Riding The Camel

Current racing conditions: soft. Q2 asset allocation preferences (unhedged US dollar-based, updated at start of quarter): neutral equities vs. fixed income relative to benchmark. Within equities, favouring a low volatility/ high dividend strategy and a small overweight in Canada. Within fixed income, neutral. Longer term outlook is to be pro-risk assets.

This week: Odd happenings in the bond market, oil prices and stock markets disconnect, Brazil turns a corner

Odd happenings in the bond market

• It is unusual, and unsustainable, but it is explainable. The two extreme ends of the global bond market in terms of risk and reward, core government bonds and high yield, have both outperformed the centre ground of corporate investment grade this year. At first glance this appears contradictory; surely core government bonds, such as US Treasuries or German bunds, see their prices rise when growth and inflation prospects are weak? These are precisely the opposite conditions that allow high yield bonds, whether corporate or sovereign, to rally.
• And yet the Barclays Global Treasury index is up 7.9% since January and the Global High Yield index is up 6.8%, while the Global Aggregate Corporate bond index is up 5.0% (all in USD, unhedged as of end of 21/4/16).
• Core government bonds have been driven by central bank policy. There has been a significant downward move in market expectations of Fed interest rate hikes in recent months, due to the ongoing absence of an inflation problem (March CPI inflation was just 0.9% over a year ago). This reduces the need for any immediate follow-up to December’s interest rate hike. Meanwhile negative policy rates from the ECB and the Bank of Japan have helped pull yields down across the curve.
• Meanwhile, high yield has benefited in two ways, both related to the Fed’s new found hesitation in raising interest rates. First, as the dovish tone emerged in February, a ‘risk on’ rally across financial markets favoured those lower-grade companies and countries that were most heavily indebted and which have been spared a series of USD rate hikes. Second, the dovish tone led to dollar weakness – particularly against emerging market currencies. This means interest and capital repayment in dollars is now easier for emerging market borrowers. As the likelihood of repayment increases, so the price of the bond rises.
• The outperformance of both core government and high yield bonds, relative to a middle part of the market comprised of investment grade corporate bonds, may persist I the near term. Particularly if US economic data weakens, and Fed interest rate expectations soften further, leading to further weakness for the dollar. But this can only go so far; investors in high yield actually prefer an environment of economic growth since this will help prevent marginal borrowers drowning in debt and defaulting. But investors in core government bonds can cope well with dismal economic data, since it drives more investors into safe haven assets and Treasury, bund and gilt prices rise, but fret when economic growth takes off and inflation rises.
• Eventually, one of these two bond markets will give way.

Oil prices and stock markets disconnect

• Amidst new uncertainty over Saudi Arabia’s oil price policy, OPEC failed to reach an agreement to curb oil production in Doha last week. WTI oil fell 1.5% a barrel on the announcement, less than might have been expected. It then rallied. But with Saudi Arabia now appearing to be willing to use a low oil price as a price worth paying in attempt to undermine Shia-led regimes in the region, hopes of a stable and meaningfully higher oil price are being undermined.
• The OPEC meeting was, however, interesting. Iran failed to show up, so allegedly scuppering a potential agreement between it, Saudi Arabia, non-OPEC Russia and other large producers. Iran wants to substantially increase production as international sanctions are lifted, the Saudis (allegedly) want to limit Iran’s economic recovery and may have hoped to use the cloak of OPEC solidarity to do so. While Saudi blamed Iran, others blamed Saudi for last-minute changes to its position.
• Driving the Saudi team, according to press reports, was the 30-year old deputy crown prince Mohammed bin Salman. He appears to have side lined Ali al Naimi, the country’s oil minister for the last 21 years, and is known to see a low oil price as a tool for exerting political power in the region. This is despite reports of the country’s currency reserves shrinking $100 bn over the last two years as low oil prices create a yawning budget deficit that a poll of economists by Bloomberg in late December forecasted could reach 20% of GDP.
• However, an interesting response to the OPEC meeting and subsequent fall in oil prices was a rally on global stock markets. Hopefully we have seen the end of the positive correlation between energy prices and global share prices that existed in the first quarter. After all, lower energy costs are broadly good for global growth and especially for those countries who are net energy exporters (most of the industrialised world and a large number of emerging markets). The tendency for stock markets to fall earlier his year as the oil price weakened was always slightly perverse.

Brazil turns a corner

• Brazil turns a corner…but the outlook for investors is far from clear-cut. The astonishing rally in Brazilian equities, and in the real, since late January has been driven by the growing likelihood of left-wing President Dilma Rousseff being impeached. But as impeachment draws nearer, the reality of what a post-Rousseff Brazil may look like has begun to set in, prompting some profit taking. Weak economic growth is partly due to structural factors that will be difficult to change, such as a poor public education system. Meanwhile the Petrobras scandal is likely to continue to damage confidence in all political parties, as well as in the business elite.
• Last week Brazil’s lower house impeached Rousseff, the upper house senate will be voting whether to confirm this or not in the coming weeks. The impeachment is nominally about altering public accounts to hide a budget deficit, in reality it is about a perception of sleaze resulting from the all-engulfing Petrobras scandal. Rousseff worked for the company before becoming head of state, and the state-controlled company stands accused of being used as a long-standing slush fund that bribed politicians and businesses on behalf of the government.
• Michel Temer, the Vice-president, is likely to take over as President should the upper house confirm the impeachment. He promises a more free-market economy, with reforms aimed at generating growth and balancing the public finances. He has also promised to end political corruption. The next elections are scheduled for 2018.
• But the Petrobras scandal will continue to haunt the Brazilian government no matter who is in charge. It is not, as Rousseff claims, a conspiracy by the right to undermine the Worker’s Party (known as ‘PT’). If it were it would not also engulf the business elite and large numbers of opposition politicians. The leader of the main PSDB opposition party, Bruno Araujo, is caught up in the scandal, as is the speaker of the lower house.
• Meanwhile structural impediments hinder the country’s growth, which the PT has done little to address since coming to power under President Lula in 2003. Instead, the PT focused on re-distrusting energy and mining revenues to boost consumption growth. These revenues have since largely evaporated.