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

 1. UK – Some Easter Egg-citement

No sooner had we recovered from the chocolate hangover of the Easter weekend than UK Prime Minister Theresa May pulled her own bunny out of a hat by announcing a surprise general election to be held on June 8th. We’ve seen some serious U-turns from U.S. President Trump since his election, but this was arguably as big as any made by Trump, as May had consistently ruled out going to the polls early. So what caused her to change her mind? Firstly, it was a consummate political act. Her Conservative party have a massive 20-point lead over the opposition Labour party in the opinion polls, meaning she is likely to increase her majority in the parliament from the current 15 seats to somewhere in excess of 50 seats. Secondly, there’s a feeling in markets that the UK economy might be about to suffer a significant loss of momentum, and last Friday’s retail sales backed up that feeling. We’ve spoken in past blogs about how the UK consumer has been driving the UK economy, but that much of that spending was being financed by credit card debt. As inflation rises, and wages remain stagnant, real incomes are being squeezed, signalling a slowdown in spending. So from a politician’s point of view, the current economic backdrop is about as good as it gets going into an election. Thirdly, and probably most importantly, we believe there is a growing acceptance amongst UK government officials that a Brexit deal will take longer than 2 years and will probably entail some significant concessions by the UK. Given that the next election was originally pencilled in for Spring/Summer 2020, that timeline could have caused difficulties for PM May and the Conservatives. Assuming they win this election, May has until the Summer of 2022 to agree a deal with the EU before she next faces the electorate. Sterling rallied significantly on the news, given that most people think this could lead to a “softer” Brexit and also given the size of the short position in Sterling, which has built up since before the referendum in June 2016. We are pretty agnostic on Sterling at these levels, and can find reasons to be both bullish and bearish in the short-term, so we prefer to stay on the sidelines.

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Champagne for Risk Assets

First round French presidential elections results: Key takeaways

It was an absolutely unprecedented first round, with four contenders quite close in the polls and just one of them (not ranked among the strongest) belonging to a traditional party. This unpredictability added to the scares and fears of the market.
At the moment, market can breathe a (brief) sigh of relief that the outcome of the vote was largely as expected (although an element of uncertainty will likely remain for the next two weeks ahead of the final round of voting): Emmanuel Macron (at 23.86%) and Marine Le Pen (at 21.43%) won the first round of the presidential elections; Macron has already gained the support of both Fillon (the Gaullist candidate, who obtained 19.94% of the votes) and Hamon (the socialist candidate that get only 6.35% of the votes) for the second round. Melenchon (19.62%) said he will not give his support to either of the two candidates. Nonetheless, the formation of the so-called Republican Front (i.e., an alliance in the run-off election between socialists and republicans/Gaullists versus Le Pen’s party) has already happened. Such an alliance has prevented any significant electoral success for the Front National (FN) in recent years and has led to a scant representation in the National Assembly for the party. In addition, it must be said that the polls were fairly accurate in predicting actual results, with the first 5 candidates in the range of 1-1.5% from the numbers seen in the week before the elections. The same polls were suggesting that Macron will win the run-off election in two weeks’ time by a wide margin (60%-40%).
In the end, it can be expected that left-to-center voters will largely choose Macron in the run-off, with only an element of center-right voters adding their support to Le Pen. This is clearly a market-friendly scenario. Macron is a European enthusiast and also has a positive track record, as a minister, of being a reformer.

Implications for Europe

A stronger impetus in advancing the construction of Europe will surely be beneficial on the economic outlook for Europe. We know there are still a number of things in which a stronger integration, or at least a stronger coordination, will help to take advantage of being part of a currency union (which is still partially untapped). This outcome will also have a short-term impact: stronger support for European actions coming from one of its leading countries will help shape policies and clarify objectives. This will also help confidence in general and will help push corporate investment, thereby reducing medium-term risks.
Taking a broader, geopolitical, perspective, the interaction between national elections and the need to reshape and reform Europe is an ongoing feature of this year, although now the Dutch election and, hopefully, also the French one seem to have cleared the potential hurdles to this process. Current polls suggest that the populist, right wing party (Alternative für Deutschland) in Germany is losing momentum; therefore it can be asserted that risks coming from the political arena are reducing. However, there is still some uncertainty related to Greece, even though a tentative political agreement was reached before Easter. What remains to be solved is political uncertainty in Italy, but this is likely to be a theme for 2018.

From an investment point of view, we expect this electoral outcome to be well received by the market– bringing a relief rally in European equities and spread tightening across European peripheral bonds (including French OAT). Within a multi asset approach, we remain constructive on risk assets, especially equity, based on a benign growth and inflation outlook. Overall, we favour Europe and Japan, reflecting the improvements in the macroeconomic backdrop and relatively attractive valuations. We consider some perceived “safe haven” assets – the 2 year Shatz in particular – to be extremely expensive and inconsistent with a reflation narrative. However, we continue to see the resurgence of volatility to be a key risk, given the number of geopolitical challenges still at play. Against this backdrop, we believe that investors should continue to keep hedging in place through volatility strategies, US Dollar exposure and Gold.


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Volatility and Tail Risk on the Rise: What to Do?

After months of complacency, volatility is coming back amid concerns about the escalation in the Middle East and Asia and the upcoming presidential elections in France. The VIX index has surged to the level of 16, an almost 50% rise compared to the minimum touched last month and the highest level since last November.

This move is once again a signal that we are living in a world with multiple geopolitical risks, symptoms of which materialize as sudden spikes in volatility, as we have highlighted in the recent paper “Geopolitics and Investing: The Normality of the Unexpected”. Continue reading

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French Election Countdown

On Sunday April 23, the eyes of millions of Europeans will be on the outcome of the first round of French Presidential elections, as the vote is considered a test for the future of the European Union. A potential victory for Marine Le Pen and the National Front party would be perceived as a key geopolitical risk for the Eurozone as a whole, raising the risk of a Euro break up.

Ahead of this event, we believe that investors should consider five things: Continue reading

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Market Values Tighten: What’s Next for US Investors?

Ken Taubes is Chief Investment Officer, US.

We continue to believe credit sectors offer modest value compared to government securities. Although global yields have risen from their July lows, many short-term non-US developed market sovereign debt continues to trade at negative nominal yields, and 10-year bonds offer zero to modest positive yields. US Treasuries continue to offer negative or modest real yields, adjusted for CPI inflation.

We hold a neutral view with respect to the agency mortgage-backed securities (MBS) sector. While we believe housing fundamentals remain strong, the Federal Reserve’s (Fed’s) significant ownership of the asset class presents increased risk. Strong employment should continue to support the housing market. Although housing affordability has declined with rising rates and higher home prices, the index indicates steady levels of affordability. Continue reading

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