High-Yield
There has not been much of an improvement/recovery in the Chinese economy. Credit growth is weakening anew, which warrants a downbeat cyclical outlook for China's industrial sectors. Malaysia is heading into a classic credit/banking downturn. Go short Malaysian banks stocks and short the ringgit versus the U.S. dollar. In South Africa, take profits on the yield curve flattening trade. Continue shorting the rand versus the U.S. dollar.
Developed Market bond yields are too low relative to improving global growth and the strong recovery in risk assets post-Brexit. Reduce portfolio duration to below-benchmark.
The breakout in the S&P 500 could boost flows to EM, and momentum could overwhelm fundamentals for several weeks. Nevertheless, U.S. interest rate expectations will rise and it, along with weak EM profits, will cap upside in EM risk assets. Take profits on our short EM stocks/long 30-year U.S. Treasurys position. Reduce short exposure to EM currencies by closing the currency trades where the long side is partially against the yen.
Today, on a tactical basis, we are moving our allocation on EM hard currency bonds to neutral from underweight. In this <i>Special Report</i>, we elaborate on the reasons leading to this decision.
A number of divergences have emerged in global financial markets. These gaps are unsustainable. The recent improvement in Asian trade/manufacturing has been largely due to firming demand for electronics/semiconductors. Meanwhile, demand/output for industrial goods and basic materials - the areas leveraged to Chinese capital spending - remain weak. Fixed-income traders should bet on yield curve steepening in India: receive 1-year/pay 10-year swap rates.
Some near-term upside in Treasury yields is very likely as flight to safety flows begin to unwind. However, given that global growth divergences remain in place, we will continue to look for an opportunity to increase duration on any meaningful back-up in yields.
At the margin Brexit only serves to reinforce the divergences in global growth that were already in place. Maintain duration at benchmark and look to increase duration exposure on any meaningful back-up in Treasury yields. Corporate spreads are still not attractive, but any Brexit related sell-off could present an opportunity to initiate a tactical overweight.
The Fed has reason to delay the next rate hike until at least September, even if volatility subsides after the June 23 Brexit vote.