“Sell in May and go away” may be the market aphorism but if followed, turned out to be wrong this May! Yet,despite political noise from the U.S. and Brazil, no substantial risk event surfaced and risky assets ended the month higher, much to the consternation of those who reduced risk. This means that markets should be well supported into the summer as cash positions remain high and the “buy the dip” mentality persists. Although politics continue to be a source of volatility so far, it has remained a distraction rather than a problem. Indeed, low levels of volatility should continue over the summer as the trends in data and policy look well established.
Developed Market Rate/FX: In much of May, yields fell across developed markets (DM), driven by increased political noise around the FBI investigation into the Trump administration's ties with Russia and weaker-than expected U.S. data. The political noise also weakened the dollar against major currencies. We do not see any obvious catalysts to drive government bond yields meaningfully higher, at least in the short term. That said, from a longer-term perspective, U.S. and eurozone core government yields look too low. We prefer some of the peripheral eurozone countries, such as Portugal and Spain, which have benefited from economic reflation. Australian government yields also look relatively attractive given the risk profile of the Australian economy and headwinds for China.
Emerging Market Rate/FX: Despite idiosyncratic setbacks, emerging market (EM) fixed income assets posted broadly positive performances in the month and investors continue to increase exposure to the asset class. Political events in Brazil weighed heavily on asset prices before stabilizing towards the end of the month. Chinese fiscal and monetary policy tightening, combined with large inventories, led to the sharp reversal in certain commodity prices, such as iron ore.
We remain optimistic about EM fixed income spreads for 2017 as country fundamentals and the macro environment remain supportive, with those countries that rely most on global trade potentially challenged. We like Brazil and Mexico bonds. Key risks are Trump's protectionist policies, a hawkish U.S. Federal Reserve (Fed), or Chinese policy tightening triggering a sharper-than-expected growth downturn. China's growth slowdown is likely to continue in the medium term, though CNY weakness looks less likely given the political and geopolitical backdrop.
Credit: Despite political headlines throughout the month of May, credit markets traded well across the credit spectrum in both the U.S. and Europe, as strong technicals helped credit spreads narrow modestly in both the investment-grade and high-yield markets. The VIX ended at its lowest monthly level since before the financial crisis. In U.S. credit markets, we anticipate a continued grind tighter in spreads toward cycle lows despite growing leverage in many industries. We continue to seek opportunities in the high-yield and convertible bond markets, sectors that typically perform better in the latter stages of the business cycle. In investment-grade, we remain constructive on financials with a bias toward subordinated debt, marginally constructive on BBB nonfinancials, and we remain less constructive on A-rated nonfinancial risk.
Securitized: Agency mortgage-backed securities (MBS) performed well in May, while credit-related securitized assets also saw continued gains. Commercial mortgage-backed securities (CMBS) performance continues to diverge depending on different collateral compositions, with those with higher retail concentrations underperforming.
We remain positive on mortgage credit opportunities and are less constructive on the more rates-based risks of agency MBS. In Europe, we have been very positive on the outlook for MBS and CMBS, but the valuation of the assets makes us less favorable now. Spreads are now significantly tighter than pre-Brexit levels.