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STATE OF AFFAIRS
Just before the start of the last quarter of a momentous 2020, our focus zooms in on the short term. We’ll touch upon US politics and overall positioning. Investment behaviour will become increasingly protective of realised returns over 2020. Long- and medium-term convictions will move to the dug-out. The divergent character of short-term scenarios might freeze markets around current valuations. However, I contend that the October month might become highly volatile as mutual funds and especially hedge funds might want to lock-in current results before November 3. So, instead of the typical end of November/early December drop in conviction positioning, we might see the bulk of profit and/or loss taking packed in October 2020.
As per Friday September 25, national polls put Biden 6.6 points ahead of Trump. When revisiting the Trump-Clinton national polls around this time in 2016 we observed a small 1-point lead in favour of Ms. Clinton. The last national polling result just before election day in 2016 put Clinton as favourite with a lead of 3.2 points. National polls are firmly in favour of Biden. However, when we dial in on the electoral votes for key swing states, we see Biden outpace Trump by a mere 3.4 points. The comfortable Democratic lead in these key battlegrounds stood at 6.8 on July 24, representing a 50% drop and that 36 days before election day. The candidate that receives 270 electoral votes out of a total of 538 will become the 46th President of the US. The rhetoric will become increasingly divergent, stirring financial market uncertainty. We watch out for the first Presidential Debate next Tuesday September 29. Historically, the first debate carries the highest impact. In about a week, we will know whether to expect another cliff-hanger on November 3. Over the weekend Trump nominated Amy Coney Barrett for the Supreme Court. The Senate Judiciary Committee plans to start Barrett’s confirmation on October 12. A full Senate vote, with Republican majority, is tentatively planned for the week of October 26. This nomination might further delay any agreement on a fourth fiscal stimulus package. To top things off, the path for the COVID-19 pandemic remains highly uncertain, as cold and flu season ramps up. The hope for an efficient vaccine is getting pushed towards end Q1 or Q2 2021. So, the northern hemisphere will have to deal and live with the virus through the winter ahead. Economic recovery scenarios, whatever the letter you believed in, will require remodelling soon.
‘Financial market positioning’ is a term often used by investment bankers. Positioning is often based on short-term demand and supply models, and tracking of fund flows across bond and equity sectors. Positioning is important for short term, speculative investors. Many hedge funds live by calendar year results. The main HFRX Global Hedge Fund index points to a modest 1.14% Year-to-Date (YtD) result. September sits at -0.65% and might become the third negative performance month over 2020. February at -1.44% and March at -5.88% were the culprits for another disappointing year. A lot of hedge funds close their calender year end of November. With the potential for gridlock present after November 3, worst case would be that the election result requires court handling, many hedge funds will reduce exposures over October. To a lesser extent, but still, mutual fund investors might succumb to similar pressures and lower their beta vis-à-vis their benchmarks. September has already given us some early signals. Gold dropped about 5% this month towards USD 1861. From August 10, highs we are down 10%. The adjustment went hand in hand with a stronger USD as well as with a drop in US inflation expectations. Model correlations between gold, the USD and break-even rates work like Swiss watches. With inflation prints till year-end offering little read-through value, the probability for further profit taking on gold and inflation break-evens is a coin toss. On the other hand, a continuation of the USD recovery versus G4 currencies, next to continued USD strength against emerging market (EM) currencies carries a higher probability. Over the past years, the US current account deficit as a percentage of global GDP is smaller by a factor of 4 versus the 2002-2004 USD sell-off episode. This was a time that saw accelerating globalisation and accommodative FED policy. Currently, we only have (admittedly extreme) accommodative FED policy. A condition of global growth in USD supply through an expanding US current account deficit is not present at all this time, on the contrary. Deglobalisation might flip the US into a rare state of having a current account surplus. Moreover, use of FED USD swap lines have dwindled and markets expect more accommodation from the ECB and the BoE. In credit markets, we took note of severe profit taking in the high yield sector, pushing global high yield (HY) ETF (in USD) performance back into negative territory YtD. Investment grade (IG) markets count on continued purchase support by central banks. Yet, over the past week HY stress spilled over and infected the IG sector with subordinated paper as the main victim. On top, the often-neglected liquidity premium is rising again, having not fully recovered compared to pre-pandemic levels. Expect positioning divergence to rise across short-term and long-term minded investor base.
The US Treasury yield curve is losing some of its risk-off appeal. With the Dow Jones index losing 1.75% and the S&P 500 down 0.65% both ending in the red for a fourth consecutive week, the expected flight to quality into US Treasuries has been notably absent. Might the CBO (Congressional Budget Office) release of their Long-Term Budget Outlook on Monday, September 21 taken the wind of the US Treasury sails? According to their central projection we will surpass the WWII record of 106% of GDP over 2023 before hitting 195% of GDP by 2050. It confronts US policy makers with the scale of the fiscal challenge. The sensitivity to changes in interest rates grasps our attention. If interest rates are 1% point higher than assumed, then the 195% number shoots up towards 264% of GDP. If interest are 1% point lower the CBO sees deferral debt at 149% of GDP. Such reports cement the requirement for close cooperation between monetary and fiscal policy. It also cements the low-for-longer call in rates relative to inflation and nominal growth. Yes, the FED balance sheet will continue to grow over the next decade and beyond. So, the risk-off background led to a very modest bull flattening of the yield curve. Two-year rates dropped 1 basis point (bp) to 12.9bp, 5-year rates dropped 1.5bp to 26.7bp whereas 10- and 30-year rates fell by 4bp and 5bp respectively to 0.65% and 1.40%.
Notwithstanding some panic in European equity markets, German 10-year rates adjusted in line with the US, shedding about 4.5bp to close at -53bp. Market participants start to test a new -40bp to -60bp range for the all-important 10-year German rates. Intra EMU rate convergence remains robust. Spanish and Portuguese 10-year spreads start to settle comfortably below 80bp. We maintain a 50bp medium-term target. The 10-year Italian BTP-BUND spread closed at 1.41%. The regional election results reduced fears of political instability. In March 2015, the month that saw the birth of the ECB quantitative easing program, the 10-year BUND-BTP spread made a low at 88bp. Impossible to predict when but 2021 might see a test of those levels.
European IG corporate bonds lost about a third of its YtD performance, backing down by 33bp between Tuesday and Friday of last week. The Iboxx index holds onto a 0.68% YtD result. Curious to see what the last three days of the month and quarter will inflict. The index yield settled close to 0.60% for a spread level around 1.20%. The average spread level over the past 20 years has been 1.30%. The question that pops up is what the IG spread level would be under the scenario of no central bank purchase support. According to ECB studies, the impact of its Asset Purchase Program would be to reduce the 10-year term premium by around 95bp. The announcement of the yield spread announcing impact of the Corporate Sector Purchase Program (CSPP) for eligible and non-eligible credit, reduced funding costs by about 35bp. With a direct effect of purchases at reducing funding costs by 70bp, the combined drop in funding costs stacks up to 1.05%. Clearly a continued presence of the CSPP is warranted, as, without it, spreads and funding levels would spike aggressively.
What a difference a week can make. European high yield markets hit a concrete wall suffering a 1.55% set-back wiping out almost 2 months of performance. The HY sector drops by -2.89% YtD. Increasing nervousness and repositioning flows explains the short term hit. With HY spreads backing up towards 4.85%-4.90%, pushing yield towards 4.25%, the sector aligns better with potential stress over 2021. 2020 will see a low realised default rate as ECB credit easing and government guarantees insulated balance sheets.
Emerging bond markets printed their worst weekly performance since March. The surge in COVID-19 cases, especially in Europe, is fuelling a more pessimistic outlook for global growth and the need for even more support. Local Currency spreads (GBI-EM), widened 6bp to 3.86%. Hard Currency Investment Grade traded at 2.35% (+15bp). Broad Hard Currency (EMBIG) widened 30bp to 4.55%. Sub-Saharan Africa spreads in Hard Currency widened 60bp to 7.45%.
EM-FX, when measured versus the USD, lost around 1%. As we have stated previously, the JPMorgan Emerging Markets Currency Index (FXJPEMCS), that measures the value of the most important EM currencies versus the USD, seems to be capped at the 56.00 level. After touching this level again on September 17, the index dropped below 54.50. Despite historical cheap valuations for EMFX, a global, more synchronized, pick-up in growth is needed for a push higher. When measured in EUR terms, EMFX, on average, performed better (0.85%) but with very high dispersion: frontier countries doing relatively well, but some of the bigger EM’s getting badly hit. Mexican Peso (-3.65% in EUR terms), South African Rand (-2.25%), Polish Zloty (-2.00%) and Brazilian Real (-1.50%) showed the most negative weekly returns. Most positive were Dominican Republic Peso (+2.20% in EUR terms), Mongolian Tugrik (+2.10%), Pakistani and Sri Lanka Rupee (+2.00).
Turkey’s central bank, in a move that surprised markets, increased rates from 8.25% to 10.25%, in order to prevent a slide of the Turkish Lira above the 9.00 handle versus the Euro. Most market participants read the hike as a possible return to independency of the Central Bank of the Republic of Turkey. The Lira reacted in a positive way, dropping back to below 8.88. Our reading is completely different. After having burned all the central bank reserves in recent months, trying to halt the collapse of the currency, a balance of payment crisis is looming. It is too little and too late. With inflation running at 11.77% Year over Year in August, real interest rates remain negative. This rate increase will not be enough to attract foreign inflow of capital. This move is not a significant game changer, but rather a last convulsion of a central bank that has lost control a long time ago.
Beware of positioning-induced volatility as we start Q4 2020. Sell-side analysis will start pointing to ‘buy on the dip opportunities’ across bonds and equity markets. Such opportunities will certainly arise for long-term investors but are expected to filter through over the final December month given premium inflows that trigger investment decisions.
The moment one gets confronted with positioning arguments against longer-term valuation arguments market participants should be careful, as additional pain could be in the offing. Indeed, the asset reflation tide that took hold of markets end of March till end of August lifted all boats. The aggressiveness of the liquidity injection ridiculed the valuation ratio. Credit-risk premiums across IG and HY sectors might have to adjust further in order to align better with aggregated idiosyncratic business and leverage risks on top of a potentially higher liquidity risk add-on.