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STATE OF AFFAIRS
Last Wednesday, the FED initiated a new policy path based on enforced forward guidance. Essentially, the FED President Jerome Powell told the public that policy rates would remain at the zero lower bound through 2023. Over that horizon, inflation would remain below target till 2022, and reach target by 2023. Also, by then, unemployment would drop towards 4% from today’s level of 8.4%. That is their base case scenario. Market participants still attach a high probability to this scenario when gauging our preferred inflation indicator i.e. the 5Y5Y forward inflation swap rates that closed the week wrapped around 2.10%.
As the main Treasury and MBS purchase programs absorb USD 120 billion each month we should not fear aggressive sell-offs in bonds. Bond markets have dubbed this ‘implicit yield curve control’. The 10 year nominal Treasury rates have been locked in a tight range since March. Short term, we observe not many events that would take 10 year Treasury rates out of the broader 0.50% to 1.00% range. Q3 earnings and the US presidential elections might cause a test on either side, but with zero interest rate policy in place till early 2024, the probability of an upside break-out is smaller than the probability for a test of the 50 basis points (bp) level. All this means that, as long as 10 year inflation expectations remain around current levels of 1.70% or higher, 10 year real rates would remain in deep negative territory. Currently, 10 year real rates fluctuate around -1.00%. We observe similar levels in Europe. The current market state exhibits high stability and predictability. The system is able to clear given persistent negative real rates accepted by market participants, as they attach a high probability of success in the ability of central banks to lift inflation towards 2.00% or higher over time. So what could go wrong? It is at this point that we construct risk scenarios. The next paragraph reflects on potential bad outcomes.
The bad outcome or risk scenario develops around the inability of developed economies to reach their inflation targets. In order to achieve healthy inflation, the presence of real economic growth is an essential precondition. Economic growth is defined in real terms and at the point of full employment. Respecting economic theory is important here. Economic growth is different from expansions (positive output gap) and contractions (negative output gap). Expansions and contractions fluctuate around the full employment economic growth path. True economic growth at the full employment point is achieved as one of the following factors improves or grows: technology, labour (human capital) and the capital stock. These factors represent the production function. Improving productivity and pushing out the production possibility curve are two results, as economic growth is established through time. Currently we are in a deep global contraction. That explains the reflationary policies by central banks and governments that try to close the negative output gap as soon as possible. It also explains why the ECB and the FED hope to achieve results three years out, at best. Currently we live in a 90% economy so to speak. We first need to catch up. So, if they succeed in closing the output gap, the real challenges start… Technological innovations, a better educated labour force, sound demographics or growing the capital stock might lift economic growth. If technology (Total Factor Productivity) is not able to achieve higher productivity levels, education quality does not improve and is not distributed more evenly or capital stock investments are postponed, we will see economic growth coming to a standstill…That might translate into persistent disinflation/deflation during the decade in front of us. Such a path would put upward pressure on real rates as inflation expectations drop. Following the Fisher equation, real economic growth equals real, risk-free long term rates + inflation expectations. We want to repeat this message. When one expects that real economic growth as per above understanding will continue to lose momentum (flat line or drop), real rates might start to rise as inflation expectations falter. Over the past 70 years, real growth rates have been on a sliding path, reaching about 1.00% year over year (YoY) today. In a disinflation/deflation-like ecosystem corporate bonds might lose their goldilocks status as market participants demand a higher credit risk premium. Overleveraged companies would crumble under the expanding weight of their debt burden. The risk scenario, based on lack or falling economic growth, would call for exposure to high quality nominal government bonds. Essentially 10 year US Treasury rates would follow the path taken by other G10 countries: the path towards 0%. Theories around the diminishing impact of technological advancements, demographic YoY growth rates that are barely positive, or the burden of stranded capital stock give credibility to the above scenario. It would also turn equity markets fragile. Gold bears would resurface. Preceding such events would be financial markets that become tranquil and languor. Extreme indebtedness will have mortgaged revenues of the next generation leaving economic growth grounded. To be fair, this risk scenario is the base case scenario of reputed investors.
The US Treasury yield curve bear steepened marginally over the past week. Upside pressure on nominal rates might build if the cooperation between monetary and fiscal policy becomes too intense. Without calling it ‘debt monetization’, the market will characterise the FED less as the lender of last resort, but more as the spender of last resort. Short-term economic stimulation through increased government spending is clearly the domain of fiscal policy. However, current FED credit easing purchase programs (direct and through ETFs) have an equity backing (first loss absorption) given by the US Treasury department. Such constellations are blurring the lines between the monetary and fiscal function. The moment FED liabilities become legal tender, breaking the Federal Reserve Act, inflation will accelerate quickly. Essentially, for proponents of Modern Monetary Theory, this is the path to follow. So be careful what you wish for. In the meantime, 10 year US rates closed at 69bp, up 2bp on the week, whereas 30 year rates inched up 4bp towards 1.45%. Expect buyers to surface as 10s go beyond 75bp or 30 year rates pass 1.50%.
We could copy paste the section on EMU government bonds posted last week. No changes in EMU rate land. However EONIA 1Y1Y forwards closed at -0.575% versus -0.56% last week. Expect ECB policy rate adjustment chatter to become more vocal over the next couple of months.
Same holds for the European investment grade (IG) corporate bond market. Interestingly, major, London -based investment banks start to adjust their end of 2020 spread targets to the downside. With EUR IG spreads closing at 1.13% the goalposts end of 2020 are heading towards 1.00%. The main argument zooms in on demand supply technical. With an insatiable ECB purchase hunger as far as the eye, such predictions are easy to construct. However, these arguments have little to do with credit valuations. I advise investors to remain focused on the four C’s. What is the Capacity of corporates to roll-over balance sheets through sound revenue growth and profitability? Are the Collateral assets valuable and marketable whenever asset disposals are required? Does management respect Covenants and provide investors with peace of mind that debt metrics will be honoured. What is the Character of the firm? Sector, size, liquidity and reputation are key aspects that need attention in order to invest in credit with conviction.
European high yield (HY) markets continue to recover in baby steps finishing the week at -1.36% for the year. As we tread towards the last quarter, it becomes clear that default rates for 2020 might print below 3.00%! Government guarantees and ECB credit easing has wiped out the notion of creative destruction. Joseph Schumpeter would be in shock and awe. How can economic innovation flourish when central banks and governments keep all companies afloat? Moral hazard and lack of innovation go hand in hand today. However creative destruction is an essential ingredient that allows for true economic growth to foster as explained in the second State of Affairs paragraph.
Emerging Market (EM) government debt denominated in local currencies performed in line with developed markets. The spread of the GBI-EM index was flat to global government benchmarks at 3.80%. External debt spreads (EMBI GD index) widened during the week by 10bps (4.24%), led by the HY segment. The spread of Sub Saharan Africa in hard currencies widened by 8bps (6.85%) when the spread of IG bonds widened by 2bps only (to 2.18%).
Flows into the asset class were still in positive territory even if they slowed substantially (USD 400 million versus USD 1.9 billion in the previous week), with hard currency funds attracting the most inflows. Overall supply in sovereign debt denominated in hard currencies stood at USD 7.7 billion, with notably Mexico, Bulgaria and the Dominican Republic tapping the market. The deals attracted investors’ interest and were easily absorbed.
EMFX posted a strong performance with +0.96% versus the Euro. The best performer was the South African Rand (+4.38%), as the central bank (SARB) kept its policy rate unchanged despite forecasting a deeper 2020 GDP contraction. South Korean Won (+2.28%) and Mexican Peso (+2.05%) performed strongly as well. Meanwhile, the Georgian Lari depreciated (-3.52%) versus the Euro, next to weakening Turkish Lira (-1.43%) and Hungarian Forint (-1.16%). The week was packed with central bank meetings across Taiwan, Indonesia, South Africa, Brazil and Russia. We emphasize that they all left their policy rate unchanged, signalling that their policy rate cutting cycle comes to an end. Most of them now adopt a wait and see stance to assess the actual impact of their accommodative policies while economies are reopening. For local rates, it means that duration gains will be less supported by yield curve front ends. This can be positive for EM currencies, however, because they benefit from relatively high carry compared to developed markets, while inflation expectations remain benign and current account deficits are shrinking due to lower imports. More generally, the economic recovery combined with a weaker USD should be supportive for a cyclical asset like EMFX.
When building robust portfolios, one should make room for the risk scenario we described above. The allocation to nominal government bonds of sustainable economies should be visible. Investors should look beyond the fact that such investment solutions carry, literally, a low yield. The diversification and capital preservation function of such a portfolio pocket will smoothen your volatility profile.
Economic theory deserves more respect. Distinctions matter. Economic growth versus expansions or contractions, the production function, the production possibility curve, the marginal diminishing returns of labour and capital factors, the role of technology…all these notions require solid understanding. Linking these correctly with the spectacle surrounding financial markets operated by speculative, retail and institutional investors is paramount.