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STATE OF AFFAIRS
Last week’s total return for European Investment Grade (IG) corporate bonds finished at 1.12%. One has to go back to July 2009 or 2012 to find such solid weekly performances. Essentially, as investors anticipated and reacted to last Thursday’s ECB meeting, global credit markets reached levels that make one question the very existence of an economic crisis. Have credit markets reached a stage of irrational exuberance, or is there something else at play? As always, we believe the truth lies somewhere in the middle.
On the one hand, the FED, ECB, BoE and BoJ’s backstop, which bolstered their respective asset purchase programs, could almost be defined as irrational. The amount of money printing is mindboggling. Moreover, these institutions have the flexibility to adjust purchase amounts as they see fit and/or an ability to broaden the scope of instruments that might find their way to the balance sheet. As such, market participants have little option but to take the side of the central banks, and subsequently increase their holdings of risk instruments. Participants monetise their allocations, which were parked in money market funds or investments in government bonds, and go on a buying spree. If the consensus is that quantitative easing (QE) programs will remain active for years to come, or even become permanent, one can question the very existence of risk premia. If QE becomes a perpetual program, risk premia might collapse entirely, consequently propelling valuation metrics upwards, alongside ever-increasing price levels of risk assets. Moral hazard gets institutionalised. A growing base of ETF investors is only exacerbating this phenomenon.
On the other hand, we see more stringent financial regulation and growing government control, which acts as a counterweight to monetary profligacy. Regulation and government influence will have to contain moral hazard. Central banks have effectively abandoned this objective, and should refrain from claiming the opposite. On this front, risk premia push back.
In the end, we are left with the connection to the state of the real economy. Real economic expectations should inform investors about the required risk premium level, as well as its (expected) volatility profile. Unfortunately, rampant financialization of economies in developed markets (DM) is running parallel with the role of central banks over the past 40 years. This has cut many links. Reality requires us to distinguish between the kind of financial products that lie in the direct scope of central banks and those that lie outside of it. Private debt and equity, as well as most public-equity- and high-yielding credit markets remain out of the central banks’ scope. This prevents the link with economic reality from completely breaking down. In addition, the signalling function that normally comes from rate markets has been permanently affected and constrained, as central banks (implicitly or explicitly) control rate levels across the yield curve. Prior to the 2008/2009 bond markets, yield curves acted as early messengers when change in the economic cycle was upon us. Today we lack such signals. Flows and sentiment might impact risk premia. Such fickle indicators make the asset allocation process weaker, not stronger.
Most DM economies have passed peak infection rates in April or May. Governments have decided to accelerate the reopening in the hope that reproduction numbers remain below one, consequently avoiding a second wave of the virus. We call for patience and prudence. Current economic and expected economic conditions in 6 months have reached extreme divergences. Any deviation from the path of perfect economic recovery might inflict outsized market corrections across risk assets.
It took exactly one week to reach the targets we wrote about last week. The steepening of the US yield curve gathered momentum as a result of promising economic dataflow. US 2 year and 10 year rates rose by 5 basis points (bp) and 25bp, finishing at 21bp and 90bp respectively. The 30 year bond shot up by 25bp as well, closing at 1.67%. After the release of surprisingly positive Non-Farm Payroll numbers, 30 year bonds reached a high of 1.75%. The steepness in 2s30s reached 152bp during the session, but closed at 146bp. With US policy rates at the zero bound, continued QE, and a prolonged path towards Q4 2019 levels of economic output, we see limited potential for higher steepness levels.
As momentum in intra-EMU rate convergence gained strength, German 10 year rates normalised at -28bp (compared to -45bp a week ago). Spanish and Portuguese 10 year rates reached a status quo, finishing at 55bp and 53bp respectively. Italian 10 year BTP’s dropped another 7bp to 1.40%. The potential for continued rate convergence remains intact. We have closely monitored the 10 year Bund-OAT spread, which dropped just below 30bp. The market expects less scarcity premium across German bunds. Berlin decided to increase its fiscal spending by an additional EUR 130 billion, which translates to a EUR 30 billion increase in bund supply over 2020. In the medium term, the German yield curve will clearly get an EU competitor. As soon as the EU initiates the funding for its Recovery Fund, this sizable EU safe asset will partially absorb the money that used to go to bunds during flight-to-quality market episodes.
As mentioned in our intro, EUR IG corporate bonds surged ahead by 1.12% last week, and finished at -1.38% year-to-date. Since the ECB considered that funding conditions had tightened for financial and non-financial corporates these past months, it decided to add another EUR 600 billion to its existing EUR 750 billion pandemic emergency purchase programme. It also pushed through more favourable TLTRO III funding conditions for banks. Such a set-up should push for more intra-EMU rate tightening in government bonds, and spill over into cheapening funding conditions for banks and non-financial corporates. However, we reckon that front-running by the traditional IG investor-base has already realised that objective. Just last week, IG spreads collapsed below 1.4%. The long-term 1.25-to-1.75% fair value IG spread range is maintained on the back of low visibility surrounding the economic recovery. We have returned to a situation that allows high quality corporates to lock in below 25bp short-term, below 50bp mid-term, and below 100bp long-term borrowing costs. In the US, we observe similar credit spread levels to Europe’s. Increased risk taking leaves almost no one behind. The most significant spread-tightening occurred across lower quality tier-two and tier-three issuers. IG subordinated bonds posted a spectacular price appreciation.
The 3.02% gain in EUR HY last week reflected a drop below 500bp in HY credit spreads. Year-to-date, EUR HY recovered to -3.98%. If we manage to avoid worries of second wave scenarios, the EUR HY sector might tighten by another 1.0%, as investor go up the risk curve, and the fear of missing out remains in place. Moreover, the avalanche of new issues across the IG sector might have rendered IG more sensitive to stress than is the case for HY. At this stage, fallen angels have not led to congestion within the HY sector. Compared to previous cycles, flexible investment guidelines have not turned IG investor as much into forced sellers.
Emerging markets (EM) continued their good performance during this first week of June. Local Currency spreads (GBI-EM) tightened 5bp to 3.9%. Hard Currency IG traded at 2.5% (-45bp). Broad Hard Currency (EMBIG) tightened 45bp (to 5.0%), and Sub-Saharan Africa spreads in Hard Currency retraced 35bp to 7.6%.
EM currencies had an excellent week. The JP Morgan Emerging Markets Currency Index (EMCI) advanced another 2.7%, helped by a weaker USD. The dollar index spot dropped 1.5pt to 96.85. The star performer was the Brazilian Real, with a weekly gain of 5.1% in EUR terms. Chilean Peso (+4.0%), Indonesian Rupiah (+3.30%) and Colombian Peso (+3.0) were also amongst the best performing currencies last week. The Costa Rica Colon (-2.6%), Argentine Peso (-2.3%), Peruvian Sol (-2.0%), and Indian Rupee (-1.8%) were amongst the weakest currencies.
EM’s central bank action has pushed rates lower. We believe that for some of the low yielders (like the Czech Republic, Poland, Singapore, …) we have nearly reached a bottom for now. EM FX will take over the baton from here, driven by a lacklustre USD, more (surprisingly) positive economic data and improving commodity prices. Still, we refrain from getting too optimistic on high-yielding, low-quality names.
Three months have passed and most markets followed a near perfect circular movement. A movement that inflicted maximum pain and broad-based liquidation in a very short period of time. The unprecedented monetary response caused such a powerful recovery response across financial assets, that it has left many market participants behind in a bewildered state of disbelief. Nevertheless, this level of relief is important, as performances have recovered to moderately-negative, low-single digits.
We prepare ourselves for a second chapter in the 2020 COVID-19 saga. Will the summer of 2020 see a continuation of the positive momentum for risk assets, pulling performances back into positive territory, or is a pause appropriate? Common sense opts for the latter, as fiscal spending will require time to positively impact investment and consumption intensity. Still, we should also consider another wave of lockdowns. This can reopen the Pandora’s box that flipped open over March but was closed immediately thanks to our central bank friends.