Strategy 2018 Q4

Strategy
September 28, 2018 by Johan Nebel, CIIA

Key messages

Developped economies are going to stay on track

■ Growth in the US is will remain solid, at least in the short term, as Europe might go through a slower patch. The
US and Eurozone growth differential is going to continue widening.

Federal Reserve and European Central Bank policy

■ Central banks message is clear. They however face challenges, the SNB is caught between a strong currency
and a strong economy, the Fed is getting unwanted attention on its actions by President Trump and the ECB is
normalizing its balance sheet, at a time which might not be the best.

Emerging markets might not be out of trouble yet

■ Turkey and Argentina received lots of market attention during the last quarter. The situation might not be over
yet as things have not changed fundamentally.

As of September 27th, 2018 USD EUR GBP CHF

Bond Asset Class Neutral Neutral Underweight Neutral

Current Central Bank’s Rate 2.25% 0.00% 0.75% -0.75%

Market Forecast – 2019 Q4 3.05% 0.15% 1.15% -0.55%

Current 10 yr yield levels 3.05% 0.50% 1.57% 0.01%

Market Forecast – 2019 Q4 3.32 % 1.03% 2.08% 0.52%

Duration Favour FRN Favour FRN Short Medium/Long

Current Low IG D/Swap levels 146 bp 76 bp 110 bp 82 bp

Current HY D/Swap levels 220 bp 209 bp 284 bp 224 bp

Credit Market Negative and favour quality

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 Strategy 2018 Q4
Strategy
September 28, 2018 by Johan Nebel, CIIA

Developed economies and markets are resilient to all surrounding noise

When looking at economic data around developed markets, everything seems fine. Growth, although no soaring is on
a progressive trend, unemployment is low and is even reaching multiyear lows in some countries, inflation is back and
is under control by major Central Banks and the consensus is that a policy mistake by one of them remains a tail risk,
stock markets, at least in the US, continue on an uptrend. The main topic of the moment, a protectionist trade rhetoric
and stance by the United States, is only affecting economies is a subdued manner, at least for now. Other issues,
such as the financial woes of Turkey and Argentina do not seem to have significantly spilled over and affected other
markets. Consensus seems rather confident and even if some analysts mention “the end of the cycle” or that “a
slowdown lies ahead”, investors do not seem to be frightened or panicking about these prospects.

While we acknowledge the above, we receive a different perception from discussions with our clients. What will or
could profoundly disrupt world markets and economies is hard to tell, if there is something, as markets are getting
complacent about political risk, external shocks and trade disputes, nevertheless, even if inconspicuous, there is that
“gut feeling” something is bubbling. In a sense it is all too good to be true, and those that have been here long enough
know all too well this situation cannot last forever.

Emerging market woes are not over

We believe volatility emerging out of emerging markets is not over yet, and least as long we continue to see the US
dollar strength. Consensus at the beginning of the year was for a weak USD, but time proved that forecast to be
notably wrong. The rally does not show signs of stopping and cases for a strong USD are plentiful, from strong US
economic growth versus a rather sluggish growth in Europe to an ever growing interest rate differential.

US Midterm elections I not a game changer but can bring some volatility
US midterm elections in November could be the highlight of the last quarter, with the main question being whether or
not the Republicans will be able to keep control of the Senate and the House of Representatives. While any
conceivable outcome is unlikely to derail financial markets, should the Democrats retake a majority in both chambers,
it might mean situations such as government shutdown, impeachment threats or investigations into the Trump
administration are more likely, these have proven to be sources of market volatility in the past.

US yield curve inversion is not a good sign

US Government yields are the highest of all G7 members, but remain low on an historical basis. We are somehow
concerned by the general shape of its curve, which continued to flatten during the last quarter, with short term rates
rising and longer ones levelling. At the end of September, the term spread between the 10-year Treasury note and the
2- year was at around 20 basis points, tightening more than 30 basis points over the first three quarters of 2018. This
level not seen since 2007. Yield curve inversions have a strong predictive power as they preceeded each of the 7
recessions over the last 50 years.

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 Strategy 2018 Q4
Strategy
September 28, 2018 by Johan Nebel, CIIA

USD Government rates

■ The United States economy and financial markets are
robust and on an upward trend, but the open question
remains, for how long this going to last

■ Two forces are pulling US Governement rates in

different directions, with the trade war being a source
of instability keeping rates low and inflationary
elements pushing rates up

■ Yield curve inversion is posing a risk

US economic and market momentum is solid. For now

Fueled by massive tax cuts signed into law earlier this year as well as a budget with increased spending over USD
300bln over the next two years, the United States economic performance has been robust this far. The raging trade
war, mainly aimed at China,which many believed would put a dent on the US economic performance, has yet not
shown any major effects. Rates were somewhat kepts in check or at least did not seem to be a source of worry for
investors, and as a result, company earnings have been solid and stock markets soared.

One question being on many minds is whether the current trend is sustainable and for how long
The trade war is a source of global instability and uncertainty. It is also undoubtly inflationary, at least on the short
term, but investors are more concerned by the fact it could derail global growth, on a longer term and put the world
into recession. It therefore helps keep the longer Treasury notes yield from rising further as investors seek safety.

On the other hand, low unemployment pushing up wages, anticyclical measures taken by the Trump administration in
an already strong economy, the need to finance higher budget deficits, robust consumer spending are all inflationary
elements, which should drive US rates higher.

Those two conflicting forces, each pulling rates in different directions have caused the 10 years Treasuries to trade
sideways since February. We believe this situation will continue over the next quarters, and do not see any meanigful
change of trajectory in one direction or another. We do however believe one source of volatility might the U.S. midterm
elections, as the majority of both the House and the Senate might pass into Democratic hands, opening the door for
more confrontations, including govenement shutdown, investigations on President Trumps activities and impeachment
threats.

The yield curve inversion is an understimated risk

As mentioned on the first page the yield curve inversion is something we are concerned about.

Some argue that the actual term strucuture is attributable to the depressed longer term yields, which are capped at a
very low absolute level due to the large quantitative easing programs which Central Banks have put in place over the
last few years. Those levels being low in absolute terms, it took very slight tightening measures from the Federal
Reserve to cause the term structure to flatten.

Yield curve inversions have preceded each of the last seven recessions. In a research paper published by the Federal
Reserve Bank of San Fransisco, Fed research advisers give some credit to the above reasoning deeming it “plausible”,
but also remind that the effect of QE on interest rates remains uncertain and that a lower term premium does contribute
to stimulate the economic activity but have at time contributed to overheat the economy and increase recession risks.
They emphasize the fact that there is no clear evidence that “This time it is different” and that forecasters should ignore
part of the current yield curve flattening because of the presumed macro-financial effects of QE.

We would adopt a barbell strategy, favoring floaters at the front end of the curve and fixed rates for longer
term securities. Favor quality.

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 Strategy 2018 Q4
Strategy
September 28, 2018 by Johan Nebel, CIIA

USD Graphs
10y-2y is still tightening Inflation expectations are steady

Dollar Index shows no signs of abating USD emerging bond markets where under pressure

Source : Credit Suisse

CPI continues rising on a controlled path Equities Markets post solid gains

Every recession has been preceded by a curve inversion

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 Strategy 2018 Q4
Strategy
September 28, 2018 by Johan Nebel, CIIA

EUR Government rates

■ The European Central Bank is continuing its balance
sheet normalization process, but this comes at a time
when risks to economic growth are increasing

■ Political risk in Europe remains high, threats range

from the budget issues in Italy, Brexit and financial
instability in neighboring Turkey

■ The path of both long and short term rates remains

however predictable

Risks to Europe relatively subdued growth are plentiful

The Eurozone economy is still going to face headwinds in the coming quarters. Threats range from a disorderly Brexit
to a worsening financial stability situation in Turkey.
Even though a compromise on the budget is the most likely outcome, we have since learnt the Italian elections in
March that European markets react strongly to Italy political and financial events. Should nevertheless the budget
break the EU limit, or the government implement other populist measures generally unwelcomed by the markets, it is
very likely we could witness a sharp widening of Italian government spreads, and increased volatility on other European
risk assets, as the Union unity and common rules would be put to the test again.

Turkey is still in the midst of a perfect storm, and although they raised rates toward the end of Q3, we doubt they are
out of trouble. Raising rates is efficient up to a certain point, what ultimately matters is whether or not the market and
the people are confident in what the Government is doing. Argentina, which raised rates to stellar levels with no tangible
effects on the markets and economy is a good example. Turkey plays an important geopolitical role as the EU relies
heavily on the country to control the flow of migrants trying to reach Europe. Should Turkey’s financial situation worsen
and turn into a geopolitical crisis, it is likely we will see some contagion and European risk assets would suffer as a
result.

Curve is likely to remain unchanged

In this climate of uncertainty it is very likely longer term German Bund rates will stay depressed. Inflation, while we
would not call it elevated, rose above the Central Bank target in August, which however can mainly be attributed to
elevated oil prices, which are a volatile component of the index. Core inflation, excluding food and energy, the measure
ECB bases its analysis on, remained relatively subdued. The service sector, whose main cost is usually salaries, has
not suffered from an increase in wages, and there is no evidence of labor cost growth acceleration in the Eurozone.
Moreover, given the relatively sluggish PMIs and a rather fragile consumer confidence, we do not expect any major
pick-up in growth.

The beginning of the last quarter also marks the beginning of ECB winding down its QE program. Starting in October,
the Central Bank will reduce its asset purchase down to EUR 15bln a month from EUR 30bln until the end of December
and then end it. They however leave the door open to more QE having stated a number of times that it was “subject
to incoming data”. Mr. Draghi also stated that “when we stop, this does not mean that our monetary policy stops being
accommodating. The amount of accommodation will remain very significant”. We can therefore clearly expect rates to
stay low for a very long time.

We realize that allocating assets to EUR Fixed Income securities and obtaining a decent return is a challenging
task. FRNs will be in very high demand and therefore might be hard to find when rates rise. Some advance
shopping might prove itself having been a remunerative strategy when we will look back in 12 months.

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 Strategy 2018 Q4
Strategy
September 28, 2018 by Johan Nebel, CIIA

EUR Graphs

Spread 10y BTP vs 10y bund remained wide Turkey 10y USD as recovered, but things are not yet over

Consumer confidence falters

PMI where disappointing Inflation remains in check

Business Climate Indicator is on a downtrend

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 Strategy 2018 Q4
Strategy
September 28, 2018 by Johan Nebel, CIIA

CHF Government rates

■ A highly valued Swiss Franc and a robust economy put
the Central Bank in a difficult situation
■ The CHF will remind sought by investors, as trade and
geopolitical tensions increase

■ The Swiss National Bank seems to grow more and more

concerned by the domestic real estate and mortgage
market

The Swiss National Bank faces a difficult situation

The Swiss National Bank is trapped between two diverging trends. An ever strengthening Swiss Franc, both nominal
and trade weighted, which makes it impossible for Thomas Jordan and his colleagues to raise rates, and a strong
economy, the GDP grew 3.4% in Q2, the largest leap in 8 years and well above its average, reflecting a level of
economic activity which would prompt any Central Bank to adopt a more restrictive stance.

This situation makes its task, and communication difficult. It has now been a year since the Swiss National Bank
modified its narrative on the CHF adopting a very slight hawkish tone, describing it at “highly valued” rather than
“significantly overvalued”, a first step towards a less accommodative policy. It is however very unlikely we see a
depreciation of the Swiss currency as the situation in Emerging Markets continues to be shaky, notably in Argentina
and Turkey, and the CHF will continue to play is safe haven role.

The SNB interest rate on sight deposits has remained at -0.75% since January 2015, the day the Central Bank stopped
supporting the 1.20 CHF for 1 EUR level. This level is today the lowest of any G10 country. From an inflation point of
view, the solid Swiss economic performance has not translated to a rampant increase in prices, headline CPI is at
1.2% yoy, core inflation remains relatively subdued at 0.5% yoy. Those numbers are below the Central Bank target
but above the average of the past twenty years.

Trade tensions could spill over in Europe

Given these numbers, it is very likely that the SNB will keep on with its accommodative policy and keep rates on hold
for at least another year. The catalyst for the SNB taking more aggressive steps towards normalization would be the
European Central Bank raising its rates, a measure they said is not going to happen before the summer of 2019.

We believe one of the major threats to the Swiss economy is a broadening of the US trade sanctions spectrum to the
European region, which has been relatively spared so far. The United Stated is Switzerland’s second main trading
partner after Germany. In 2017 Swiss exports totaled CHF 220.6bln and 15.3% of those were intended for the US
market. Tariffs aimed at the wider European region might include Switzerland and could be detrimental to its economy.

The SNB is growing increasingly wary of the domestic real estate market, having qualified it a number of times and
said that it is the greatest threat to the domestically focused banks. The institution is concerned by the prices of real
estate going up and rents going down, and the growth in buy-to-let investments.

The SNB will continue to kick the can down the road until the ECB starts to tighten its monetary policy. We
also believe the risk is asymmetrical, with spreads and yields that could only go one way.

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 Strategy 2018 Q4
Strategy
September 28, 2018 by Andrew Gillham

GBP Government Rates

■ The Brexit debate builds towards a crescendo ahead

of the November “deadline” to reach a deal

■ The Bank of England hikes rates for the second time

in a decade and Governor Mark Carney extends his
term

■ The woes on the high street extend to some iconic

British retailers

Prime Minister May insists it is the Chequers Plan or no deal

The Chequers Plan, forged at the Prime Minister’s country residence in July, was supposed to pull the cabinet together
and accelerate negotiations with the EU. The compromise, or “soft Brexit”, proposal whereby the UK would abide by
the “common rulebook” for goods and agricultural products, however, triggered the resignations of the Brexit and
foreign secretaries in protest and provided an opportunity for some leading Remainers to exploit the undermining of
Theresa May’s authority and push for a second referendum.

The pound fell to a 14-month low shortly after but despite the vocal opposition, Theresa May clings on. EU leaders
were just as critical at the Salzburg summit and rejected the key elements of the proposal which they regard as cherry-
picking. The two sides are back at an impasse and the probability of a no deal has increased. We will soon find out
whether this prospect provides a catalyst for a change or more flexibility in negotiations. In the meantime UK assets,
especially the pound, will remain in thrall to politics and Brexit.

The Bank of England delivers another dovish rate hike

Although the Monetary Policy Committee voted unanimously 9-0 to hike the base rate by 25bps to 0.75% at its August
meeting, the emphasis on a “limited and gradual” approach to further increases saw the pound fall and government
bonds rally in the aftermath. Against a backdrop of tepid growth, the UK economy expanded 0.4% in the second
quarter, and softer inflation, it was a questionable move and perhaps only served to meet the BoE’s desire to normalize
rates and provide more ammunition in the next downturn. Mark Carney also agreed to extend his term as Governor
to January 2020 to support the economy through the turbulence of Brexit.

Troubled retailers leave many investors with buyer’s remorse

The pressure on traditional bricks and mortar retailers intensified despite the benefits provided by the hottest summer
on record and one-off events such as the World Cup and Royal Wedding. House of Fraser, the iconic department
store chain founded in Glasgow in 1849, collapsed into administration in August leaving senior secured bondholders
wearing losses of more than 80 per cent of face value. Debenhams and John Lewis followed up with disappointing
results and harsh profit warnings in September.

Retailers have struggled to adapt to the rapid shift towards digital shopping, online sales represent just 21% of the
total at Debenhams and 39% at John Lewis, and are encumbered with long, inflexible store leases taken out more
than a decade ago when interest rates were rising. The structural challenges have been amplified by the introduction
of the national living wage and higher import costs from the sharp depreciation of Sterling which retailers have
struggled to pass on in a fiercely competitive environment. Dented consumer confidence and reduced footfall on the
high street has also been acutely felt by the restaurant sector.

We remain underweight gilts on valuation grounds and favour select corporate debt where credit spreads
provide compensation for interest rate risk and inflation. More clarity over Brexit can provide opportunities in
UK corporates and financials that have underperformed against the uncertain outlook.

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 Strategy 2018 Q3
Strategy
September 28, 2018 by Johan Nebel, CIIA

GBP & CHF Graphs

EURCHF is still SNB main source of concern So is real estate as per UBS Real Estate Bubble

The US are the second Swiss trading partner Unemployment is low, but has not changed in Q3

UK Markit PMI Manufacturing continues its fall EUR GBP remains volatile

UK rates are on the uptrend CPI is on the rise again

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 Strategy 2018 Q4
Strategy
September 28, 2018 by Johan Nebel, CIIA

Credit Markets
USD Investment Grade bonds in developed markets have widened slightly due to global macro uncertainties,
but they remain low by historical standards.
However USD long dated high grade bonds offer the best opportunities right now. While the shorter end of the
curve certainly seems attractive on an absolute basis and given the low term premium, we believe that if the
current economic situation in the US persists, the curve will continue to flatten as the longer end will trade range
bound. A downturn can however not be excluded, in which case the Fed would stop raising rates and longer end
rates would go down. In both scenarios, we estimate credit spreads on High Yield bonds are at cyclical lows and
we believe think are not remunerated for their risk at these levels.
Many investors see the actual weakness in Emerging Markets as a potential opportunity to put on long positions,
judging the selloff is mainly induced by the deteriorating situation in Turkey and is sentiment induced. We believe
differently and think continuing trade issues will hurt EM economies and a continued strong USD and relatively
high USD funding rate will continue hurting countries with large external debt. Moreover, investor sentiment has
played an enormous role since the beginning of the year and should continue to do so over the coming months.
EUR investment grade bonds continue to look unattractive to our eyes. Credit spreads have widened slightly
since the beginning of the year but investor faces an asymmetrical risk. As mentioned earlier, it can be expected
European rates will remain at their present levels for an extended period of time as we do not see any meaningful
pick-up in inflation. Should trade tension spill over into the European region, it is likely investors would seek
safety in the form of government bonds, but should this situation happen, this would have a negative effect on
credit spreads. In our sense, the decline in government yields would not compensate the rise in risk premiums.
The asset purchase program, that included euro-denominated corporate bonds, the European Central Bank has led
over the past 2 years has certainly helped High Yield debt credit spread stay tight, as yield hungry investors were
rushing to the riskier higher paying securities. With the ECB now leaning towards the end of its asset purchase
program, halving it to EUR15bln starting at the end of September and ending net asset purchase in 2019, some argue
that EUR HY credit spreads will widen significantly, as investors move to safer assets.

While this scenario makes sense, we do not believe we will witness a sharp spike in EUR HY credit spreads, as the
tightening is partly due effectively to the market moving to the HY segment as a result of the ECB asset purchase
program but also to the relatively improving state of the economy. We are actually more concerned by the possible
threat of US tariffs on EU exports that would certainly be harmful to EUR HY credit spreads. HY could also be
hampered by the sluggish economic data coming out of Europe should this trend continue.

Consequently, knowing that EUR High Yield is often the often the only alternative to at least cover costs for EUR
investors, we would encourage HY bond buyers wishing to add securities to their portfolios to do so on a selective
basis.

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 Strategy 2018 Q4
Strategy
September 28, 2018 by Johan Nebel, CIIA

Credit Graphs
Markit CDX North America Investment Grade Index 5y Markit CDX North America High Yield Index 5Y

Markit iTraxx Europe index 5y Markit iTraxx Europe Crossover index 5y

High Yield and Equities move in tandem in times of stress Diversified IG portfolios offer a better protection

Median S&P corporate rating over time Rating needed to get 5% yield in USD for a 5 years maturity

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