The contours of a new model


By Peter De Coensel,
CIO Fixed Income at DPAM


    • The pandemic rages through Europe and the US. The increase in infections and casualties caused another wave of risk aversion by the end of last week.

    • US and EMU government bond markets profited most at the close of business on March 27, 2020. German 10 year bunds finished roughly -50 basis points (bp) . US 10 year notes finished at 67bp. Bond volatility remains elevated. We maintain our base-case scenario, which predicts that the pandemic will abate in Europe and the US in April/May. We also expect a tapering of core-rate volatility in April as market participants adjust to current central bank purchase programs.

    • Central bank programs are up and running. Their flexibility strengthens the adagio: ‘Don’t fight the central bank’. The active presence of almost unlimited central-bank purchasing power might have put a short-term floor under rates and investment grade (IG) credit spreads across the Eurozone and the US.

    • High yield (HY) unfortunately has not benefitted as much from these programs. Uncertainty and debate regarding the shape and strength of the upcoming default cycle have increased. We expect decompression between IG and HY credit spreads.

    • Interestingly, investors and central bank quantitative easing (QE) programs found their way to inflation-linked bonds. Indeed, rising inflation expectations staged a strong comeback in the US Treasury Inflation-Protect Securities market. Within the EMU linker market we observed a tentative rally. The US 5Y5Y inflation swap indicator closed the week at 2.00%. A textbook example of a V-shaped recovery, after hitting a low of 1.22% on March 12, 2020. The EU 5Y5Y inflation swap indicator ended the week at 0.96%. The jury is still out on whether EMU linkers can hold on to their modest gains after a low of 0.72%,which occurred at the start of the week. The ECB could benefit from a better monitoring of this indicator.

    • Assessing rates in developed markets (DM) versus emerging markets (EM), IG versus HY credit spreads, inflation expectations or currency attractiveness in an environment of persistent high volatility, is likely to lead to short-term disappointment. However, assessing longer-term portfolio construction robustness and the underlying quality of security selection should be the N°1 priority for (bond) investors. DPAM bond fund managers and credit analysts are confident that both characteristics are present.


    • In our first March 19, 2020 update, we pencilled in a broad 75bp to 150bp range for 10 year US rates. However, this week, we were hit with persistent, extreme volatility. US 10 year Treasuries dropped by an impressive 40bp between Friday, March 20 and Friday, March 27 closing at 67bp. Still, the positive yield curve slope reflects normalization of economic growth conditions in 4 to 6 quarters. Over 2020 market participants expect a net US Treasury issuance of USD 2.4 trillion. The FED balance sheet grew beyond USD 5 trillion this week. Short-term risk aversion and central bank intervention should balance out such an issuance avalanche. In the longer term, we expect 10 year nominal US rates to increase compared to US 10 year real rates. A rise in inflation expectations will be one of the unexpected longer-term outcomes of this health and economic crisis.

    • German 10 year closed near -50bp, rallying from -25bp a week before. The start of the ECB Pandemic Emergency Purchase Programme program did not miss its target as we observed aggressive rate rallies across EMU government bond markets. We stand by our base case scenario, which foresees continued intra-EMU rate convergence. The ECB decision to drop issuer- and issue limits marks a landslide change to its capacity to spread optimal funding conditions across Eurozone countries.

    • On the political side, a growing number of EMU heads of state are convinced of the necessity to mutualise EMU debt. In such times of human hardship, the unwillingness of Hansa and other heads of state to even discuss such options is nothing short of shameful. European Stability Mechanism funding has too much conditionality attached to it. No country can be blamed for a health crisis. Solidarity should not come with conditions. Still, we remain on the hopeful side. The day a qualified majority is reached that can enforce issuance of European (corona) Bonds, we expect a sizeable acceleration of EMU rate convergence. Our analysis shows that, once we remove flight to quality and ECB QE from 10-year German bunds, we arrive at a fair value range somewhere between positive 25bp to 50bp. One should expect that, within a fiscally backstopped EMU, a safe European Bond asset carries a higher risk premium.

    • EUR and US IG corporate bonds staged a promising recovery last week. We assess that ECB and FED credit support will prevent a credit crunch. Credit-line support through the European Stabilization Fund (up to 2% of GDP for member states) might be a final backstop. The confluence of improving liquidity conditions and strong primary issuance provided much needed confidence to market participants. Backed by ECB and FED support we ponder that IG markets will better clear. Nonetheless, the presence of open primary markets will exert spread-widening tensions as New Issue Premium concessions – between 40bp to 70bp – impact valuations in secondary markets. Such attractive offerings will attract ‘once a decade’ value investors. The reopening of primary markets has pushed EUR IG spreads into an appealing 240bp to 260bp bracket. As this primary channel is persistent, we adjust our EUR IG spread estimate to 225bp-275bp for the remainder of 2020. US IG corporate spreads finished the week at 300bp. We detect value in high-quality US corporate credit as the FED has been enabled to purchase up to USD 550 billion.

    • EUR HY recovered in an unsynchronized fashion. Quality HY credits tightened between 80bp-100bp. Index yields remain well above the 9.00% handle. Liquidity conditions are still poor. Experience and solid expertise in HY credit analysis and portfolio construction are key survival factors. HY market participants focus on estimates of an upcoming default cycle and its subsequent recovery. We can capture some value as spreads reward for a substantial, likely–frontloaded, default cycle. Selection capabilities will split the robust from the weak performers.

    • Last week, emerging bond markets stabilized. Local Currency spreads (GBI- EM) tightened 25bp (to 490bp). Hard Currency IG dropped 40bp (to 360bp). Broad hard Currency (Emerging Markets Bond Index Global) shrunk by 60bp (to 640bp) and Sub-Sahara Africa spreads in Hard Currency by 85bp (to 975bp).

    • The index yield within Local Currency Emerging markets sits at 5.50%. Despite the Emerging Markets Forex (FX) sell-off, which particularly hit commodities- and oil-exporting countries, central banks have been on the easing path. They pushed through aggressive rate cuts, ranging from 50bp to 150bp. In addition, they curtailed the incentive to protect the value of the currency , due to the lack of any immediate inflation threat. Going forward, it is a concern in an environment of squeezed USD funding and positive US real rates. Despite the FED’s bazooka, USD depreciation (which is usually good news for EM FX) is limited. Countries that rely heavily on USD-based capital flows face a dilemma. They have to choose between further easing of domestic conditions or retaining the needed foreign capital flows. Some EM Central Banks have even announced, or have already started, QE (e.g. South Africa, Romania). We remain defensive, and continue to favour countries that are strong enough to weather the storm: i.e. countries that have space for fiscal stimulus and are unlikely to be impacted by external vulnerabilities.


    • The 2020 market dislocation is about a month old. High uncertainty will ensure continued elevated levels of asset volatility.

    • We start to notice the contours of a new model. This model combines monetary and fiscal policy levers. We will study and learn how cooperation and interaction between both will impact expected returns across short, medium and long-term investment horizons. Most fiscal policy initiatives deliver basic Keynesian demand-side economic impulses. Others provide credit guarantees to the supply side. Monetary policy mainly acts as a backstop to global financial markets. Central banks want to prevent a credit crunch or a full-blown liquidity crisis.

    • This new model has the potential to push up inflation. Demand-pull inflation might become visible through the fiscal support for populations which are hit by the health crisis and are affected by highly dysfunctional supply chains. Cost-push inflation, which was present before 2020, will not disappear anytime soon. The upcoming unemployment shock will be severe, but should only last up to two years. Acquired fair pay results and persistent ambitions will continue to pressure overall salary costs and the broader cost of revenue. Companies will be faster to adopt new (read higher) pricing policies for goods and services. Companies with pricing power will flourish.

    • The geopolitical maze has increased the energy uncertainty and caused major supply chains disruptions. The resulting regionalisation will reinforce inflation drivers that were absent after the Great Financial Crisis of 2008.


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