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STATE OF AFFAIRS
The July 21 agreement on the European Recovery fund and multi-year EU budget reached by the European Council on Tuesday was mainly visible in currency markets. The Euro appreciated across most developed market (DM) and emerging market (EM) currencies. The main EURUSD pair moved ahead from 1.1440 early Tuesday, July 21,closing the week about 2% higher at 1.1656. Such rapid moves should trigger attention. What was behind this adjustment during a week where rate, credit and equity markets behaved in an uninspiring fashion? The strong Euro posting might embody a kind of promotion for the single currency. A promotion that lifts the status of the Euro as a reserve currency. We are not contending that the USD is losing its uncontested global reserve currency position, but we might see the Euro growing in market share among global reserve managers. As of 2021, the EU, through the European Commission, will start issuing Euro Recovery Fund bonds with maturities between 3y and 30y. Essentially, we will see the birth of a liquid, high quality (AAA), EU safe bond market directly competing with the US Treasury market. The Euro, not so long ago, was analysed in terms of survivorship probabilities. That door has been closed last week. The Euro future looks brighter and the market is pricing this upgrade in reserve currency status accordingly. At the same time, the continued rise in US-China geopolitical tensions is isolating the US more than is the case for China. The USD has been the dominant reserve currency over much of the 20th century and at the start of the 21st century. Consensus, realistically, calls for China to become the first world economy over the current decade, bypassing the US. Over such long periods it is difficult to position portfolios, but the USD versus the Euro in the reserve currency balance might seek a new equilibrium. I have not forgotten my pushback against a weaker USD over 2020 from a week ago. I pulled such an event into 2021 given the aggressive ECB balance sheet growth, next to a lack of synchronized global growth conditions. So we will have to include the above Euro reserve currency argument. Notwithstanding, the conclusion still stands: ‘We call for a decent USD exposure in order to optimize diversification quality amidst a global portfolio.’ It is up to the investment manager to define what % links up with the word ‘decent’. For the sake of completeness, I do raise the capacity of the Japanese Yen to absorb financial market shocks under increasing risk-off momentum. Admittedly, that has not really been the case over the past 3 months…however over longer periods the JPY stands firm next to the USD in its flight to safety status.
Time to revisit Minsky’s hypothesis that economic agents observing low financial risk are induced to increase risk taking. Excessive risk taking can lead to a crisis. Minsky summarized as follows: ‘Stability is destabilizing’. Financial market volatility is a condition that, on its own, has little influence on risk taking, the real economy or financial crisis. However, moments of unexpected low and unexpected high volatility can morph into bad market outcomes. Time is a key requirement as well. Unexpected low volatility has to be present for long enough time in order to build credit booms. Less low-volatility time is needed to build equity booms. So it bears the question for how long the global monetary and fiscal response since March has the ability to contain and suppress volatility? A condition that is supportive for credit and equity markets alike. The answer is clear: we don’t know, as we lack a proper yardstick. The only reference period takes us back towards WWII, a time where financial markets were highly regulated and less open than is the case today. DM monetary policy has sedated long term rates. The explicit and implicit yield-curve control-framework is allowing governments and corporates to refinance at historically low levels. The banking sector can play its role as intermediary exceptionally well and refrain from own building balance sheet risk. That means that the public at large through the mutual fund industry, insurance companies, (sector) pension funds and the retail investor absorb large amounts of financial product exposure. With the monetary backstop well in place and credibility intact, the weight of fiscal policy is increasing. Bad fiscal policy geared towards subsidies and unproductive projects will shorten the time of stability. Good, responsible and inclusive fiscal policy geared towards value added projects might lengthen the time before we hit another serious bump in the road.
The US yield curve bull flattening was back in vogue over the past week. The 2 year note stuck around 14 to 15 basis points (bp), whereas 5 year bonds touched an all-time 25bp low this week to close at 27.5bp. The generic 10 years dipped below 60bp closing at 59bp. The winner was 30 year rates dropping a lofty 10bp at 1.23%. Market participants start acknowledging that the economic recovery will be lengthy and uneven. Going into a potentially dovish Fed meeting on Wednesday next to a series of new inflation data points that will barely be positive, we expect another stable, ‘uneventful’ week in US Treasuries. The 10 year TIPS auction on Thursday delivered confirmation that demand for inflation-linked bonds is sound. We closed 10 year US inflation expectations at 1.50%. These levels take us back to end of February or in pre-corona markets for the US and the EU. We expect continued normalisation and 10 year real rates dipping firmly below -1.00%. They closed the week at -0.91%.
European Government Bond (EGB) markets were blessed with the positive fall-out of the European Summit outcome. The intra-EMU rate convergence we had been advocating over the past 20 Fixed Income Updates continued unabated. The 10 year Italy –German government bond spread closed at 145bp, down a solid 15bp. The 10 year bund slipped back to its year-to-date average at -45bp. Spain and Portuguese 10 year government rates shed another 5bp closing around 35bp. The 10 year Bund-OAT spread remains stuck at 30bp. Expect attempts below 20bp over the next quarters as French economic conditions improve faster than EU peers. That will translate into lower risk premia. EGBs added 39bp to this year’s tally that ends with a +2.68% performance Year-to-Date (YtD).
Once more EUR corporate investment grade (IG) markets put in a stellar week with a 44bp result. With a YtD at -5bp the sector returns into positive territory. In less than 5 months the sector recovered. Primary markets are buoyant and average yields still attractive around 78bp compared to EGB markets at 28bp duration weighted and a mere 0.01% or 1bp market value weighted.
EUR high yield (HY) momentum was strong adding 95bp in performance. YtD the sector closes at -3.10%. With an effective yield around 4.10% and a spread around 475bp, the sector continues in its healing process. Primary activity is sound. The monetary and fiscal backstops are key ingredients for a continued mending of the HY universe. Moving into EM markets, we see a higher struggle…with long term value though.
At the hopping procession of Echternach, a small town in Luxembourg, people move three steps forward followed by two steps backward. Over the past two and a half months, emerging market local currency (EMFX) government bond markets followed the same pattern: up and down but without real advance. Spreads performed relatively well. Local Currency spreads (GBI-EM), last week, tightened 4bp to 386bp. Hard Currency Investment Grade traded at 220bp (-13bp). Broad Hard Currency (EMBIG) tightened 19bp to 457bp. Sub-Saharan Africa spreads in Hard Currency widened 3bp to 725bp.
A cheaper US Dollar usually bodes well for EMFX. The Dollar Spot index indicates the value of the USD against major world currencies. The index dropped from around 96 last week to 94.63, the lowest level since September 2018. EMFX did not advance on the back of this move, when measured in EUR terms. It lost around 1% on average. Hungarian Forint (+1.8% in EUR terms), Brazilian Real (+1.7%), Polish Zloty (+1.6%), Uruguayan Peso (+1.5%), Czech Koruna (+1.4%) and Chilean Peso (+1.2%) advanced. All the other currencies from our eligible universe posted negative returns. Jamaica Dollar (-3.4% in EUR terms), Ukrainian Hryvnia (-3.1%) and Ghana Cedi (-3.0%) were the top losers. For now, both a weaker USD and an improvement in commodity prices seem to have little positive impact on EMFX.
Argentina is still negotiating with bondholders a proposal that would provide the country with more than USD 35 billion in debt relief (on USD 325 billion public debt). Even if a deal is reached, it will leave Argentina with an unsustainable debt burden. Depending on how deep the contraction of the economy will be (and depending on the conversion rate of the Peso), debt as a % of GDP will reach 100% or more, even after this deal. In the Philippines, one of the best performing markets this year (+11% YTD annualized return in USD), President Rodrigo Duterte ordered to shoot those violating rules on social distance. Ukraine successfully issued EUR 2 billion, 12 years bonds at 7.25% yield. Earlier this month, they cancelled issuance after the resignation of the Governor of the central bank. Despite the fact that the bonds have the highest available yield in EUR for a sovereign issuer, we believe there is very little potential for performance from these levels. In Mexico, the government plans to review the pension system by increasing the share of employer contributions. In Hungary, we saw a massive rally of long tenors, on the announcement made by the central bank to increase the buy-backs in this part of the curve. Last April, we raised our position in Hungary long end from zero to 2.5%, whilst taking profit on our position in the belly of the Polish curve. We believe the short end of the Romanian local curve, with yields around 3.35%, has value. The market does not discount properly further rate cuts of the Romanian Central Bank.
The European Union and the Eurozone surpassed a historic hurdle over the past week. The birth of a European safe bond is a reality. Investors should embrace this moment. Europe leads the globe in terms of solidarity, democracy and hope for a better future.
Investors cope with unseen challenges as global, quality, fixed income product yields are falling well below 1.00%. Credit investments carry and offer small risk premia. Equity investments, selecting the quality balance sheets out there, are certainly a way to hide as a good non-market friend broadened my perspective of late. In the meantime, whilst capitalism tries to adapt to a new regime in which monetary and fiscal authorities take control, take care.