US Fed takes a pill to sooth its ‘shrinking pains’

9 minute read

A prominent topic in the last month (aside from the ECB’s aggressive new monetary stimulus) was the sudden cash crunch in the repo market, i.e., the market for very short-term, typically overnight, lending.

On Monday, September 16, overnight borrowing rates started to rise, spiking to as high as 10% the following day. The Fed calmed the market by announcing a two-week operation to meet the demand for cash. In the meantime, the Fed has gone even further: it will begin to buy around $60 billion of Treasury bills per month for six months. The Fed is calling this latest intervention the 'organic growth' of its balance sheet, keen to avoid the slightest impression that this is a new form of QE. We are pretty relaxed about these developments. In our view, the recent tightness in the repo market was a purely technical issue. It has been caused mainly by the unwinding of the Fed's balance sheet, which had ballooned in the wake of the financial crisis. The Fed's intervention in the repo market can be compared to taking an aspirin against its 'shrinking pains'. It is not a sign of a new financing crisis.

On a tactical horizon, we have changed our overweight in fixed income to neutral. Also, our previous underweight in equities has been rebalanced to neutral. Finally, we remain neutral on alternatives.


Within Fixed Income:

  • We have reduced our overweight in fixed income to neutral.
  • This month we are overweighting high-yield and emerging-market debt.
  • Sovereign bonds have an underweight.
  • Securitized and investment-grade debt are neutral.
  • The overweight categories offer a spread pickup versus (low-yielding) government bonds, leading to this relative positioning.

Within Equities:

  • We have an overweight this month towards REITs and Japanese equities.
  • European equities are being underweighted.
  • The remaining equity categories are neutral.

Figure 1: Our asset class overweights/underweights in our model portfolio as of October 1, 2019 on a 3-month horizon. Each percentage reflects the relative weighting of the different asset classes within our model portfolio.

Fixed income – Government bonds

US: Positive. Our opinion on US sovereign debt has improved to positive from neutral, largely due to better fundamentals. Valuations are neutral. Treasury yields have retreated from their near-term lows, which have made valuations more reasonable. 10Y Treasuries remain rich compared to other currency-hedged developed sovereigns and they are still cheap if unhedged. We have upped our sentiment score from negative to neutral because investor sentiment is no longer at extremely bullish levels for 10s and 30s. Also, credit risk appetite is now only slightly elevated, while global and equity risk appetite is slightly depressed. Technicals are modestly positive. Momentum is now mixed, and overbought conditions have cleared. We think the Fed is likely to cut rates one more time by the end of the year and we are forecasting three cuts until the end of next year.
Europe: Negative. Fundamentals remain positive after the ECB unveiled a comprehensive new stimulus package consisting of a deposit rate cut, the generous introduction of two-tiering for banks, relaxation of LTRO conditions, adjusted forward guidance and the re-start of QE (open ended). Mr. Draghi stated that this was all the ECB could do and that the ball is now in the court of eurozone states — they need to do the rest of the work in order to lift inflation by enacting fiscal measures. Valuations are negative, as they have been for months now because German yields have deviated from any measure of "fair value" as estimated by nominal or real growth. The curve has flattened, so carry and roll went down slightly, especially in the 7-10 year segment. Sentiment is still negative, but it did improve slightly last month following the creation of the new Italian government and its more Europe-friendly budget, as well as due to new hopes of progress in the US-China trade talks. Technicals are neutral.

UK: Negative. Fundamentals are neutral. The latest round of PMIs came in at under 50 (except for the services sector, which is just above 50). The only bright spot in the UK economy is the labor market. Wages are rising at the fastest level since 2008 and inflation is above the Bank of England's target. Valuations are negative and sentiment is modestly positive. While the chances of a no-deal Brexit have receded somewhat, there is now a greater chance of elections, and gilts will react differently depending on which scenario unfolds. Technicals are neutral. Gilts broke through the all-time lows of 50 basis points.

Japan: Neutral. Fundamentals remain positive. The yen depreciated last month after it strengthening as trade talks between China and the US gave some hope of the two countries coming to a solution. Also, a more dovish tone by the Bank of Japan could keep the yen on the weaker side. Prime Minister Abe has reshuffled his cabinet by replacing 17 ministers, though some key positions were left unchanged. It is expected that Mr. Abe will further loosen fiscal policy further in an effort to stimulate growth as monetary stimulus has run most of its course while economic growth continues to lose momentum. Valuations are still very negative: The 10-year rate trades below zero at the lowest end of the range as defined by the Bank of Japan. Sentiment and technicals are neutral.

Fixed income – Investment-grade

US investment-grade: Positive, unchanged. Fundamentals are neutral. The US economy is still growing at a reasonable pace, and GDP is poised to clock 2% for 2019. US companies' growth is decreasing and corporate margins are narrowing. Most issuers have termed out their debt, which gives them enough cushion space for the near term. Cash payouts to shareholders continue to be high. Valuations are negative. Credit spreads tightened by 8 bps over the past month to an OAS of 109. Spreads remain fairly rich versus their long-term average. Adjusting for leverage and duration, the asset class looks even less attractive. Sentiment is neutral. Technicals are positive and are expected to improve. The first two weeks of September witnessed record issuance and we are now around 2% shy of year-over-year levels. We expect to see further inflows into the asset class because the yield advantage in the US should drive demand. Hedging costs are expected to decline further with the next rounds of expected Fed rate cuts.

European investment-grade: Neutral. Fundamentals remain negative. PMIs are still under pressure, hovering around neutral, and inflation remains low overall (though in some countries, inflation is picking up). That said, we see more profit warnings, and credit ratings are deteriorating. Valuations remain neutral. Yields have increased, averaging now around 0.42%. Recently, spreads have tightened due to sheer amount of issuance in this market, and they still have room to tighten once the ECB resumes QE on November 1 and becomes a firm buyer in this market. Sentiment is neutral. Technicals are very strong: a significant amount of supply is coming to the market and new issues are being easily digested. New issues come with almost no premium.

Fixed income – High yield

US high yield: Negative. For the first time in a while, we are negative on US high-yield debt. Fundamentals are neutral. Although commodity prices remain volatile, energy-related credits performed better in September. Defaults are still below long-term averages. Valuations are very negative. Spreads have tightened materially since last month and yields are well below 6%, near YTD lows. CCCs are outperforming higher quality for the first time in a long time. Sentiment is neutral. Technicals are slightly positive: Issuance has picked up, coupled with inflows into the market (70% of which is refinancing activity).

European high yield: Negative. Fundamentals are negative. European economic indicators continue to deteriorate, recession fears are rising, and inflation is still (very) low. Company results reflect little or no growth, and in cyclical sectors, margins are getting thinner. Levered companies with no or limited free cash flow and short maturities are in a bind. Defaults, while still low, are rising. Valuations are also negative. The OAS for BB is 220 bps and for Bs 500 bps — both are lower than long-term averages. Overall, sentiment feels bearish. Technicals are driving this asset class at the moment. There is very little issuance, and most of it is refinancing. The BB space may never be revisited by investment-grade 'tourists' again. Lots of money needs to be reinvested, but it's not enough to get us overly enthusiastic given the low level of spreads.

US leveraged loans: Negative. Fundamentals are neutral. Earnings are generally growing, except in retail and chemicals. US GDP growth of 1.5%- 2.5% still provides a decent backdrop for this asset class, and default expectations remain low through 2019. Valuations have become neutral, reflecting the rally in last few months. BBs have rallied back much faster than single Bs. Despite the price decline, there is still some value in single Bs. Sentiment is negative due to lower expectations of future interest rate hikes. Retail flows are likely to remain negative, although the pace of negative flows has slowed recently. Technicals are neutral. Primary activity has been active throughout this year, although deal quality remains poor and many aggressive triple D deals continue to print. CLO creation remains a pillar of this market.

Fixed income – Emerging market (EM) debt

Emerging markets: Neutral. Fundamentals are negative. Growth forecasts are falling and real rates are still high. With inflation expectations declining, it is expected that emerging-market central banks will cut rates in order to synchronize with developed markets and counter global growth slowdown. Valuations are positive. Hard-currency sovereign debt is up 12.73% YTD (YTM 5.28%). Emerging-market corporate debt is up 10.19% YTD (YTM 4.81%). Sentiment is negative. The oil price has become the top concern for investors in this asset class. Emerging-market credit performance is being driven less by valuations, and more by risk sentiment in this late-cycle environment. Developments in Saudi Arabia have added a fresh layer of complexity to an asset class that had become too sanguine about geopolitical risks. Most emerging markets benefit from higher oil prices. However, any positive impact could be wiped out by an increase in risk aversion from rising tensions in the Middle East. Technicals are positive.

Fixed income – Securitized

US securitized: Positive. Fundamentals remain healthy and stable in most securitized sectors. While delinquency and default trends in certain ABS sectors have increased, the current levels are no cause for concern. Developments in the housing market remain positive. CMBS/Commercial Real Estate fundamentals are also healthy. We are modestly positive overall on valuations in most securitized sectors. Securitized spreads tightened in most sectors month over month. Agency MBS (nominal and option adjusted) tightened slightly, but still appear somewhat attractive. Implied volatility has moved much higher in recent months, which is positive for the sector; however, convexity remains very negative. We expect spreads to be range bound over the next few months. Sentiment is neutral. Technicals are positive overall. Issuance has been elevated lately, but there is robust demand for it, despite the broader market volatility.

European securitized: Positive, less so than last month. Fundamentals are neutral. EU growth is slowing and consumer confidence is waning. Valuations are modestly positive. Spreads have been broadly stable during the last month. The move in rates is generating negative returns as floors on coupons/Euribor are creating longer-duration securities that mimic fixed-rate bonds. (However, this is not fully priced in). CLO spreads are broadly stable. The relative value for ABS is still very attractive versus covereds and corporates. Sentiment is neutral. Technics are slightly positive. Demand since the end of the summer has been quite strong. Also, supply is being met with strong demand due to a lack of EUR-denominated issuance in several of the more plain vanilla sectors.


Our underweight in equities last month has been rebalanced to neutral. We are overweighting REITs and Japanese equities, while European equities have an underweight. Below some of our thoughts about each regional equity class.

US: Neutral. Fundamentals are positive. Reflationary deficit spending has supported nominal growth. The enacted tax policy has been front-loaded and could sow the seeds for the next cyclical upturn. Pressure is slowing building for wage inflation. However, US and global economic growth is slowing, and trade-related risks have risen. Valuations are positive, but sentiment is negative (albeit less negative than last month). Technicals are positive. Weekly stochastics are roughly neutral and the price is regaining its lead versus moving averages

Europe ex-UK: Neutral. Fundamentals are negative. There are large differences between the eurozone economies and further convergence is needed. The macroeconomic momentum is negative and the effects of monetary policy are fading. Expected earnings growth for the next 12 months is around 7%, but GDP downgrades might impact earnings. A weaker dollar could also pose a headwind for earnings. Valuations and sentiment are both neutral this month. Implied volatility is lower than last month and sector dispersion is very low compared to other regions. European equities suffer from continued outflows. Technicals are positive.

UK: Negative. Fundamentals are neutral. The current thinking is that a hard Brexit would be swiftly followed up by meaningful fiscal easing and potentially QE, which could make UK assets more attractive. Recent economic data has been a positive surprise following a period of weakness through Q2. Brexit aside, the UK economy looks challenged. Valuations remain attractive, particularly from a dividend yield perspective. Sentiment is negative. Short-term technicals are positive and have improved recently.

Japan: Neutral. Fundamentals remain negative. Valuations are neutral. The market is up 7-8% since the last House View and earnings have not grown. The new multiples are 1.2x book, 13-14x P/E ratio and a 2.4% yield. Many commentators call these multiples "cheap" but we view them as about fair value for a market with so many structural challenges. Sentiment is negative. Technicals have turned negative. Our key indicator is the 200 DMA, which is still heading south. Short term, the RSI suggests that Japanese equities are overbought.

Emerging markets: Positive. Fundamentals have turned positive thanks to an improved macroeconomic situation. The EM PMI for Services has risen. Based on recent EM PMI data, we see a likely turnaround in shorter-term economic activity. Emerging market central banks are the most dovish since 2009; this supports EM rates and equities. Valuations are negative. The blended forward emerging-ratio P/E ratio (12.10 x) is again trading slightly above historical averages, and YTD earnings still suffer from downward pressure. Earnings growth is clearly negative. Year to date, earnings have dropped 12%, which is the worst year after 2015 so far. Sentiment is neutral. Technicals are positive: the percentage of members trading above 200dma has increased to around 60% from 40% last month.

China: Marginally positive. Fundamentals are neutral. The Chinese manufacturing PMI dipped further to 49.5, reflecting the escalation of the trade war in August. Chinese officials have announced that they will introduce important measures to ease the negative impact of the trade war. Valuations are negative. This asset class is trading slightly below historical averages. While EPS growth for 2019 is still slightly positive, growth has almost disappeared. Technicals are positive, with local 'A' shares looking more attractive from a technical standpoint.

Alternative Assets

REITs: Positive. Fundamentals have deteriorated to neutral. Listed real estate markets are up +1.6% since last House view (in line with forecast) compared with +3.6% for global equity markets (above forecast). Spreads in BBB markets have declined by 9 bps. The slowdown in WeWork's expansion could impact office demand. Thanks to the ECB's policies, the investment and financing markets are still supportive for REITs. Valuations are positive/close to neutral. REITs are cheap versus credits, and firm versus equities on earnings. Sentiment is down compared to last month. The main reason for this is that has been a higher allocation from active funds into REITs, which makes the sector vulnerable. Technicals are still positive. The 200 dma continues to be positive in all markets and for constituents, and there is no change in momentum.

Distressed credit: Negative. Nothing is really new in this asset class. Fundamentals, valuations and sentiment are all negative. Risks to the downside persist (China tariffs, European economic slowdown) and defaults are expected to rise in 2020. Year to date, CCC issuers have been materially underperforming high-yield debt on both a total and excess return basis. We believe returns will continue to be impacted by spread/yield widening for the remainder of 2019 and into 2020. Technicals are neutral. Net flows into high yield are positive year to date because the rate move is driving the search for incremental yield. New issue supply is still constrained and the forward calendar looks light.

Commodities – oil: Neutral. Fundamentals are positive this month. Global growth expectations have been downgraded, but overall, we view macro developments are moderately supportive for oil prices. Crude oil inventories dropped 5% in August. Regarding supply and demand, compliance is high with OPEC's decision to extend production cuts into 2020. The growth of US shale production has peaked and the rig count is drifting lower. Despite the Saudi drone attack, most of its production will be restored this month. Valuations are mildly supportive. The oil price is relatively strong against the strong dollar, which could become a headwind for oil prices. The carry or roll yield dynamics of the oil-futures curve is supportive. Overall sentiment seems mixed. Technicals are also neutral.


USD: Positive. The broad, trade-weighted USD recently reached a new 20-year high. We think the dollar will move in a tight range into year-end as the dollar has expensive starting levels and shrinking rate differentials. Positioning for the dollar remains long. Based on our valuation measures, the US dollar is the third most expensive currency in the G10 behind the CHF and NZD. The USD remains vulnerable to large downward corrections should US conditions deteriorate quickly or economic activity improve in the rest of the world. The monetary easing and restarting of QE by the ECB is likely to keep the EUR/USD capped. The biggest risk to the US dollar is deeper-than-expected rate cuts from the Fed.

EUR: Neutral. The euro has been trading as a proxy of German manufacturing. Eurozone activity has continually surprised on the downside and we expect further weakness. The evolving news flows around German fiscal stimulus will be key for the broader outlook on the euro. On a positive note, the euro might be supported on the margin by lower risks of a no-deal Brexit, greater government stability in Italy and news of policy stimulus in China. Since Mr. Draghi's most recent announcements of new stimulus, there is very little more that can still be priced in. Regarding technicals, a bearish medium-term bias seems appropriate.

JPY: Positive. Our bullish view on the yen is supported by downward revisions to global growth, worsening trade tensions and more central-bank easing support. The market is short for the first time since July. The timing is right to build JPY longs. The Bank of Japan (BoJ) — the most constrained central bank — is likely to resist an easing trend from central banks. It is harder for the BoJ to prevent the yen from strengthening when other G10 central banks have more ammunition to ease monetary policy. Japanese macroeconomic data is good, and Japan's large business index is now positive. Our analysis concludes that the yen is one of the world's cheapest currencies.

GBP: Negative. The outlook for sterling is clouded in multiple layers of uncertainty, and the outcome is impossible to call. We forecast that the GBP/USD is 1.10 on a no-deal scenario and 1.30 on a soft-exit scenario. UK recession fears have receded after a surprise GDP growth of +0.3% in Q2. Valuations continue to point to sterling being undervalued. We expect this to persist until the political and economic uncertainties have been removed. Sentiment is negative: GBP price action has become so focused on the prospects for Brexit that economic data are completely overshadowed.

About the House View

Aegon Asset Management operates from centers of expertise in North America, the UK, Continental Europe and Asia. The Aegon Asset Management House View is updated on a monthly basis, and is an excellent example of how we leverage our international expertise. First, we collate a global set of asset class views from our international teams. The asset class views are subsequently reviewed from macro, rates and asset allocation angles and an overarching committee then establishes the global House View. The outcome of this disciplined global process provides portfolio managers with latitude while at the same time ensuring that our products and solutions remain aligned.


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