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STATE OF AFFAIRS
Last Thursday’s US Non-Farm Payroll (NFP) numbers showed an increase of 4.8 million jobs over the month of June. Consensus estimates for NFP stood at 3.23 million. This is yet another nice economic surprise in the list of positive economic data. Market participants (and the US Administration) approved of the NFP results, and US risk assets closed a shortened week on a strong note. At the same time, initial unemployment benefits grew by 1.43 million and continued claims printed just below 20 million. The tracking of real economic data is important to assess the strength of a recovery (or the lack thereof). However, we must look at it from the correct angle in order to accurately interpret the economic data. We set aside the month-to-month increase in NPF and instead looked at ‘total payroll numbers’. From its previous peak of 152 million in late February, and its bottom of 130 million in late April, total payroll numbers have now recovered to 138 million. The chart reveals that last Thursday’s NFP numbers should be taken with a grain of salt. If we add in the 20 million continued claims, it becomes clear that the economic recovery will take a lot more time than markets currently expect.
One should also be careful when one tries to read or predict recovery shapes in the Purchasing Manager Index (PMI). This is a month-on-month diffusion index. The PMI diffusion index is defined as follows: “[…] a statistical measure often used to detect economic turning points. It aggregates multiple indicators by examining whether they are trending upward or downward, but ignores the magnitude of the movement. The Purchasing Managers Index (PMI) is calculated by adding all the replies that indicate ‘better’ to those that answer ‘same’. This figure is then changed to a percentage. Thus, a PMI of 50 is equal to no change.” Over the past weeks the released PMI numbers show considerable strength and recovered towards a comforting 45 to 52 range (depending on country or region). However, it is important to bear in mind that there is a possibility for human bias. One wonders whether, after being in lockdown for nearly three months, purchase managers just wanted to leave positive and optimistic answers on the surveys. Additionally, as PMI numbers ignore the magnitude of the trend, it puts the actual relevance of these aggregate results into question. Beneath the surface we see less optimism. Employment prospects have not recovered. On top of all that, we have noticed the presence of cost-push inflation pressure, as the ‘prices-paid’ component has bounced far over 50. Handle PMI figures with care!
The state of affairs in the asset volatility field is remarkable. We observe a clear dichotomy in markets. In rates and investment grade (IG) credit markets, central banks have been very effective in dampening volatility. Realised and expected rate as well as IG spread volatility has collapsed towards historically low levels. As quantitative easing (QE) has gone global, the so-called ‘market breadth’ of this low volatility condition is strong. On the other side of the spectrum we note that high yield (HY) spread volatility and equity volatility remain above ‘normal’. The dispersion between IG and HY lingers in the background on the back of accelerating default expectations. Over the first half of 2020, defaults have been rather rare, and the HY markets might brace for a tougher market environment ahead. Interestingly, the increasing number of fallen angels has become a positive for HY investors. They can now diversify portfolios towards companies or capital tranches which previously had an IG label in pre-COVID-19 times. This might become a volatility dampener. In equity, the VIX index closed at 27.7 on Thursday. Such high numbers still reveal potential for 1%+ daily movements in the S&P500 index. In this case, the ‘market breadth’ is also not promising, as most of the heavy lifting has occurred across tech and digital sectors. Before the pandemic, the VIX ranged between 10 and 25. In order to see HY spreads drop another 100 basis points (bp), the VIX should settle below 20. The jury is still out on this one.
The US Treasury yield curve slightly bear-steepened last week. Firm interest at the short end kept 2 year notes at 15bp, compared to 16bp at the end of June. 10-year notes backed up 3bp and ended at 67bp, whereas 30 year rates climbed 6bp and closed at 1.43%. Yet again, most of the interesting action occurred in US TIPS. The real US Treasury curve bull-steepened rather aggressively. The July 2025 real bond closed below -1.00%, down 11bp over the week. The 10 year real rate closed at -75bp, easing 5bp. The 30 year real rate stayed more or less unchanged and closed at -19bp. Inflation expectations continued their uptrend. 5 year, 10 year and 30 year break-evens closed at 1.23%, 1.39% and 1.60% respectively. We repeat that we classify this movement as ‘normalisation’. As stated previously, we only expect acceleration in 2021-2023.
Within European Government bonds (EGB), Portugal gripped the attention with a highly successful 15 year bond auction with demand of over EUR 40 billion. A total of EUR 4 billion new 0.90% October 2035 PGB came to market at a yield of 92.8bp (priced at 99.602%). It rallied nicely and closed at 101.50%. Italy and Spain saw continued interest across their curves. Italian 10 year rates settled at 1.25%, down 4bp. Meanwhile, Spanish and Portuguese 10 year rates landed just below 45bp. We repeat that demand/supply will be supportive over the summer months. The ECB purchase programs are on cruising speed and have left the market with net negative supply conditions. Like the FED in the US, the ECB controls long rates, and markets have succumbed to such dominance.
An ECB study which analyses the positive channel effects of the combined QE efforts (which are currently at a monthly clip of approximately EUR 120 billion), recalibrated how low the deposit rate would have to drop in order to induce similar effects on inflation, credit provisioning and overall economic support. The result is stunning. The deposit rate, which currently stands at -50bp, would have to drop towards a range of -1.00% to -1.50%. Indeed, the study calculated that a deposit rate of -1.50% would generate similar effects to those of an asset purchase program of approximately EUR 1.45 trillion. For now, the ECB has clearly opted for the QE path. Still, one cannot exclude that -in order to achieve its mandated inflation objective- the ECB might return to the interest rate instrument in 2021 if the effects of asset purchases remain unsatisfactory. Bear in mind that the German Constitutional Court has previously given a thumbs down to the asset purchase instrument.
EUR corporate IG markets added another solid week to their track-record of steady recovery. The universe gained 6bp over the week and closed at -1.10% YtD. European HY performance had a strong week too, climbing 36bp and finishing at -4.64% YtD. Since we will soon enter earnings season, secondary market liquidity in credit will dissipate and primary issuance will phase out. Exogenous market shocks can quickly push credit spreads higher. Interest in protective hedging through September options across IG and HY credit default swap indices was markedly higher last week.
Emerging markets started the second half the year on a positive note. Local Currency spreads (GBI-EM) tightened 6bp to 3.90%. Hard Currency Investment Grade traded at 2.40%, easing 8bp. Broad Hard Currency (EMBIG) tightened 12bp to 4.81%. Sub-Saharan Africa spreads in Hard Currency also tightened 11bp to 7.21%.
Emerging market currencies remained broadly unchanged. The strongest performers were the Chilean Peso (+1.5% in EUR terms), the Colombian Peso (+1.5%), the South African Rand (+1.3%) and the Mexican Peso (+1.3%). Indonesia announced that it would fund the equivalent of around 40 billion USD of government spending via the central bank. This had a negative impact on the Indonesia Rupee and made it this week’s worst performer (-2.50% in EUR terms). Both the Russian Rouble (-1.8%), troubled by the ‘Russia bounty story’ and the referendum, as well as the Ukrainian Hryvnia (-1.5%), troubled by the departure of Yakiv Smoli as governor of the National Bank, posted negative returns.
The first half of 2020 will go down as the GPC or ‘Great Pandemic Crisis’. On average, Local Currency markets went from a YtD return of roughly +3% in mid-February to around -17% in mid-March. In the end, they ended the first half of the year between -5% and -6%. Rates (including carry) were positive (around 4.50%) but FX return was highly negative (-10.25%). Our well-diversified, high-quality, sustainable portfolio has outperformed peers and has posted the best risk-adjusted return.
Future developments will be very difficult to predict, as they will be strongly dependent on how fast the world can find a cure. For now, we return to our neutral stance in EM (from cautiously optimistic), as markets have already generously priced in the rebound.
A call for realism in recovery expectations is overdue. Markets, on the back of the global monetary and fiscal policy response, have been highly optimistic in their interpretations of month-over-month improvements of leading, lagging and coincident economic indicators. In the meantime, the pandemic is still raging across EM countries. Unlike Europe, the US still has yet to reach a peak, even if its lockdowns started around the same time in March. In Europe we have observed local outbreaks in Germany and the Spanish Catalan region.
The much-hoped-for V-shaped recovery will most probably not materialise. A square root formation is in the offing. The initial bounce still leaves us miles away from late-2019 levels. It will eventually morph into a slow-growth function, as it awaits a genuine solution to the global health crisis. As soon as we have developed and spread a vaccine, growth can re-join the previous growth function, and even move beyond it. Expect the global policy response to be sustained across all of the above episodes.