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STATE OF AFFAIRS
As we approach the summer holiday months, markets might become less frantic and liquidity conditions might switch down a couple of gears. The timing is about right as well as appropriate to ask ourselves the question “What kind of events might disturb financial stability?” Only about 15 months have passed since we were brutally confronted by financial market distress. The market rout was the shortest in history, spanning a mere 3 months from March to May 2020. By August US equity markets were making historic highs, a trend that was only accelerated once mass vaccination became a winning ticket to exit the global pandemic. Financial market volatility, read ‘pricing of uncertainty’, collapsed as the shock absorption represented by an aggregate central bank asset purchase program has passed the USD 11 trillion marker today. The aggregate balance sheets of (developed market) DM central banks rose by an astonishing USD 11 trillion over the past 15 months. I repeat this message in order to understand the magnitude, because it represents about the same growth over the 11 years between end of 2008 and end of 2019. When a system receives such an adrenaline shot, one should ask how the patient will behave the moment the administrated dose starts to fade? Over the past month we witnessed a series of well-orchestrated central bank communications that prepare markets for less interventionistic behaviour over 2022. Indeed, over H2 of 2021, financial markets can still count on around another USD 1.75 trillion in QE intensity. However, the cliff-hanger awaits us by Q1 2022, or possibly a bit earlier if effective herd immunity is reached. The moment virus variants cause renewed lockdowns and restrict economic activity across the Northern hemisphere by next autumn and winter, all bets are off. Central banks will be required to come to the rescue again, and fast. I consider the latter as a tail-risk. Today, we think alongside the base case scenario and focus on what can destabilise markets the moment central banks quietly leave the stage. Fiscal, regulatory and macro prudential policies will have to lift sustainable economic development prospects in order to propel market and animal spirits. I sum up a series of potential fault lines that can disturb a goldilocks outcome:
The first fault line I discuss is the impact of an unorderly and divergent growth recovery. Economic healing differs as a result of different success rates in vaccination programs. The growth path aiming to close output gaps will diverge in line with priorities set by governments and central banks. Proof is gaining traction that a synchronised global economic recovery is not in the cards. A couple of weeks ago, I published the letter ‘A Nash Equilibrium’, where I expressed a hope that central banks would pull away from aggressive asset purchase programs in a concerted manner. Now, if they opt to go at it alone, so to speak, and pull-back monetary support or start tightening financial conditions based on the level and potential uneasiness over domestic economic indicators – inflation springs to mind – we can expect market havoc. Governments deal with different fabrics when supporting manufacturing versus service sectors. Across DM and emerging market (EM) economies we look at a scattered picture. The scarring in service sectors has been important. Countries that score high on tourism as a % of GDP behave differently than countries with a high dependency on industrial exports. Lack of proper government concertation across economic blocs (the EU, the USMCA, the Asian RECP – Regional Comprehensive Economic Partnership) might result in less optimistic growth figures than consensus reflects today for 2022 and 2023. Yet again, the unrelentless financial market recovery has lifted all boats across equity and credit public markets. Equity valuations of hard-hit sectors are closing in on end of 2019 levels. Credit spreads show an even more aggressive reading, as QE has wiped out most of the differentiation. In credit we are on the verge of tackling credit risk premium levels witnessed before the GFC if we take iTraxx or US CDX CDS indices as our guide! Divergent monetary and/or fiscal strategies might lead to sudden market stops.
The second fault line centers around the stability of banking systems. Last week, all 23 US banks passed the Federal Reserve’s exam showing well-above-minimum required capital levels during a hypothetical economic downturn. US banks can withstand a severe global recession with hits for commercial real estate and corporate debt holders, 10.8% peak unemployment and a 55% drop in the stock market. The industry would post USD 474 billion in losses. Loss-cushioning capital would still be more than double the minimum requirement. To give you an idea, 50% of US banks posted ROE above 10% over Q4 2020 versus only 7% of European banks! That brings us to the stability of the banking system in Europe. Europe has, like the US, increased capital buffers by a factor of 3 to 4 compared to 2009. However, as already mentioned, the lack of consistency in risk-weighting methodologies in the EU banking sector, the lack of market-based disintermediation (leading to important corporate – SME – loan books) and the sovereign-bank-corporate nexus complicates the equation for the Eurozone. Luckily, average bank credit funding cost will decline forcefully to below 1.00% over the next 4 years. That will require stable EU rate markets alongside a status quo ECB policy. Euro area bank profitability will recover slowly. The market projects an average ROE of 3% end of 2021 and 6% in 2022 as loan loss provisions are taken back. Still, the Achilles heel rests with the distribution and migration between Stage 1, Stage 2 versus Stage 3 loans. Over 2020, risk migration from Stage 1 to Stage 2 for the accommodation sector increased fivefold from 5% to 25% over 2020. Current estimates indicate that the stock of Stage 2 assets would increase from 13% in the fourth quarter of 2020 to 17% at the end of 2021 for euro area banks on aggregate. Watch this space carefully over the next couple of years and assess the level of bank credit spreads against it.
A third fault line is represented by the procyclicality of investment funds. Market-based financing (replacing the old-term shadow-banking system term that had a negative connotation) remains solid since the summer of 2020 and has recaptured its previous 20% of total external credit pre-pandemic level. Notwithstanding, over Q2 and Q3 2020 purchases of the official Eurosystem sector were around the same size as those by investment funds, insurance companies, pension funds and other financial institutions combined. Image a scenario where the ECB announces less support as of Q2 2022 the moment the PEPP ends. Even if replaced by an invigorated APP program that grows from EUR 20 billion to EUR 40 billion a month, European credit markets might experience a small taper tantrum. This taper tantrum could get ugly if, over 2022, bank loan losses rise alongside increasing stress on high yield spreads, as banks and investors retreat. I expect that an orderly, modest rise in long-term rates will not represent a fault line.
On Friday July 2, we have the release of US Non-Farm-Payrolls. Consensus expects a +700k number. Expect stable conditions in US rate markets till then. US Treasuries markets gave back a lot from the unexpected bull flattening of past weeks. The steepening mainly affected the 10-year to 30-year bracket with rates inching up 8.5bp and 14bp respectively. 10-year rates closed at 1.525% versus a 2.15% on the 30-year long bond. The 2y30y interest rate differential closed at 188bp, comfortably below 200bp and a far cry from the 230bp high of mid-March. With US risk assets hitting historic new highs it is almost comforting to be able to lock-in 2%+ in US Treasuries or between 2.5% and 3.5% across high quality financial and non-financial US corporates.
Another tough week for European Government Bonds, with a set-back of 49bp. That pushes the damage back towards -3.65% YtD. The ECB duration absorption intensity should be able to control EU rate levels over July and August as summer illiquidity might work in their favour. Expect Next Generation EU issuance to ramp up over July and August. Investor appetite is high. Short-term it might put a damper on the intra-EMU rate convergence theme. Long-term we can expect further convergence. In the meantime, carry and roll-down return on EGB’s has tripled compared to end of November 2020. Back then, EGB expected return stood at 0.32%. End of May 2021, we clocked at 0.92%. We will provide you with an update for the end of June in a next letter.
European investment grade (IG) credit retreated by 21bp, whereas high yield (HY) posted a flat weekly performance. With IG total returns around -0.85% and HY at 3.01%, investors are satisfied. The above fault lines address potential heavy weather ahead…2022 carries a longer shadow than 2021.
EM showed impressive resilience, especially on the currency front. The EM currency index jumped 1.76%, helped by some weakening of the USD and tightening of monetary policy in some countries. Mexican Peso (+4.2% in EUR terms), Brazilian real (+2.60%) and Hungarian Forint (+1.50%) were the top movers. Ghana Cedi (-2.4% in EUR terms), Peruvian Sol (-1.4%) and Thai Baht (-1.4%) represented the laggards. Curve flattening was the general theme, with the 10-year acting as the pivotal point on the curve.
The gradual normalisation of monetary policies has shifted into a higher gear this week. Whilst rate hikes in the Czech Republic (+0.25% to 0.50%) and Hungary (+0.30 to 0.90%) were pencilled in a long time ago, the Banxico hike (0.25% to 4.25%) surprised many market participants. However, in retrospect, the latest quarterly report indicated that the Mexican Central Bank would act should inflation deviate from the expected trajectory. It did. Core inflation increased from 4.14% in April to 4.37% in May (YoY), putting at risk convergence towards the 3% target starting the second quarter of 2022. The divergence of opinions among the board’s members (vote was 3/2) makes it difficult to interpret the Central Bank’s reaction function going forward, but it certainly shows strong commitment and willingness to anticipate should divergence from the path persist.
Gradual normalisation of monetary policies, having a positive impact on the valuation of currencies, is a view we repeated many times since Q3/Q4 last year. The Banxico move strengthened the Mexican peso from 20.60 to 19.70 versus the USD, a 4.50% move. The Latin American Currency index strengthened 2.80% this week, the biggest positive weekly move of the year. Meanwhile, the Mexican rate hike caused a re-pricing of 12-month forward rate expectations, that now stand at +1.25% in Mexico, +2.40% in Brazil, +1.20% in Colombia and Chile and +0.55% in Peru. This will be supportive for Latin American currencies going forward.
S&P affirmed Malaysia’s credit rating (A-), stating that despite increasing the statutory debt limit from 55% of GDP to 60% until 2022, the government has been increasing expenditures within a responsible level to fight the crisis. Key credit strengths of the country are the strong external position and the monetary policy flexibility. Pressures on the recovery from Covid outbreaks are mounting though, and a new Movement Control Order 3.0 (mobility restriction) started as of June 1. The impact of lockdowns led the World Bank to revise its 2021 growth forecast down to +4.5% from +6.0%. The Malaysian government is expected to announce another round of economic help after the MYR 40 billion package (ca. USD 10 billion) announced at the end of May. With previous government forecasts of a budget deficit of 6%, it looks increasingly likely to us that the debt ceiling will be tested while monetary policy is likely to stay accommodative to help the economy recover. Policy makers still have some room with Malaysian CPI rising 4.4% YoY in May, down from 4.7% in April and below the central bank forecasts (7.00% in May before easing to 5.00% in June). The external position is good with a positive current account balance (+4.6% in Q1), and the currency should benefit from both strong tech-oriented exports and improved commodities terms of trade.
As we passed summer solstice, we also witnessed peak positivism in financial markets. Those are moments when investors should become more vigilant.
We presented 3 fault lines that market participants should consider today. The impact of divergence across economic indicators, question marks around the European banking system as well as the procyclical issues encountered within investment funds deserve close attention.
Expected returns across bond DM and quality EM government sectors improved markedly over the past 6 months as a result of the US yield curve repricing. Increasing allocations to safe-haven investments should be pondered. The ‘there is no alternative’ narrative dismisses the fact that bond markets offer valuable investment opportunities mid-2021.