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STATE OF AFFAIRS
In about a week and a half, commentators will discuss H1 2020 performances. We bet that the word ‘surprise’ will feature heavily. It is truly remarkable that financial markets have only experienced a marginal correction in the face of a global economic standstill with real GDP figures collapsing by 5% to 15%. Whatever the shape of the recovery path, it will take years instead of quarters to get back to the size of late-2019’s global economy. We will only be able to speak of a ‘positive’ or ‘booming’ economy again when global economic activity reaches this level once more. Is it fair to say that we are going through an economic bust today? I do believe so. We will witness a rising number of defaults across governments, companies and households. The current monetary and fiscal policy response is buffering this process. It might even end up lengthening the clearing process instead of shortening it. Business models that cannot cope with changing consumer and B2B buying behaviour, working conditions, sourcing options across production factors, and a lack of pricing power will find it difficult to survive. The low interest rates will not protect them for long. In addition, if we agree that we are currently in a transforming economic environment, we must also agree on its disinflationary nature.
In the first paragraph, I essentially took you through two of the four quadrants that Charles Gave has studied and explained. Over the past 20 years, I have always carefully listened whenever Charles speaks. I remember a meeting in 2016 where he explained the investment template below. According to him, there are essentially four basic investment environments. In these environments, economic activity expands or contracts under conditions with rising or falling prices. An economic boom versus bust scenario depends on the level of actual/market rates compared to the immeasurable natural or optimal rate.
Since 2009, the market rate has mostly been set at the zero- or effective lower-bound. Disinflation was the rule. So, essentially, between 2009 and 2019 we were living in a disinflationary boom. Investors who bought into growth companies with pricing power have been the clear winners. Value companies, or those with little pricing power, were the dogs. Interestingly, most fixed income sectors still delivered handsome returns thanks to the highly interventionist monetary policy. As the market rate was below the natural rate, capital misallocation grew.
Since Q1 2020, the corona pandemic has kick-started an investment episode known as a disinflationary bust. Here investors should buy and hold on to safe government bonds and sell risk assets. Performance data across financial sectors has confirmed this outcome. US Treasuries, EMU government, global nominal and inflation linked government bond indices all post positive returns over H1 2020. Also, the winning companies of the previous disinflationary boom period have continued on their winning streak. These winning few hide the slow bust that grows in strength beneath the waterline. The capital misallocation from the previous episode will try to clear under this episode. The million dollar question remains: ‘How long will this disinflationary bust episode stay with us?’ Our best guess is for another two years. High selectivity among risk assets will separate good outcomes from bad ones. However, the latter will outnumber the former. As we stated last week, the monetary arsenal is not exhausted yet, and explicit yield curve control might push nominal rates to even lower levels in order to dampen the impact of the bust we are currently traveling through.
Fiscal policy will push us into the next phase, which Charles describes as the ‘inflationary bust’. This phase might occur over 2022 and 2023. Similar conditions have occurred during the early 1970’s, under Arthur Burns’ US FED presidency. Cash in the safest currencies will become king, and financial assets will have to be avoided. Inflation linked bonds might be your second best choice. If so, it is a choice for which you should already start preparing today. Equity risk should be limited to robust business models that can thrive under rising inflation conditions. Again, estimating the length of this episode is complicated, as it is dependent on central banks’ audacity in testing their inflation symmetry. Refrain from tightening interest rates as inflation readings reach 2.5% to 3.5% levels.
This period will see us passing into a growth trajectory which surpasses end-of-2019 levels. Real estate, commodities and gold will revalue to new levels. At this point, you should avoid long-term nominal bonds. Broader equity might break out of a long consolidation pattern and provide decent equity returns.
The purpose of going through these four investment quadrants is mainly to take some distance and reflect. We have been flooded by such extreme amounts of information that it is easy to lose perspective. Again, reality will likely be different, but we should be on our guard. The timeline described above might be far shorter or longer. We just do not know yet. As a result, we should carefully keep track of how quickly or slowly financial markets value uncertain future real economic outcomes.
The US Treasury curve levels remained the same as last week. If we were to apply a Japanese candle stick technical on it, we would discern a doji pattern. Market participants have been completely undecided. The market direction should be revealed this week. As the nominal Treasury yield curve remained the same, we have witnessed interesting activity in US TIPS. Inflation expectations have continued to normalise rapidly. The 5 year point has led with break-even rates finishing at 1.08%. 5 year nominal Treasury rates have remained stuck at around 0.30% since end of March. As a result, we have witnessed 5 year real rates drop about 75 basis points (bp) over the same period towards -75bp to -0.80bp! The break-even curve flattened fast, meaning that 3 to 5 year inflation expectations have been catching up to 10 year and 30 year expected inflation levels. 10 year inflation expectations closed at 1.27%, and 30 year at 1.55%. As stated, these inflation expectations are still cheap even under disinflationary conditions and could easily adjust another 50bp upward before entering the lower bound of the long term historical range. Since the creation of US TIPS in 1997, 10 year break-even rates have fluctuated between 1.50% and 2.50%.
There has been a continuous interest in German paper last week, as fragile risk markets second-guessed the impact of virus outbreaks across the world. German 10 year bunds closed at -42bp versus -44bp the week before. Investors did find their way back to the South and bought across curves. Italian 10 year rates dipped towards 1.35%. In 2020, 10 year Italian rates reached their low point of 90bp back in February. Spanish and Portuguese 10 year rates dropped 10bp and 5bp towards 48bp and 50bp respectively.
The EUR IG Iboxx index delivers once more, climbing 19bp. With YtD performance at -1.10%, investors’ hopes for a positive 2020 are rising. At the same time, the sector will require an environment of stable rates in order for carry and roll-down to have a positive impact. Additionally, positive-performance hopes will require some extra, albeit modest, credit spread tightening.
EUR HY index remained status quo over the week, with a small -3bp result. The Itraxx Crossover CDS index closed at 3.88%. Over 2020, this pure HY credit spread risk indicator has stood as low as 2.04% in early January, reaching a peak of 7.06% on March 18. So, effectively, we have retraced more than 60% from the highest level. We repeat that the sector might rally another 50 to 75bp. That will require an improvement in virus spread numbers and more explicit support from the ECB.
Emerging markets moved sideways this week. Local Currency spreads (GBI-EM) tightened 2bp to 3.98%. Hard Currency IG eased 3bp, and traded at 2.52%. Broad Hard Currency (EMBIG) tightened 6bp to 4.94%. Sub-Saharan Africa spreads in Hard Currency tightened most and rallied 15bp to 7.40%.
Emerging market currencies traded a touch weaker this week. The JP Morgan Emerging Markets Currency Index (EMCI) declined 1.5%. The dollar index spot ended slightly higher at 97.30. The top performers were the Russian Rouble (1.3% in EUR terms), the Colombian Peso (1.1%) and the Philippines Peso (0.6%). Brazilian Real (-5.7% in EUR terms) did not digest the 75bp Selic Rate cut, which reached a historic low level of 2.25% (FED rates stood at this level in February!). Other weak performers were the Chilean Peso (-2.3%) and the South African Rand (-1.6%).
The IMF has extended its Flexible Credit Line (FCL) to Peru and Chile. Together with Mexico and Colombia, its lending capacity has now reached just over USD 100 billion. FCLs are available for countries with a track record of responsible policy making.
The financial market regime to which we got accustomed between 2009 and 2019 will forcibly change as a result of the COVID-19 pandemic. This decade-long episode was our disinflationary boom. Part of the solution will be to clear the misallocated capital, even under monetary and fiscal support. The disinflationary bust followed by the inflationary bust should not scare investors. It should challenge them to correctly allocate savings and diversify for capital preservation and growth (even if such growth might only be modest in the short to medium term). In the longer term, we should see a resurgence of a stronger economic cycle based on sounder foundations. This inflationary boom will allow risk assets to flourish again.