3 Things the European Investment Grade Fixed Income Team Talked About Last Week

Hands Holding Puzzle

1. Key Takeaways from UK’s “Super Thursday”

Christened “Super Thursday” for the confluence of the Bank of England’s (BoE) Monetary Policy Committee (MPC) meeting, the release of the minutes of the previous MPC meeting and the publication of the quarterly Inflation Report, last week’s Super Thursday had a little bit of extra spice. It was also the day that the UK High Court published its verdict on the Parliament’s role in triggering Article 50. Here’s what we learnt from last Thursday:

  1. The risk of a general election in 2017 has, in our opinion, increased. UK Prime Minister Theresa May pledged to appeal the High Court’s ruling to the Supreme Court. Should the government lose its appeal, it will probably have to introduce legislation to start the Brexit process. If that legislation faces amendments from pro-Remain MP’s, PM May could lose her patience and decide to call a general election. Polls indicate that the current government would win with a larger majority.
  2. The ruling and need for parliamentary approval reduces the likelihood of a “hard Brexit”. We talked in last week’s blog about a “dirty Brexit”, and most of the developments we saw last week continue to point to that type of scenario developing.
  3. The MPC have moved firmly towards a neutral stance from its previous dovish stance in terms of interest rates. Monetary policy was noted as being able to respond “in either direction to changes in the economic outlook as they unfold to ensure a sustainable return of inflation to the target”. However, the MPC did sound a warning note, cautioning that “there are limits to the extent to which above-target inflation can be tolerated”.
  4. The near-term economic outlook looks stronger than the BoE expected when it eased policy in August, but the medium-term outlook is considerably cloudier. Inflation is expected to increase to 2.7% in 2017, before falling back to 2.5% in 2019.
  5. The MPC in obviously in “wait-and-see” mode, with no clear feeling for what’s going to happen in the future. As noted above, the Bank has been surprised by the resilience of economic activity since June, but remains concerned about the impact on activity once Article 50 is triggered. But right now, in our opinion, they have little confidence in their forecasts.
  6. From a markets perspective, we continue to believe that a steeper UK yield curve should be warranted, as a bigger inflation premium is incorporated into longer-dated bonds. We also believe that Sterling will remain under pressure in the long-term, and would suggest any bounce in the currency may provide an attractive opportunity to sell Sterling.

2. Finding Value in Italy

Italian sovereign bonds have been one of the under-performers recently, with the spread between 10-year Italian and German government bonds widening to levels not seen since earlier this year. The reason is pretty simple – investors remain concerned about the outcome of the referendum on political reform to be held on December 4th. At the moment, opinion polls show that the “No” camp holds a small but solid lead over those in favour of the reforms. Italian Prime Minister Mattel Renzi has initially suggested that he might resign in the event of a “No” vote, although he has now pledged to remain in power regardless of the result. Investors, however, remain fearful that Renzi’s government would struggle following a “No” vote, and think that national elections could follow in spring or summer of 2017. That might provide an opportunity for the Five Star Movement to become Italy’s biggest political party, and their opposition to the Euro is well known. A large part of the Italian electorate are still undecided about which way to vote, so there is still a fighting chance that the “Yes” camp will prevail. We also think that the ECB, via its Public Sector Purchase Programme (PSPP), would support Italian government bonds in the event of a “No” vote and consequent further widening of spreads against German bonds. At current spread levels, we believe a “No” vote is being discounted by bond markets, and we favour overweighting Italian bonds.

3. Hedges against U.S. Political Uncertainty

We believe that successful portfolio management is as much about good risk management as it is about finding good investment ideas. With that in mind, and considering how close the polls are showing the U.S. Presidential election, here are three potential hedges in the event of either candidate winning. Should Donald Trump be elected the 45th President of the United States, we expect that the Mexican economy could be one of the biggest losers, with Trump’s plans to curtail immigration and build a border wall. Much attention has already focussed on the Mexican Peso as a means of hedging against a Trump victory, but another hedge might be to expect Mexico’s sovereign bond yields to underperform U.S. Treasury yields. In such a scenario, buying protection on Mexican sovereign 5-year CDS could be warranted. Secondly, should Trump be elected, we would also expect to see some significant volatility in U.S. Treasury yields, as markets try to figure out what a Trump victory means for the U.S. economy. Being long U.S. Treasury volatility straddles should allow investors to benefit from this increased uncertainty. Thirdly, a Clinton victory would probably mean “business as usual” for the U.S. economy, with the Fed potentially feeling confident enough to hike rates at their December meeting. In turn, this should support the U.S. Dollar. Currently, at the money Euro puts/U.S. Dollar calls are quite cheap and, in our opinion, offer a very attractive payout ratio. With that in mind, using these Euro put/U.S. Dollar call options could be beneficial. All three of these ideas are easily tradable, short-term in nature and could be closed once the result is known.

About David Greene

Client Portfolio Manager for European Fixed Income. Prior to joining Pioneer Investments, David was Managing Director of Conning Asset Management (Europe) Ltd, specialising in insurance asset management and responsible for the management of Conning’s non-US dollar fixed income assets. Before joining Conning, David was a Senior Portfolio Manager at KBC Asset Management Ltd, Ireland’s fourth-largest pension fund management company. At Pioneer Investments, David is responsible for the euro-domiciled fixed income products and his role involves explaining the investment philosophy, process and performance of the fixed income products, as well as providing updates on overall financial market performance, economic trends and the company’s economic outlook.
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