Pause, Think, Brace for Turbulence

If we think for a second in what markets we traded during the month of July, we get the answers as to why managing asset portfolios remains a fascinating and difficult job. I tried to explain in the previous post how the current financial markets are unique, special (inflation at 40 years high, Central Banks removing all together accommodative monetary policies that stayed with us for years), and how past trends do not offer a means for analyzing a portfolio’s past and present behavior and do not provide possible and certain indicators of future performance. I recommend flexibility (if Central Banks ask for this, portfolio managers should adapt accordingly) and the need to continue to get data to confirm a certain asset allocation or for rapidly changing an investment strategy if new elements were contradicting previous portfolio positions. Stock markets rallied, IG and HY yields tightened across the board, XOVER dropped more than 100 points reaching the levels seen at the beginning of June, liquidity re-emerged after several months of lethargy. The market is more liquid now than during spring and the beginning of the summer, even if the prices on the screen are most of time unrealistic.

The month of August continues with unexpected outcomes at least from US: strong NFP, CPI and PPI who surprised to the downside showing signs of softness after months where all the forecasts were always short of the real numbers.

Allow me to add two more points which were in the mouths of many strategists: EUR/USD did not finish down to the hell and rebounded against the overbought USD and the yield of 10Y US Treasury dropped from 3,47% (mid-June) to 2,60% in the first days of August despite the FED QT (which is negligible so far). It is difficult to get bored.

Briefly (it is summer, after all): why this happened, and do we buy this rally (or whatever you would like to call it)?

1. Markets were in oversold conditions, and it was very difficult to keep several asset classes at depressed levels without attracting money chasing for opportunities. There is money available, and we even saw positive flows arriving to the credit markets.?For days, Asian investors started the trading sessions with active buying of European assets.
2. The drop of UST Treasuries contributed to the easing of global financial conditions making investors more confident about a global soft landing and less pessimistic about an inevitable recession.
3. Credit Indices started to grind tighter because many “hedge positions” started to be unwound.
4. Corporate earnings for Q2, despite some dispersion, came out better than expected. This was crucial for improving further the risk sentiment. The buying activity concentrated all the flows in secondary market being the primary lackluster. Prices in fixed income went up for many credit names. HY market performed very well.

Last but not least, Powell’s remarks on the neutral interest rate of the Federal Reserve rate. This remark cemented the market perception that the FED has reached a peak in its hawkishness.

In Europe, we did not have the same data and verbal surprises that emerged from the US, but the governments yields eased, following the downtrend of the American yield curve. The good conference call of the European Central Bank, as I have anticipated (I never had mixed views on the efficacy of the message regarding the TPI), did the rest of the job. The ECB rate hike did not have any effect on the swap rate and core govies in Europe. Italy spreads widened on the back of Draghi’s resignation but behaved well in general. (of course, the channel of 200 basis points against Germany remained a solid threshold). The reinvestments of the PEPP out of core countries into periphery that was apparent from the most recent ECB purchase data, played a role so far and contained any uncontrolled widening. I remain cautious here and I stick with my forecast of slow widening of the BTP/DBR spread. September and October are always busy months for Italian Treasury and elections are always an element of volatility.

Where are the problems that could complicate the bullish scenario? There are several points that trouble me, but I highlight the most important ones:

1. The FED has not finished its monetary adjustment. The ECB has barely started.
2. Stock market is not pricing a recession, not in US, nor in Europe.
3. Credit markets have found a delicate equilibrium, but this balanced position depends on many unstable parts: CLO market, inflows and outflows from fixed income, government bond yields in Europe. Some credit sectors are definitely money good (I suggest, as usual, to keep a close eye on the AT1 bond market in general and the AT1 in USD from recent issues of European and UK banks for example), others will have some problems mainly from inflationary pressures and changes in households spending.
4. The credit spread tightening came in summertime. The upcoming period of high trading activity might test if this firm and bullish movement has legs strong enough to jump the fences when it is (finally….) raining.

HY BB long duration names, short duration single B credits, AT1 from Banks and subordinated Insurers remain the best spots in absolute and relative value in European credit markets.

Author:?Sergio Grasso, Director at?iason

Previous Market Views available?here