Source: Barclays

–  –  –

• Duration: The portfolio’s duration equals 3.6 years. More than 50% of the duration exposure origins from the euro area. Not more than 25% relates to US securities.

Exposure to Japanese bonds was further reduced and now equals less than 10% of the overall interest sensitivity.

• Treasuries: Exposure to the 5-year area in US Treasuries is kept very low in favor of exposure to German Bunds in the same maturity

• Treasuries: The exposure to the European periphery was slightly increased to 33% and is concentrated in Italy, Spain and to a lesser extent Ireland.

• Credits: The allocation to pure investment grade credits and high yield equals 29% and 8% respectively.

• EMD: Allocation to local currency emerging debt is kept low.

• FX: Besides our emerging debt positions we run a short position in the Japanese yen versus the US dollar.

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