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STATE OF AFFAIRS
Four months from today we hope to know who will become the 46th President of the US. According to several polling results (US PredictIt 2020, Real Clear Politics 2020…) Trump is lagging Biden by on average nine to ten points. That is a substantial gap. Markets, rightfully so, have been solely focused on the impact of the pandemic. A brief market shock was followed by a financial market recovery at the speed of light. The mega-cap technology and digital giants led the surge. However, we expect that the US elections jitters will start stirring markets around this time. Trump essentially represents the 80%/20% US economy. One of his main achievements has been the lowering of the average US corporate tax rate towards 21%. During the Trump presidency US companies were able to increase stock buybacks never witnessed during any other episode in history. One of the first policy reversals under a Biden presidency will be a rollback of such policy and turn the US economy (back) into a 70%/30% equilibrium. Biden declares to increase the corporate tax rate towards 28%. On top, he will penalize US corporates that keep profits abroad, exploiting international tax arbitrage structures. On this subject, the incumbent and Biden target the same mega-cap companies that saw their valuations surge over the first half (H1) of 2020. Markets are prepared and have incorporated a dismal earnings season kicking of this week. Question remains if they already discounted a Biden win? This important political uncertainty factor, next to enormous economic and social uncertainty, will keep markets in general, and US rates specifically, at bay over the next 4 months.
On a more technical note, we want to address the shape and levels of USD and EURO Overnight-Indexed-Swap (OIS) curves. These OIS curves price short term rates at current or lower levels over the next three years and at extremely depressed levels over 10 and 30 years. These OIS curves are essentially representing the market expectations for the FED and ECB overnight target lending rates and the term structure thereof. When calculating the term structure based of the overnight rate one arrives at a 3y USD rate at 0.00% and EUR rate at -53 basis points (bp). On the USD 10y OIS point we get 40bp and a 30y USD OIS rate of 65bp. On EUR 10y OIS we achieve -32bp for EUR 30y OIS at -10bp. These curves matter a lot for pricing derivatives instruments across the globe. The curve shape and level of these rates exhibit and predict enormous stability at low levels over the next decade. We entered a new era that will see monetary and fiscal policies that are dominant whilst highly interconnected.
Currently I’m reading “The Day the Bubble Burst: A Social History of the Wall Street Crash of 1929” by Gordon Thomas and Max Morgan-Witts. I was drawn by the many similarities between today and back then. Political manoeuvring using financial markets as an instrument to increase popularity. Stock market participation as a channel to reduce inequality! Early last week, Chinese government controlled newspapers continued to entice people into stock market investing. This resulted in a 14% increase of the Shanghai Shenzhen CSI 300 index since July 1. Trump masters the art when reflecting on economic data, the surging stock indices or the negative rates that Europe is profiting from. His administration puts pressure on monetary and fiscal policy whilst linking buoyant markets with a better future for all. By the end of July a fifth fiscal spending program (estimated to increase the accelerating budget deficit by another USD 1 trillion) should increase US consumption, US equity markets and bolster his chances for re-election. As a result swaths of new retail investors, young and old, have discovered the thrills of investing or better day trading. The press and the masses love this, as was the case 91 years ago. For completeness, the big difference now versus then is monetary policy. A divided FED Board wanted to stifle speculative behaviour during 1929. It refrained to provide bank funding when that money led to margin based investing. Today, the Fed has adopted a zero interest rate policy and engages in massive asset purchases across the risk spectrum. So, if there is a bubble, it might take years to burst as the guardian of financial stability has joined the party.
Minor bear steepening reversed into a minor bull flattening over the past week. The key word in the previous sentence is minor! Across rates, the 2 year note closed unchanged at 15bp whereas 10 year rates dropped 3bp and 30 year rates dropped 8bp towards 0.64% and 1.35% respectively. The 2y30y curve steepness sits comfortable around 120bp or about 5bp away from its long term 115bp average. Across the US TIPS curve real rates consolidated in, by now, accepted negative territory. The latest surge in gold over the week was sort of a catch up move. Investors should be aware that gold and real rates are highly negatively correlated. So if the positive gold trend remains intact it should go alongside US real rates becoming more negative.
Over the past week the strength in 10 year German Bunds was always present. German 10 year rates closed at -47.3bp. Any risk-off event is enough to push this benchmark rate through the -50bp resistance. Clearly, the long term funding operation (TLTROIII) offered on a plate by the ECB to the EU banking system at a -1.00% level might have changed the goalpost. The 10 year bund might effectively start to seek a lower equilibrium range of about -50bp to -75bp versus the existing -25bp to -50bp range. That should also help to decrease funding costs across EMU member states. With 10 year Spain and Portugal closing just above 40bp it might push their funding costs towards 25bp. Italy, closing 10 year BTP’s at 1.22% might zero in on 1.00% or towards the 0.92% lows of early 2020. The EU Recovery Fund negotiations are evolving towards a positive finish over the summer and could become a catalyst for this European Government Bond market adjustment.
EUR corporate IG markets recovered beyond -1.00%, finishing at -0.87% YtD. A weekly 27bp of total return was generated mainly from flattening credit curves of quality companies. As the ‘low for longer’ consensus in rates strengthens, institutional investors want to capture the attractive valuation of quality corporate bonds with maturities between 15 and 30 years.
In EUR HY we will need to wait for September in order to get a better dynamic in primary issuance. End of June LTM (Last Twelve Months) defaults reached a very modest 2.3%. Risk aversion is preventing investors from entering the sector. The ECB might give a signal on Thursday, July 16. In the US the HY market is in better shape as the FED support is present. Even as LTM default rate rose towards 6.3% over June, US HY saw the the highest one month issuance ever at USD 55.6 billion. Inflows remain robust towards US HY.
Emerging markets posted a small positive return this week. Local Currency spreads (GBI-EM) widened 2bp to 392bp. Hard Currency Investment Grade traded at 236bp (-4bp). Broad Hard Currency (EMBIG) tightened 4bp to 477bp. Sub-Saharan Africa spreads in Hard Currency traded unchanged at 721bp.
Emerging market currencies gained on average around 0.3%. Most positive performers were Chilean Peso +1.5% in EUR terms, driven by the V-shaped recovery in copper prices, South African Rand (+0.6%) and Peruvian Sol (+0.4%). Uruguayan Peso (UYU) was the biggest loser (-3.9% in EUR terms). The BCU, one of the few central banks that did not cut rates this year, announced it will accept the weekly BCU bills to be paid with USD, meaning that they actually seek to receive USD rather than UYU. This made investors angry, as the announcement came just after the issuance of local currency bonds.
Emerging markets issuance continues at a record pace with the highest ever quarterly issuance of USD 231 billion in the second quarter of 2020. El Salvador (rated B3 positive outlook at Moody’s and B- stable outlook at S&P) successfully issued USD 1 billion 2052 bonds at a yield of 9.50%, the first issuance of bonds in the region with a rating below BB. We see limited value for this (rather long) point of the curve. Costa Rica is preferred. The country has a better rating (rated B2 at Moody’s and B at S&P), is better in the ESG ranking and will join the OECD as the 38th member.
South Africa witnessed a turbulent week. SAGB yields continued the widening trend initiated after the latest budget release. The move was reinforced by figures showing a decreasing pace of bond purchases by the SARB as well as a disappointing demand from investors at the first weekly auction with increased supply (ZAR 6.6 billion versus 6.1 before). In the low beta CEE space, Romania was in focus with a new USD 10 and 30 year benchmark.
After our call for realism, we want to make a call for patience this week. In bond investing patience will become a key ingredient as capital appreciation will diminish and income accruals will flatten. The steep drop in yields witnessed over H1 2020 has enabled fixed income investors to recover well from the March disruption. Looking beyond 2020, extracting value from fixed income markets will require high international exposure and a truly global approach to portfolio construction.
The purpose of our brief reflection back to 1929 was not meant to create bubble fear, on the contrary. It is an invitation to read an interesting book. A book that discloses the complexities in society the moment the combined impact of public, private, monetary and fiscal policies lead to unwanted outcomes. Even if each of them, taking separately, wants to achieve an optimal, rationally defendable, result.