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STATE OF AFFAIRS
Markets digested the start of second quarter (Q2) earnings releases well. US banks stole the show at first sight. Morgan Stanley, Goldman Sachs, Citi and JP Morgan surprised with stellar trading income across Equity and Fixed Income, Commodity and Currency markets. These institutions thrive when volatility is high. However, Q2 provisions were raised to eyebrow raising levels between USD 5 billion and USD 10 billion. The market took it as a responsible precautionary management decision. Nonetheless, if one looks at these provisions as a percentage of total loan book you come at about 1%. We believe that Q3 and Q4 will see more increases in provisioning as payment delinquencies and defaults accelerate. Governments have reached out with guarantees or interest payment relief schedules. These are not permanent. Banks might be confronted with multiple balance sheet cliffs as the economic recovery stalls. The provisioning effort is not that impressive when observing a 6.3% realised 12 month default rate for US high yield corporates end of June. The ECB warned that, according to the latest bank lending survey, credit conditions will tighten over H2 2020. That will be the case across the globe. So we refrain from being too complacent and will monitor the behaviour of bank management teams closely. The regulator has provided an impressive series of exemptions with respect to bank capital requirements. A bizarre approach that smells like pushing moral hazard yet again. The risk premium on European subordinated financials sits around 150 basis points (bp). This iTraxx Sub Financial CDS index saw a low print around 100bp in pre-COVID times versus a high of 375bp over the March panic. At a 150bp spread, subordinated bank credit is sharply priced.
Over the past weeks, the number of analysis pieces have been published that draw on the ‘reversion to the mean’ investment principle. I want to counter this approach in a thought experiment by taking the opposite side. Across a series of markets we have or are in the process of breaking out of historical ranges:
The US 10 year note broke through pre-COVID 19 lows of 1.30% over the last week of February. There was an attempt to get back above but that failed on March 18, making a high of 1.20%. Since end of March we have been fluctuating within a 60bp to 70bp tight range. The implicit yield curve control we have been advocating many times is well in place. Given fragility of economic conditions we might see a test sub 50bp sooner than a retest of the 1.20% highs of March.
Gold closed at USD 1810 last Friday. The September 2011 high of USD 1921 will be targeted given strong momentum and institutional investor demand. We repeat that gold and real interest rates are negatively correlated. As gold rises expect real rates to drop further.
Emerging market currencies remain under pressure as accommodative monetary policies take their toll in combination with accelerating indebtedness. The JP Morgan Emerging Currency index (FXJPEMCS index in Bloomberg) bounced tentative since the April 52.00 lows to settle at 55.09 on Friday. However it broke through 2018 and 2019 supportive levels at 60 as we entered the pandemic. Emerging markets still need to flatten various virus curves. Reversion towards pre-COVID levels is questioned.
The EURUSD is trending up of late and sell-side consensus sees further USD weakness ahead. However, taking the broader USD index (DXY index) the positive trend since 2011 is intact as a result of stalling globalisation and increasing (bank) regulation. The surge in US money supply has put the brakes on the USD ascent but not the underlying support structure. That structure is built on its proven safe haven status and the USD bid coming from USD indebted emerging market (EM) governments & corporates. We repeat that in order for the USD index to reverse course, synchronised global growth conditions must be met. A successful vaccine is a prime requirement. At best this is a 2021 event. We still call for a decent USD exposure in order to optimise diversification quality.
The US yield curve saw a tiny parallel shift to the downside. Demand for US Treasuries is intact across the curve. Especially the 30 year auction was successful, explaining the strong finish at 1.33% versus 1.35% the week before. 10 year US Treasuries closed at 62.5bp pushing against its lower band at 60bp.
European Government Bond (EGB) markets were rather uneventful. The European Summit outcome or lack of it might set the tone for the week ahead. The ECB assured market participants that the increased Pandemic Emergency Purchase Program will be fully exhausted and run till June 2021. Expect EGB rates to remain steady or seek lower grounds as the demand/supply technical are highly supportive. German 10 year bunds closed 2bp higher at -45bp whereas Italian, Spanish and Portuguese rates continue on their slow grind lower. Italy, the best performing market with 10s, finished at 1.16%. Spain pushed ahead with 2020 funding. They already achieved 85% of total funding requirements for the year. The Iberian countries closed around 40bp on their 10 year benchmark rates.
EUR corporate IG markets performed solidly as July summer illiquidity supports prices. With a 34bp positive week result, the sector sits at -0.49% Year-to-Date (YtD). The ECB credit sector purchase program is highly supportive, even if its weight in the overall purchase glut is limited to around 5% of total. Given the ECB flexibility, it is sometimes hard to find evidence that could widen spreads. On both sides of the Atlantic, IG credit markets and their spread levels are truly dictated by the ECB and the FED.
EUR HY was inspired by supportive IG markets and left a strong +52bp performance print. YtD the sector closes at -4.02%. With the VIX index closing at 25.7, reflecting a strong risk-on momentum, the HY boat was lifted as well. No news is good news and with the occasional European primary issue hitting the market place the HY cash is put to work. As we stated, fallen angels are at times manna from heaven for the HY investor seeking quality.
Emerging markets posted a small positive return this week. Local Currency spreads (GBI-EM) tightened 2bp to 390bp. Hard Currency IG traded at 233bp (-3bp). Broad Hard Currency (EMBIG) tightened 1bp to 476bp. Sub-Saharan Africa spreads in Hard Currency widened 1bp to 722bp.
It was a special week for EM currencies as only 1 out of 72 in our eligible universe showed a positive performance in EUR terms: Chilean Peso (+0.4%). In USD terms, EM FX was slightly positive. The Dollar spot index dropped half a point (from 96.60 to around 96.10), indicating that the move was due to EUR strength versus the USD. Weakest currencies were Indonesian Rupee (-2.9% in EUR terms), Ukrainian Hryvnia (-2.7%), Russian Rouble (-2.3%) and Thai Baht (-2.3%).
The risk sentiment in EM is a function of news on a possible vaccine. This explains the up and down pattern in recent weeks, with little progress being the net result.
In Poland, incumbent Andrezej Duda narrowly won the race for president from Rafal Trzaskowski. Ukraine appointed Kyrylo Svevchenko as the new central bank governor, after a clear warning from the IMF on the bank’s independence. A bill, allowing citizens to tap part of their pension savings amid the outbreak in Chile, has steepened the local curve. The 2y/10y spread is at an attractive 235bp. Lebanon is in contact with Kuwait, Qatar and Iraq to help solving its financial crisis. The newly elected government in Suriname successfully renegotiated the 2023 bills it issued in December last year. Ecuador has reached an agreement with China to reschedule debt (USD 2.4 billion) payments and is still in negotiation with bondholders, who made the restructuring of bonds conditional to the conclusion of an IMF staff level agreement.
July is evolving as a standard summer month. Most sectors are well supported for a lack of liquidity and swaths of market participants taking a short break. August does not have such a comforting label. As always, in order to prepare well for what could be a hot autumn, one has to adjust portfolios today when volatility is low.
Have banks given a comforting message this week? We have some doubts and expect higher stress over Q3 and Q4. As a renowned bank analyst stated this week: “Be careful with bank accounting, as it is all smoke and mirrors anyway.”