It’s Inflation, Stupid

Weekly Fixed Income Comment – 19 June 2017

Overall Markets

Like many of the best sayings, this one (about the economy, not inflation) was never said; well not in this exact form anyway.

We have focused on the economy a lot in the last six months, or more specifically on growth. And growth has been and is fine, from a cyclical perspective. However, last week was another reminder that arguably the most important thing to have watched was inflation as the CPI (consumer price inflation) data in the US came in low again with the 3-month moving average of core CPI being 0% (maybe we should say “noflation”). Lower oil prices are part of this story now and will be in the months to come. US Treasury yields can be thought of as having two, main components: the real yield relating to growth, and so called breakeven inflation relating to inflation expectations. The rally in longer dated US Treasuries this year has largely been due to lower breakeven inflation rates.

For MENA bonds this year there has been a battle for supremacy between underlying US Treasury related returns and credit spread related returns (i.e. the return from the credit spread itself and the price gains due to spread tightening). So far the contributions have been roughly equal. Last week, US Treasury related returns were slightly larger than spread related returns. Although the Federal Reserve meeting and rate announcement were key focuses going into the week, the soft inflation data was the main market mover last week. The credit spread component of returns continues to be supported by global growth data that suggests steady growth rates ahead with or without any further stimulus from President Trump and the Republicans in the US.

As noted above, lower oil prices are helping to keep inflation in check and oil prices are likely to stay in the range that has begun to develop over the past year. On the one hand, inventory levels of crude and downstream products remain elevated, supply from the US, Libya, Nigeria and others outside the OPEC/NOPEC agreement is rising. On the other hand, demand remains healthy, the contango on the oil price curve through time looks extended, and positions in the financial markets are suggestive of a somewhat oversold market.

Bond Funds & Mandates

In The Region

MENA bonds and sukuk had a constructive week despite the 25 bps rate increase by the Federal Reserve last Wednesday as the weaker inflation and housing market data in the US tempered expectations of the Fed’s interest rate hikes in the future. Credit spreads for UAE bonds widened by 2 bps to 136 bps as indicated by the Bloomberg USD UAE Index. The broader JP Morgan MECI universe did better with spreads tightening by 4 bps led by Qatar. This all meant that MENA bonds did better than much of the EM bond universe.

Following the Fed’s decision to increase interest rates, the UAE, Saudi Arabia, Bahrain and Qatar raised their benchmark interest rates by 0.25% as the regional currencies are pegged to the USD. Higher interest rates and stronger GCC currencies might pose further downside risk on regional growth when viewed alongside the OPEC/NOPEC oil production cuts. Kuwait decided not to follow the Fed’s increase in interest rates mentioning the country’s modest economic growth.

It was light in terms of GCC macroeconomic data last week aside from some inflation figures in Qatar and Saudi Arabia. The Kingdom’s inflation rate remains in negative territory with a print of -0.7% in May 2017 down from -0.6% in April. In Qatar, the cost of living decreased from 0.6% to 0.1% between April and May. Growth seems to be supported by tourism in the UAE as Abu Dhabi’s tourist arrivals rose by 7% between January and April compared with the same period last year, reaching 1.6 million guests.

In order to prevent further outflows from Qatari assets and to maintain liquidity, Qatar’s banks are boosting interest rates on USD deposits. Rating agencies continue to monitor the developments in Qatar. Fitch placed Qatar’s AA rating on negative watch mentioning the “absence of a timely resolution to Qatar's isolation; further escalation of measures against Qatar; and evidence that the measures taken against Qatar are having a significant impact on the economy or other credit metrics.” Fitch also noted that a ban on financial relations with the UAE, Saudi Arabia and Bahrain could lead to disruptions in the Qatari financial industry. Additionally, Fitch placed Ooredoo, Rasgas, Nakilat and Dolphin Energy on rating watch negative.

Fitch affirmed Bahrain’s BB+ credit rating and revised down its outlook from stable to negative citing “double-digit fiscal deficits, high and rising debt, a highly oil-dependent government budget and domestic political tensions that hamper fiscal adjustment.”

Elsewhere, Egypt’s central bank lifted the USD 100k limit on foreign exchange transfers as FX reserves reached a comfortable level of USD 31.1 billion in May 2017. The USD 100k cap has been in place since the 2011 turmoil.

Dana Gas cast a shadow over the sukuk market when it declared its own Sukuk as non-Sharia compliant and a court in Sharjah barred holders from taking any action against Dana Gas securities as per UAE law whilst it reviews the issues raised. Given Dana Gas’s cash flow difficulties, there have been questions about the motives behind the moves and implications for the broader sukuk market, especially for issuers that are in difficulty.

Out of Region

The JP Morgan EMBI Global Diversified (US dollar denominated, sovereign, emerging market bonds) gained 5 bps last week. Return was driven by the US Treasury market rally as spread related returns were negative. On a regional basis, Middle East was the best performer with a 47 bps gain and Africa was the worst performer with a loss of 23 bps. While El Salvador, Oman and Paraguay performed well with an average return of 96 bps, Gabon, Nigeria and Venezuela were the laggards with an average loss of 217 bps. High grade bonds performed better than high yield ones, as expected in a negative spread environment. For the corporate sector, the CEMBI Broad Diversified (US dollar denominated, corporate, emerging market bonds) also recorded a gain, of 21 bps driven by US Treasuries. Similarly, the Middle East was the best performer with a gain of 43 bps return while Africa was the worst performer with a loss of 10 bps. Consumer was the best performing sector with a 38 bps gain, Oil and Gas was the worst with a 10 bps gain.

In the local currency markets, the JP Morgan GBI-EM Global Diversified index was up 10 bps in US dollar hedged terms last week. Currency returns were also positive with the unhedged returns recording a 15 bps gain. Latin America was the best performing region with a gain of 48 bps, while Europe was the worst one with a loss of 26 bps. Mexico was the best performing country with a 264 bps gain in US dollar hedged terms, as recent data confirmed that economic activity kept growing at a moderate pace. Inflows could accelerate further as short-term uncertainties related to trade with US continue to dissipate. Thailand and Brazil also performed well with 73 bps and 55 bps gains respectively in US dollar hedged terms. Sound macroeconomic fundamentals with the debt to GDP ratio at around 43% and rising real yields are factors that explain the recent inflows into Thai bond market. The Brazilian market is recovering from the latest episode of the political scandal with investors slowly rebuilding their positions. Russia was the worst performer last week with a loss of 200 bps in US dollar hedged terms. New, proposed sanctions from the USA are negatively affecting the Russian bond market. However, the Russian economic recovery should continue with the oil price remaining the main hurdle. Colombia and Argentina also performed poorly with 198 bps and 178 bps losses respectively in US dollar hedged terms. Markets remain cautious regarding Colombia due to the rising instability and delay in implementing the required reforms, although falling inflationary pressures remain a positive point for the bond market. Argentina is suffering despite primary public spending being expected to fall in real terms this year. Furthermore, inflation is expected to fall by around half this year from a high of 40.9% in 2016.

In the FX markets, the Mexican peso, South African rand and Turkish lira performed well last week. The laggards were the Colombian peso, Russian ruble and Philippine peso.

The Funds

Our internal systems show that the MENA Bond Fund (MBF) was up by 0.33% last week to June 16th. The Bloomberg UAE Index was up by 0.12% whilst the JP Morgan MECI and the JP Morgan MECI GCC indices were up by 0.51% and 0.52% respectively, so MBF’s performance was slightly behind the broad market. According to the 15th June NAV, MBF was up 2.82% year to date. The yield on MBF is 4.26%, duration is 3.20, volatility is 1.81%.

The Sukuk Income Fund (SIF) was also up by 0.33% last week to Friday 16th June according to our internal systems. Indices were up too, the JP Morgan MECI Sukuk Index and the Dow Jones Sukuk Index were up by 0.35% and 0.27% respectively. According to the 14h June NAV, SIF was up by 1.44% year to date. The profit rate for SIF is 4.09%, duration is 3.32, volatility is 1.78%.

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