FI_Emerging opportunities

CIO’S VIEW

Emerging opportunities

By Peter De Coensel,
CIO Fixed Income at DPAM

STATE OF AFFAIRS

- The Biden-Harris victory over the weekend will be more than cheered on by financial markets. Gone will be the days that market participants got disturbed and confused by the level of insane propositions, viewpoints or decisions that the 45th president of the US inflicted on the world. These reached us through an incessant flow of tweets that definitely impacted markets. Most of the time, these impacts were short term and fading. However, the scarring through rising geopolitical tensions and reduced global economic prosperity was especially filtering through across emerging markets (EM). Today’s message concerns the opportunities that lie ahead in emerging bond markets. As democracy prevailed in the US, the US institutional fabric can heal, and multilateral cooperation can stage a comeback. These are essential ingredients for markets that were increasingly left on their own, as the US pulled the card of predatory unilateralism.

- The fight against the pandemic has led EM policy makers to adopt a similar policy response as their developed market (DM) counterparts. Central banks of emerging markets have, on aggregate, reduced policy rates by about 5000 basis points (bp). Unprecedented. The impact on currency valuations has been severe. Taking the JP Morgan Emerging Market Currency Index as our guide, we observed a 12.5% depreciation across EM currencies since start of the year. But, over last week, EM currency (FX) recovered by more than 2.5%! Yes, the two main EM Local Currency bond indices, JP Morgan GBI – EM Global Diversified and Bloomberg Barclays EM Local Currency Gov 10% Country Capped, stood out last week, as they recovered 1.73% and 0.95% respectively. The stars across bond sectors. Still, year-to-date the damage is important; at -7.77% for the JPM EM index and -5.39% for the Bloomberg Barclays EM index expressed in Euro. However, their repair time might be shorter than expected by the public at large. With a running yield of around 4.35% they possess and offer long term value for yield depraved bond investors in DM rate and credit markets. Effectively, the year-to-date performances in EM local currency government bond markets put them right at the bottom across bond sectors. The main culprit comes from the EMFX depreciation. The JP Morgan EM Currency index closed the week at 55.66, bouncing off a double bottom end of September and the day before the US election. Pay attention. The Biden win might be a buy signal.

- The ink of last week’s message, warning investors that market volatility would, on balance, remain high due to the presence of global quantitative easing (QE), wasn’t even dry, or the Biden victory consensus crushed implied market volatility across the bond and equity asset class. I expect that market participants might take this moment as an opportunity to buy-the-dip in volatility. Indeed, the three months ahead are littered with obstacles, ranging from an accelerating pandemic, semi-lockdowns across the EU, hesitating DM central banks (again) and dwindling expectations on 2021 fiscal support packages. On the latter, the President elect will most probably face a divided Congress. A Republican Senate majority will seek a moderate tax stimulus plan. The heavy lifting will need to be done by the FED, even if they only control the lending channel and not the spending channel.

- During team discussions, the synchronised response by the UK Government on fiscal initiatives, alongside the Bank of England’s aggressive increase in asset purchases, was flagged as an intelligent, pro-active move. Not all things from across the channel should be downplayed as irresponsible. With the Brexit negotiations cruising towards a Free Trade Agreement ‘light’ with the EU, one can expect repositioning flows towards UK Gilts, UK credit and a supportive Sterling backdrop.

VALUATIONS

- Intraday, on November 3, the US 10 year note eclipsed the 90bp hurdle pushing towards a high of 94bp. At the end of a momentous week in US politics the 10-year US rate settled at 0.82%. The FED’s message on Thursday was clear. Expect a change in size, composition and yield curve targets with respect to the FED’s QE policy during the final December 15th meeting of 2020. The current USD 120 billion a month, or USD 1.44 trillion a year, large scale asset purchase program is not well aligned with the increased government funding needs over this and next quarters. From a net positive Treasury supply over Q2 and Q3 of about USD 75 billion/month, we look at a net positive Treasury supply of USD 150 billion/month till the end of the year and over Q1 2021. The FED will respond to this imbalance in order to contain any undue upward rate pressure. The current USD 80 billion/USD 40 billion split across Treasuries and MBS (Mortgage Backed Securities) might need adjustment in favour of Treasuries next to an overdue operation twist supporting the long end of the yield curve. Such decisions should take out some steam and pressure of the Treasury cooker that pushed the steepening to uncomfortable levels.

- Italian government bonds were shining within the EMU market. 10-year Italian BTP’s dropped a lofty 13bp towards 62bp, and a spread of 1.25% to Germany. A couple of months ago, we flagged that, on the 5-year point, the BTP-Bund spread would break the 1.00% level. Well, it happened last week, closing at 88bp. Once the Next Generation EU (NGEU) funding program gets underway over 2021, we should observe some extra rotation pressure out of Bunds into European Union paper. This element, at the margin, will help push EMU rate convergence closer to levels that were present before the Great Financial Crisis of 2008. The factory glitch of the EMU construct has been mended on July 21, as the EC president Ursula Von der Leyen broke the news on the EUR 750 billion NGEU.

- Another record-breaking week for European investment grade (IG) corporate bonds, as the Iboxx index printed a new historic high. Adding 39bp in performance over the week, the index is closing in on the 2% marker for the year, finishing at +1.92%. The upward pressure on credit spreads the week before the US election melted like snow under the sun. The Itraxx Main CDS (125 IG names) index closed at a spread of 52bp, down an eye-popping 13bp. Participants keep on dancing as long as the music plays.

- European high yield (HY)… a serious bump in the road was followed by an even more impressive risk-on rally. Performance jumped forward aggressively as HY spreads tanked. The Itraxx Crossover index (75 speculative grade names) dropped a massive 53bp falling from 3.68% to close at a spread of 3.15%. The European high yield index added 1.60% over the week to finish at -76bp since the start of the year. Such strong momentum is scaring contrarian investors this close to year-end. We guess the path of least resistance lies open for an asset class that is looking with eagerness to the December 10 ECB meeting. Would they dare to include part of the high yield sector (BB’s) into their corporate asset purchase program? The jury is out. Christmas might come early.

- As mentioned, EM enjoyed a strong rally this week. Taking the GBI-EM and EMBI GD as references, spreads of local debt tightened by 10bp (to 3.75%) while spreads of debt denominated in USD tightened by 31bp (to 4.25%). We saw a spread compression in the EMBI GD with debt from Sub-Saharan Africa tightening by 53bp, while IG credit tightened by only 17bp.

- EMFX posted a strong performance versus the USD, with a surge of +2.53% for the EMCI index. The EUR/USD rallied as well during the week, so EMFX returns in Euro terms are only up 22bp. The best performing currencies versus the Euro were the Brazilian Real (+2.33%), the Czech Krona (+2.19%) and Hungarian Forint (+1.96%). The worst performer was the Georgian Lari (-5.85%). The Turkish Lira again had a tough week, losing -2.51% versus the Euro.

- Effectively, markets flipped scenarios. EM markets rallied on a Biden Presidency with a Republican Senate. Prior to the elections this scenario was polled as the worst outcome for risk assets… Under a Biden presidency, US foreign policy would become more predictable and more inclined to multilateralism, with China and Mexico being the likely winners of this improvement. As trade tensions commanded an elevated risk premium in EM assets over the last few years, less policy uncertainty will probably support EM asset valuations. At the same time, hopes for a strong fiscal stimulus with a Republican Senate are fading, which probably means a weaker US contribution to global growth. It seems that forces driving the USD lower will also be less strong than anticipated, but lower fiscal spending provides more comfort to low rate expectations in developed markets. As said, EM local debt is in a sweet spot, with low yielders less at risk of core rates steepening, while the search for carry behaviour will benefit high yielders.

- Support for the ruling Law and Justice party in Poland is falling, after a contested amendment that would ban abortion in the country sparked the biggest street demonstrations in decades. On top, the Polish central bank took the decision to postpone its meeting due to concerns that additional lockdown measures may be needed, which means that policy makers might be preparing more stimulus.

- In Peru, President Martin Vizcarra faces a second impeachment vote in Congress on November 9. However, it is likely he will remain in power due to limited support amongst largest parties for removing him, and the president’s high approval rating. In this context, Peruvian government bonds were amongst the best performers in the local universe, only beaten by the massive collapse in South African bond yields over the week.

CONCLUSION

The US election dust will settle over the next couple of weeks. In the bond space, EM government bonds and EM IG credit should be among the winners for long term investors.

The required cooperation between the US administration under Biden and the FED will also find more common ground upon which to build joint policy. This perspective carries high value and should lower the fear of bond investors that the fiscal outlays under Biden would initiate a bear market in Treasuries. On the contrary, expect the newly appointed US Secretary of the Treasury and the FED to build a relationship along the examples set by the Bank of England and the Bank of Japan with their respective governments. Assessing differentials between 10-year US rates with 10-year Gilts and JGB’s push me into the mildly bullish camp among US Treasury investors.

I end the weekend with a smile of contentment. World politics can start to heal alongside the healing from the pandemic. When and how we will combat the pandemic might become the main theme of 2021.

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Emerging opportunities