Fixed Income Strategy: Implications Of Renewed Commodity Price Weakness

All eyes are on Greece at the moment, but in the background EM demand continues to lag and non-oil commodity prices are quietly softening. Metals have been particularly weak, while the rise in iron ore prices since April is beginning to look like a dead-cat bounce. Weak demand and accelerating production is beginning to take their toll on oil prices. There are several implications for fixed-income investors:

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  • EM US$ Bonds: As highlighted in a recent Insight, we believe that EM sovereign and corporate bonds will eventually “catch up” with the drop in commodity prices and EM currencies. Though difficult to time, incremental commodity price weakness and/or dollar strength would turn up the heat on EM sovereign and corporate spreads.
  • High-Yield Bonds: Spreads in the U.S. energy sector would blow out again if oil prices suffer anew. Our global fixed income strategists have cut speculative-grade bonds to underweight in the major countries in anticipation of higher Fed-related bond and equity volatility. Declining oil prices provide another reason to avoid junk bonds in the U.S.
  • Linkers: Exit overweight positions in inflation protection at the long end of the curve. Our global fixed income strategists have recommended these positions in most of the major countries given our view that long-term inflation expectations are likely to mean-revert from still-depressed levels as long as output gaps continue to shrink. Holding inflation protection at the long end is risky when oil prices are falling, although the correlation between oil and 10-year and 5Y/5Y forward CPI swap rates appears to be eroding.
  • Canada: GDP contracted for the fourth month in a row in April, creating the possibility that the country could have back-to-back negative quarterly real GDP growth in the first half of the year. We warned that the Bank of Canada was overly optimistic when it claimed that the worst was over in terms of the economic fallout from lower commodity prices. Stay overweight Canada versus global hedged benchmarks.

The Manic Chinese Market Bodes Well For Our Long Chinese Consumer/Short Chinese Exporters Trade

Global Alpha Sector Strategy’s intra-Chinese equity sector pair trade hit the 20% return mark. We recommend sticking with the trade, but raising the trailing stop.

The Chinese stock market is in freefall, forcing the authorities to scramble daily to stop the hemorrhaging. This backdrop has propelled our long Chinese consumer/short Chinese exporters pair trade much higher in a short time span, taking out our secondary return target of 20%. While relative earnings fundamentals remain intact favoring Chinese consumer-related stocks over Chinese export-dependent equities (please refer to Tuesday’s Special Alert) , we are compelled to raise the trailing stop, as part of our risk management process, to the 13% return mark. Chinese stock market volatility has skyrocketed. And, given heavy exposure to margin trading and the voluntary suspension of trading for nearly half the Chinese stocks, volatility could become even more intense. Importantly, the broad Chinese stock market has been inversely correlated with this pair trade, and the current message is to expect additional gains for relative share prices at least until the Chinese authorities manage to arrest the overall market’s plunge. Bottom Line: Stick with the long Chinese consumer/short Chinese exporters pair trade via the long CHIQ:US/short CHII:US exchange traded funds, but raise the trailing stop to a level of 0.93 near the 13% return mark in order to protect profits. The next target for the trade is at a level of 1.06.

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Anastasios Avgeriou, Managing Editor
anastasios@bcaresearch.com