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STATE OF AFFAIRS
The number of positive narratives is rising steadily. The majority of sell-side strategists count on accelerating growth conditions over 2021. Global reflationary policies will succeed in pushing economic growth swiftly back on the pre-pandemic 2019 path. That should propel risk assets into double-digit return territory. The ECB joined the chorus over the past week. Optimism is indeed an essential ingredient in order to unleash animal spirits. However, the pandemic is still raging as new strains propagate contamination faster. Not if, but rather how strong a third wave will hit the EU becomes the main worry. As confinement policies get extended and harsher government bodies adapt their growth forecasts. Germany shaved its 2021 real growth prospects from 4.4% to 3.00%. Expect more Eurozone countries to adjust their expectations.
In the meantime a large swath of market commentators have warned the public that bonds should be avoided by all means. The classic 60/40 bond-equity (or the reverse for less risk-averse investors) should be replaced by hybrid-equity portfolio solutions. Hybrids can take the form of convertibles, subordinated debt, precious metals, illiquid infrastructure bonds or structured products linked to commodities or digital currencies. The narrative goes that we have to prepare for an episode of positive return correlation between equities and traditional fixed income. Effectively, investors would lose the diversification benefits that have been in place since 1998. It is true that we have been confronted by brief moments of positive correlation over the past year. But to extrapolate these instances into a genuine new regime is nothing less than trying to create an undue panic. Proper studies, looking back more than 50 years, have revealed that a positive bond-equity return correlation requires two conditions. First central banks have to engage into effective policy rate tightening. Moreover, the tightening has to be broad-based. Effectively the local tightening cycle by the FED between December 2015 and December 2018 did not derail the negative bond-equity return correlation. Second, markets have to be confronted with a sustained episode of high inflation. High inflation is present the moment year-over year CPI readings consistently print above 3.00%. We state that we are years away before both conditions are fulfilled. Indeed, central banks will adopt controlled high accommodation in order to give a chance for average inflation to reach targets around 2.00%. A brief episode of inflation above 2.00% would surely be welcomed, but markets will look through such prints and focus on the ability of policy makers to maintain inflation around the anchor. Do not expect a sudden flip into a 1970-style inflation backdrop.
The main argument used, namely that the presence of low rates requires another diversification approach, is fluked. Active bond managers have long passed the reluctance encountered when crossing the 0% yield borderline into negative territory. 2020 was a case in point with European government bonds posting a +5.12% return, whilst starting the year with an index yield around 0%. It is not the level of rates that counts. Over the past years active bond managers have been focusing on the shape of government and corporate yield curves. Exploiting the steepness characteristics of yield curves opens a broad range of opportunities. The US Treasury yield curve has gained attractiveness in this respect over the past months. Within the emerging market (EM) bond universe opportunity calls as well. In Europe the challenges are higher. Still the ECB will remain flexible across conventional and unconventional policy instruments. We repeat that policy tightening is not an item for 2021 or beyond, across either side of the Atlantic. Government budget deficits will remain uncomfortably high over the next 3 to 5 years. Mending scarred labour markets, an objective for governments, will be the main argument used by central bankers for keeping the direction of policy unchanged. Expect high focus during next weeks’ Fed press conference.
The hybrid-equity solution proposed increases the expected return profile. However, is it a correct alternative? Does some dissipation in negative correlation warrant a jump towards sectors that exhibit, bluntly stated, rather high positive correlations to equity? Do we throw everything overboard and go all-in on a portfolio construction journey with positively correlated assets. Good luck. I remember the 2003-2005 era well. Back then, US 10-year rates dropped below 4% and 5-year rates ranged between 2.00 and 3.00%. Historic low levels at the time that unnerved many portfolio constructors. That was a signal for Structured Product desks of many investment banks to create and distribute on a global scale higher return alternatives. The CDO market became mainstream. Today the presence of low to negative rates creates a similar atmosphere. Investors should be on their guard. Again, banks, confronted with declining net interest margins and disruptive new entrants, want higher rates. They need higher trading income that comes with the distribution of higher bid-offer, less liquid, instruments. Indeed, hybrid instruments create higher profitability. Guess, in a sense, history repeats.
We observed a buoyant Treasury market up to the 5-year point closing down about 2 basis points (bp). US 10 and 30-year rates closed largely unchanged at 1.08% and 1.84% respectively. Once again; US TIPS caught most of the attention. 2-year TIPS break-even rates or inflation expectations spiked 10bp towards 2.48%. A reopening of 10-year TIPS was met with very high demand. The 10-year break-even rate printed a high of 2.17% on Thursday only to fall victim to profit taking closing unchanged for the week at 2.08%. US inflation expectations have engaged in a volatile patch. It will increase the FED’s confidence. Next weeks’ FED meeting should not herald a lot of new initiatives or change in policy direction. The start of the Biden administration, as hopeful as the inauguration ceremony was, will not be a walk in the park. The pandemic will weigh on economic indicators over H1 2021. Potential structural changes in consumption and corporate investment behaviour can inflict disarray in the predictions of economists on recovery shape outcomes. The current US yield curve steepness offers correct expected returns.
The ECB messages released on Thursday surprised many. Instead of increasing transparency, the use of words from holistic to multifaceted when addressing policy direction and measurement of financial conditions, it reduced the credibility of the central bank. As if introducing more variables to assess financial conditions (average government & corporate yields, money supply growth indicators, appropriate borrowing rates for housing and consumer credit…) opens up the possibility of using more excuses the moment attaining objectives looks frail. The fact that the ECB has to pass by the EU banking system to hit targets is a sizeable obstacle. Unlike the US, where public markets and not banks are the main credit channel, the Eurozone encounters many hurdles to reach a workable banking union. No ECB press conference might have been a better choice. 10-year bunds closed at -51bp, up 3bp. The EMU periphery encountered some headwinds, given bad corona tidings and lingering Italian political uncertainty. Spanish 10-year rates jumped 7bp towards 0.12% whereas Italian 10-year rates spiked 14bp hitting 0.75%. EMU government bond markets are off to a difficult start of 2021, shedding 52bp in performance over the week settling at -0.84% YtD (year-to-date).
European corporate bonds show high resilience retreating 9bp over the week. YtD performance sits at -15bp. Investment grade (IG) credit risk premia behave very gentlemen-like at low volatility levels. Notwithstanding, whenever you want to sell long maturity credit, market makers tend to put in very low bids. Clearly, liquidity conditions are not in line with the “all is under control as we have the ECB backstop” market attitude. In European high yield (HY) the quest for yield is intact. The HY index added a solid 26bp and delivers a hefty +0.71% YtD result. Government guarantees are shielding balance sheets and banks are allowed to maintain moratoria on large parts of their loan book. Indirectly, government intervention and central bank patience towards the banking system keep the HY sector protected.
A busy week for EM with a new US administration, lots of supply and central bank meetings. EM currencies have been looking for direction between the positive boost from expected US fiscal stimulus and growth fears as the COVID-19 crisis is showing no signs of abating.
The JP Morgan index for EM currencies (EMCI) has finally lost losing ground on Friday to end the week at -0.85%. In terms of spreads, local currency debt (JPM GBI-EM) has decreased vs developed markets by 1bp to 362bps and the spread of hard currency debt by 2bps to 405bps.
Primary Markets for Sovereign credit have shown a lot of activity again with IG issuances of USD 6.7 billion in just two deals: Chile multi-tranche in EUR and USD, including a sustainability bond (USD 4.3 billion in total) and Panama (USD 2.4 billion) just after securing a credit line from the IMF. In HY we had USD 6.3 billion of issuance with Bahrain (USD 2 billion), Paraguay (USD 830 million) and Turkey (USD 3.5 billion) which attracted a record book of more than USD 15 billion for 5 and 10 year maturities yielding in USD 4.90% an 5.95% respectively.
Local debt has been very busy as well with notably some frontier markets successfully tapping the market: Uganda issued a new 10y at 16.15%, Kenya a new 16y at 12% and Ghana a new 6y at a cut-off yield of 19.25%. The latter issuance has been a tremendous success allowing the country to issue GHS 2.8 billion (USD 490 million). SAGBs auction next week will be interesting to watch, after the bond rallied around 20bps this week. This appetite for EMD in a low yield world has pushed inflows into EMD funds to the impressive level of USD 4.3 billion, with local currency funds outpacing hard currency ones.
The RBI has been pursuing its normalisation policy in India (i.e. draining excess cash in the financial system) in order to push money market rates closer to its repo rate of 4.0%. The exercise is tricky because the central bank is trying to correct excesses in money markets while aiming at capping longer-term borrowing costs at the same time.
Supporting the currency may have been the reason why none of the central banks that met this week – despite some having ones of the highest real rates globally (Turkey, Malaysia and Indonesia you name it) – actually cut their base rates. The SARB in South Africa also adopted a neutral tone, despite a turn for the worse in the COVID-19 crisis. It seems that policy makers are choosing to remain attractive for foreign capital inflows that help absorb the on-going supply of government debt, despite the need to support their domestic economies. While the path to global recovery is not straightforward, we think EMFX is one of the cheap asset classes and should perform once the lid on global growth is gradually removed. We believe the dispersion between countries’ economic recoveries is an interesting source of alpha generation for the active manager.
Attempts to call the end of the capital preservation and growth characteristics of the traditional fixed income asset class are premature at best and populist at worst. We monitor the bond-equity correlation through our tested in-house dynamic model featuring long and short-term signals. The negative correlation is intact. Without an imminent threat of global monetary policy tightening next to the absence of high and persisting inflation prints across DM economies, we are not flipping into a new regime.
The banking system thrives on higher rates and high volatility. The banking narrative looks to increase transaction volumes and fees. Real money investors should focus on sound portfolio construction and seek exposure to a maximum amount of independent factors. Whether some of those factors exhibit negative yields should not be our main worry. Beware of new narratives in this decade of low rates.