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STATE OF AFFAIRS
Complacency by market participants always occurs in hindsight. As a result, defining the factors that make up complacency is a daunting task. This challenge becomes even more complex as we travel through the initial, early economic recovery phase, reflected across multi-decade highs in soft, survey-based indicators. PMI indices (and sub-indices) are leading the charge. Complacency precedes drawdowns. In this letter we touch upon some themes that might trigger broad-based market stress and describe reaction functions across bond sectors and resulting return impact. The themes that are most relevant circle around:
Inflation scares and frontloading of lift-off dates for central bank policy rates
Changes in peak-optimism that might appear through negative adjustments in growth prospects or actual data disappointments on lofty growth consensus estimates. Both will impact many narratives
Tapering paths across multiple central bank asset purchase programs
Political (election calendars) and geo-political stress (Middle East & China leading)
I pull on the first three themes as triggers of changing complacency. US ‘Real politik’ on the international front is required, with the Biden administration giving priority to domestic issues. Vaccination is progressing. Uncertainty surrounding the long-term trajectory is supportive of defensive, qualitative investment flows but remains complex to measure.
Since November 2020, when we welcomed a new US president, and, more importantly, effective vaccine solutions, DM long-term rates have been trending higher. The US 10-year rates adjustment, and concurrent US yield curve steepening, accelerated through February and March, but since then both have been consolidating. US 10-year rates have been able to consolidate between 1.50% and 1.75%, notwithstanding the confirmation of inflationary flares across core CPI & PCE series showing a 3% handle. EU 10-year rates, highly resistant over Q1 2021, succumbed to the pressure ‘leaking’ higher over Q2, with German 10-year rates touching -0.10% mid-May, ending the month near -0.20%. YoY Eurozone inflation data will jump towards 2.3%-2.5%, reflecting base effects and supply bottleneck price pressures across goods and commodities. The structural versus cyclical inflation debate will rage on over 2021 into 2022. Fact is that the market today expects a US and EU average longer-term inflation of 2.42% and 1.60% respectively.
Complacency risk in rates translates into the narrative that we have reached appropriate levels in long-term rates as we pass through a period of peak growth optimism, peak PMI readings and peak inflationary data points. It also counts on steady US monetary policy that will intelligently and slowly taper asset purchases and not frontload any interest rate hiking cycle before H2 2023 as maximum employment conditions might only be reached by 2024-2025. At current levels in US rates, I estimate that investors can be complacent and that the probability for a similar Q1 2021 push higher, driving US 10-year rates towards 2.25%-2.50%, is low. Such a statement is driven by decent expected returns in US Treasuries versus long-term return expectations across publicly traded risk assets. The ‘third mandate’ of the FED is to preserve stability in financial markets. That is not saying that the FED will provide the market with backstops the moment adjustments crystallise. Effectively, the FED has welcomed the rate normalisation over the past 6 months. Sustained accommodative monetary policies have pushed investors up the risk ladder across investment grade (IG), high yield (HY) corporate bonds, convertible bonds and equity. I will not comment on any specific equity valuation factors, as I want to respect my rule of thumb not to comment on a sector that doesn’t belong to my field of expertise. However, bond investors cannot neglect the equity sector as flight-to-quality flows have not disappeared. The narrative tells us that bonds cannot offset any correction in risk assets anymore. I guess such a point, in hindsight, was relevant over 2020 and early 2021. At current rate levels across the US Treasuries, quality EM sovereign and specific EMU government bonds, the picture has changed. With complacency risk at the lower end, I assess that complacency risk on spread product have grown.
Fact is that spread sectors might run into difficulties the moment US 10-year rates would disorderly rise another 60bp to 90bp or EU rates, taking a similar beta, adding another 30bp to 45bp. Such a move might cause a more pronounced adjustment in US equity markets, with negative spread-widening spill-over effects. Financial conditions across financial and non-financial corporates would bite. Corporate loans on banks’ balance sheets, possibly confronted with a combined loss of moratoria and or government guarantees, would deteriorate, leading to an increase of banks’ cost of risk. Banks would tighten loan standards at the worst possible time.
On the other hand, from a risk-adjusted expected-return perspective, government bonds might become the best choice of lesser evils. With rates consolidating at current levels, or at best dropping, handsome carry and roll-down returns or correct total returns might be in the offing. Consensus makes most sense on the call that policy rates will remain at the negative or zero-lower bound for at least another 2 years. So, the moment peak positivism makes room for less buoyant growth surprises, credit spreads might become victim to increased profit taking flows. Subpar liquidity conditions, given prudent risk control across sell-side market makers next to the prospect of less supportive central bank 2022 QE programs, might turn current complacency into more active hedging or rotation flows towards DM and EM government rates. Positioning in credit has indeed grown from strength to strength as the narrative of central banks as the lender of last resort for corporates gained traction. In the US, the FED ended their involvement across various corporate and banking relief programs over Q4 2020 and Q1 2021. Complacency risk are growing in the European IG credit sector, and, by extension, HY sector (a HY sector that saw stubborn and continues interest from yield-searching retail and institutional investors). Investors that might have or are in the process of rotating out of the defensive rates sector at the worst possible moment.
We add another low volatility week to our tally in US nominal rates. Auctions of US coupon bonds have been successful over the past weeks. As the Treasury General Account on the FED’s balance sheet is depleted (sending money to US citizens across various support programs) most of that money creates bank deposits that find their way into the excess reserves account of the banking system at the FED. The downside pressure on short-term rates is substantial. The FED will be required to increase the Interest on Excess Reserves (IOER) at the latest on the next meeting on June 16 in order to steer the effective FED rate well within the 0.00% to 0.25% range. US 10-year rates shed about 2.5bp, closing at 1.59%. The long end of the Treasury across many IG corporate credit curves attracts high interest. June central bank meetings will deliver consistent messages on the temporary character of inflation pressures as well as the long read ahead for all conditions to be met leading to a first lift-off in policy rates.
For the first time since early April, the ECB PEPP flexibility worked its magic. The JP Morgan EMU index returned a lofty 55bp over the week bringing the year-to-date drawdown to -3.54%. The European periphery staged a solid performance with spreads to 10-year bunds tightening around 6bp to 7bp across Spain and Portugal. Bund-BTP 10-year spreads closed back below 110bp, reaching a disturbing high of 123bp about 10 days ago. The good news is that the Next Generation EU program has received the go-ahead across member states. Over July-August the market will absorb the first tranches of EU safe assets at an average pace of about EUR 15 billion a month. Expect pricing in line with the Austrian Government Bond yield curve or in between France/Belgium and Germany/Holland.
Over the past week the European IG and HY bond sectors returned 27bp and 30bp respectively. Expect a buoyant issuance calendar over the month of June as the uncertainty (maybe ill-placed) of tapering will unnerve corporate CFO’s. Credit spreads across IG and HY remain skewed towards the tighter side of narrow ranges.
This week we focus on the impact of the pandemic on Emerging markets currencies. Starting point is mid-February 2020, the peak of the emerging markets rally that started in September 2018. Emerging market central banks lowered rates at an unprecedented pace in order to boost growth during the crisis.
Usually, when facing a (financial) crisis, EM central banks would hike rates to stop currency depreciation and capital outflows, thus undermining domestic economic activity. This time EM central banks were able to ease monetary policy, supporting domestic economic activity. The low inflation environment and relatively well-anchored inflation expectation across many emerging economies, cushioned the risk of exchange rate pass-through and allowed deep rate cuts without immediately raising inflation risks. The impact on emerging markets currencies has been important.
The JP Morgan Emerging market Currency index dropped almost 13% from just above the 60.00 level mid-February 2020, to 52.30 in April and remained below the 56 handle until October 2020. By then it became clear that inflation prints in many emerging market economies touched multi-year lows. Over the same time horizon, the average policy rate of 30+ emerging market central banks dropped from 4.70% to 3.15%, also a multiyear low and, for us, a clear signal that a reversal of monetary policy was imminent.
This policy normalisation, combined with better prospects on global growth, strengthening commodity prices and lower volatility were the main ingredients to be bullish on EMFX at the start of the last quarter. When measured in USD, EMFX has recovered around 10% compared to the April 2020 low, and are now, only 3% below the pre-pandemic levels.
Which currencies were able to return to the pre-pandemic level and which currencies never recovered? It is no surprise to see that the top performers are all currencies that are close to the EUR: Bulgarian Lev, Albanian Lek, Serbian Dinar, North-Macedonian Denar, Croatian Kuna all posted 10%+ returns, followed by the Central European currencies like Czech Koruna, Romanian Leu, Hungarian Forint, with returns between 7.50% and 10%. Further from Europe, it is the South-African Rand (+7.1%) that leads, followed by Chile (6.9%) and Israel (5.4%). More important is probably what happened at the other side of the spectrum. Argentine Peso (-53.7%), Zambia Kwacha (-53.3%) and Turkish lira (-40.1%) distribute the medals for the worst performers.
In the list of countries with a negative performance in USD terms bigger than 10%, LATAM is very well represented: Colombian Peso (-10.4%), Peruvian Sol (-13.6%), Uruguay Peso (-15.6%) and Brazilian Real (-23.3%). All these four currencies merit our special attention on cheap valuations. Colombian Peso has suffered on the tax reform and recent downgrade by S&P (see last week’s letter). Peruvian Sol discounts a win by far-left Pedro Castillo versus Keiko Fujimori in the second-round elections (June 6th). Uruguay Peso’s slide should be halted, as the central bank stated at the May 15th meeting that a gradual process of increasing interest rates will start once the health emergency is over and especially because inflation (6.76%) is within the target range (3%-7%) for the first time since 2018. With a natural benchmark rate at 6.50%, according to Roberto Campos Neto, President of the Banco Central Do Brasil, more Selic rate hikes are on the table. This will be supportive for the BRL.
Complacency risks or drawdown probability is a function of valuation, positioning, flows, momentum, volatility and liquidity conditions. Valuation across US rates has improved markedly alongside absorbing a realistic pricing for future inflation around 2.5%. Negative real rates are part of the longer-term solution accepted by monetary and fiscal authorities. Current rate volatility estimates do not point to high uncertainty ahead. Valuations across EU rates might adjust further. However, the bulk of the damage should be behind us.
Valuation, positioning, momentum and liquidity risks are above average for corporate credit risk. Moderation is required independently, whether rates go higher or lower from here.
From a multi-asset perspective equity risk might start to find a solid diversifier in EM Government Bonds (HC or LC). Candidate EM economies require current account surpluses or modest deficits (1% to 3% of GDP) in current accounts as well a moderate overall state indebtedness between 50% to 85% of GDP.