Return of the Bund Bears
As the ECB confirmed the continuation of QE measures despite improving inflation data, Valentijn van Nieuwenhuijzen, head of Multi Asset at NN Investment Partners (NN IP), comments on the implication for his asset allocation strategies.
So the Bund bears have not yet been hunted down. During the second half of May it seemed that the technical re-set in the German government bond market had run its course. The excessive optimism about QE driven capital gains in Bunds had disappeared, but markets calmed down, yields trended a bit lower again and most investors seemed still convinced that lowflation and QE would keep yields stable at a “normalized”, but still very low level.
This perception was also reflected in other parts of the market. The April-May sell-off in Bunds was never accompanied by signs of broad-based risk aversion in global markets. For example, a well-known indicator of risk aversion like the VIX index remained remarkably stable during April and May. Also, the first stage of this Bund correction was completely driven by real yields and was not accompanied by a re-pricing of inflation risks. All this created the impression of a technical correction from overbought levels in Bunds with ripple effects into closely related segments of the market (the Euro exchange rate and European equities), but limited fundamental drivers behind it or signs of global contagion in markets.
Since early June this picture is changing again. The daily jumps in 10-year Bund yields have increased significantly again recently and the level of yields has risen substantially further. The unusually high levels of daily and intra-day volatility in Bund yields still hints at technical factor being at play as it would be very hard to argue the underlying “fundamental” picture has changed by so much in just a few days (or minutes!).
At the same time, it should be acknowledged that an upside surprise in European inflation data and a tentative improvement in global data surprises have maybe added a bit of fundamental collar to the bearish Bund view. This is partly also reflected by the modest rise in inflation expectations recently and small, but more broad-based signs of risk aversion in markets as the VIX has started to move up, the US dollar has strengthened (while weakening in April-May) and emerging markets have started to underperform again.
This does suggest the outlook for the Bund market remains surrounded with significant uncertainty as the technical shake-out might not have been finished after all and the bearish Bund story might get some fundamental backing. We are not convinced that the latter will already start sending persistently bearish signals for government bonds as we see lowflation and QE to be around for some time to come. We do acknowledge however that the strongly intertwined global bond market has very little valuation anchor at this point in time that should prevent bond yield from swinging another 50 bps up or down over the coming months.
The graph above shows nicely that risk premiums in government bond markets, proxied by the steepness of the 2-10 yield curve, are close to their long-term average. Signs of shifting direction in growth and inflation and investor positioning and flows will drive the future evolution of yields, while the “fair value” level of bond yields will be more an intellectual guessing game than a driver of future direction of markets.
Even without valuation signals however there is enough reason to stay cautious on government bonds. On other parts of the market we have not changed our constructive medium-term outlook, but continue to have low conviction in the short-term. This translates into small and diversified tilts towards risky assets with equities and real estate as small overweights and fixed income spread products and commodities as small underweights.
The underweight in Bunds was reduced to a small underweight. Within a small underweight allocation to Spread products we downscaled our beta exposure. The overweight EUR HY was reduced to small as the category lost momentum on lingering concerns surrounding Greece and unfavourable market technicals. We nevertheless remain small overweight as investor inflows, European earnings and European economic growth are supportive. Simultaneously, we increased our allocation to USD IG and USD MBS as a widening yield gap versus EUR paper may be increasingly difficult to resist for investors. Also, with a more dovish FOMC meeting in March, FED exit concerns have been somewhat pushed out.
Because of above moves we are temporary overweight IG. We still prefer EUR paper over USD but less so than before. We are small overweight Eurozone Peripheral Treasuries (EPT). We expect ECB purchases to tighten EPT spreads further. So far little contagion from Greece is seen as ECB purchases dominate and other firebreaks are in place (ESM, OMT, banking union). Also Peripheral macro data are supportive.
We moved EMD Local rates to underweight. Weak momentum and investor flows, fading EM monetary policy easing potential (apart from Asia) and negative signals on inflation surprises are behind this change. Overall, EM therefore becomes small underweight.
Equities are a small overweight. The outlook for Eurozone equities is driven by the improvement in the earnings momentum, the better than expected economic data and the attractive equity risk premium. On the behavioural dynamics we observe a continuation of flows into Europe, mainly at the expense of US equities. This underpins our thesis that investors should favour those regions where markets are driven by accelerating earnings and loose monetary policy. Both factors act as tailwinds for the Eurozone and Japan. We stick to our view that 2015 will be less US-centric given these earnings and policy trends.
Next to Europe we also prefer Japan. The country remains attractive thanks to high earnings growth, positive earnings momentum, attractive valuations and last but not least policy making.
Finally, emerging markets are neutral. Flows improve and stable commodity prices should underpin the region. We also observe loosening of monetary policy in several EM countries. On the other hand, EM currencies are weak and Chinese data are showing further slowdown.
We cut real estate from a medium to a small overweight. Underlying fundamentals remain supportive: stronger labour data, better consumer confidence, positive impact of oil prices on retail sales. Real estate remains the biggest beneficiary of the search for yield from institutional & private investors. The trend in US treasuries should be monitored closely especially as positioning is high and flows are weakening. Within real estate we have a small overweight European real estate. ECB QE and a strengthening labour market should offer some support and pricing is not excessive.
Commodities are a small underweight. Concerns regarding Chinese data are headwinds. At the same time, uncertainty with respect to the stability of the financial system in China offers a potential headwind for commodities. With the exception of Energy and Industrial Metals, non-commercial net length in other commodity segments has been reduced, lowering downside risks.
Within commodities we expect the cyclical segments to be in for a pause after their recent outperformance. We moved copper to underweight and closed the overweight WTI. Net length in crude oil non-commercial positioning appears to have rolled over removing price support from speculative demand.