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STATE OF AFFAIRS
As we approach the end of April, we can put an ‘exceptional recovery’ stamp on this month. The US experienced the most visible performance recovery. An effectively-scaled Fed response across supportive funding programs has backstopped the market slide across sectors. A bipartisan fiscal response of nearly USD 3 trillion (or 14% of USD GDP), set us up for a swift growth recovery path. The fragile backstop in EU markets is rather contrasting in comparison. This is reflected by our ‘risk-free’ EMU government bond index. The often-used JP Morgan EMU Government Bond index represents our EU safe assets and posts a negative YtD (Year to Date) return of -0.46%. The Bloomberg Barclays US Treasury Total Return Unhedged USD clocks a 9.21% YtD return. This difference, of about 10%, has had an enormous impact on returns of well-diversified balanced portfolios. I invite the reader to pause for a minute and carefully think about the consequences of this phenomenon. A US investor can rely on US Treasuries as a true safe asset, which dampens the impact of negative returns from his allocation to risk assets (i.e. mainly credit and equities). An EU investor lacks such a safe asset. Even worse, EU investors’ perception of the diversification merits of EMU government bonds is getting increasingly pessimistic. Institutional investors who select this index have to combine overvalued German bunds with volatile Italian government bonds. About 40% of the JPM EMU Government Bond index holds a BBB rating. The longer it takes for the European Monetary Union to create an EU safe asset (combined with ECB intervention to lessen rate fragmentation), the higher the probability that the EMU Government bond sector gets orphaned. Other bond sectors with higher visibility and more attractive risk/return dynamics might come to replace the asset class.
The EU Council approved the Eurogroup’s EUR 540 billion support package last Thursday. The Council wisely decided to let the European Commission work on the set-up of a Recovery Fund. A doubling of the EU budget, from approx. EUR 160 billion to EUR 320 billion, might enable the European Commission (or other EU funding institutions) to raise between EUR 1 trillion to EUR 1.5 trillion, if the additional EUR 160 billion gets levered seven or nine fold. Next stop is May 6. Thankfully, we have noticed less resistance from political leadership in the Netherlands and Germany.
The ECB is expected to increase its Pandemic Emergency Purchase Program (PEPP) next Thursday from EUR 750 billion to EUR 1 trillion. The ECB president will emphasize the flexibility of the programs, not only in terms of capital key, but also with regards to their duration and size. With EMU members’ funding requirements at around EUR 820 billion for the remainder of 2020, the ECB purchases will outpace government bond supply. Market participants have welcomed the inclusion of fallen angels into the ECB’s collateral framework, as long as the issuer had been Investment Grade (IG) before April 7. Below BB rated paper is out of scope for collateral purposes. Going forward, the Corporate Sector Purchase Program (CSPP) might be allowed to purchase fallen angels. Such decisions partially reduce the impact of the rating agencies’ assessments.
That brings us to the concept of crowded positioning. Crowded positioning occurs when investors flock to a rational investment idea, which is underpinned by qualitative or quantitative evidence. These can occur on a sector-, country- or company level. The presence of speculative money or sell-side market makers is a key requirement for such investment to turn sour. These investors actively search for stop loss triggers, inflicting maximum pain. Correct sizing and diversification are the only answers.
The WTI (West Texas Intermediate) May oil contract that expired last week is a case in point. Producers and refiners (physical market participants), as well as speculative participants reinforced each other, as they all tried to avoid a delivery in May, since no one had the necessary storage capacity. The contract reached a -USD 40 low. All eyes are on the June 2020 contract that closed at USD 17.02. One has to go as far as May 2024 to see oil at USD 40. Capacity is curtailed as shut-ins are happening across the globe. The number of US active oil rigs has dropped from 650 in January to around 375 today. Together with OPEC+ production cuts, which go into effect as of May 1, demand and supply might balance out faster than expected. Reduced froth and healthier oil markets might be the end result.
Crowded positioning in subordinated financials or corporate debt instruments is another example featured in “Worst performance rankings”. The moments of maximum pain are generally correct entry levels. We describe correct entry levels as valuations where carry and (high) volatility compensate each other.
We are cautiously constructive in that respect (carry per unit of volatility) on EUR High Yield (HY) and Emerging Markets (EM) Local Currency Government Debt. Still, we do not underestimate the continued selling pressure in both bond sectors by tourist investors (i.e. investors who bought into the asset class in search of attractive, upfront yield, and are currently trying to time their exit).
The US yield curve continued on its gentle bull-flattening path. 2 year notes went up by 2 basis points (bp), finishing at 22bp, whereas 10 year rates dropped 4bp to 60bp. Meanwhile, 30 year rates shed 9bp to 1.17%. The Fed announced a lowering of its daily purchases from USD 15 billion to USD 10 billion. The news passed without any curve impact. Inflation-linked bonds (i.e. US TIPS) staged a notable comeback with break-even rates (inflation expectations) rising by 10-15bp. This then pushed US real yields deeper into negative territory. Market participants have gotten comfortable with the implicit yield curve control. With the US Fed at the effective lower bound, all developed market (DM) central banks have reached 0% or negative policy rates. This turns on the appetite for duration. Quantitative easing programs (automatic duration absorption) and a global search for quality yield might dampen steepening pressures. We repeat our neutral duration stance on US bond markets.
German 10 year rates were flat this week and closed at -48bp. The rollercoaster on 10 year Italian rates surprised with another steep ascent to 2.15% followed by a steep return to near-start-of-the-week levels of 1.83% by Friday. Spanish and Portuguese government paper saw rates regress as supply was absorbed. The Spanish debt office issued a record breaking EUR 15 billion in the 10 year sector. Both markets recovered well by Friday. After market close, the S&P surprisingly held onto its BBB rating (negative outlook) for Italian Government debt. The external cause of the worsening debt ratios (i.e. the corona health-crisis) was their main reason for not downgrading the government debt. We expect a positive read-through on Monday morning. This might also stop Moody’s from downgrading Italian government debt on May 4, or Fitch from doing so on July 10.
Demand for high quality EUR IG corporate bonds is rampant. This week saw aggressive purchases across credit curves, including 15y to 30y maturities. The EUR Iboxx corporate index finished the week with a -3.62% return YtD. This represents a solid 50% recovery from the March 25 bottom of -7.28%. Index spreads roughly stuck to the 200bp mark, with an index yield of around 1.46%. Primary markets were thin. We expect higher new issuance from May onwards as the result season progresses. US IG credit saw reduced positive traction, as the impact of the primary and secondary FED corporate funding programs did not turn into front-running behaviour. We repeat that the ECB’s CSPP is significantly more potent, as it is direct and of high impact to longer-term funding conditions. Interestingly, Money Market funds that can invest in bonds seek to profit from attractive spread levels adding bonds expiring within 12 months. In general terms, we might expect continued high demand for (quality) EUR IG credit in the 2 year to 7 year sector, as investors still seek to lock-in yield levels between 0.5% and 1.50%. Again, it is pretty clear that all DM central banks have adopted zero or negative policy interest rates for the next 2 to 3 years at least.
EUR HY credit took a pause last week. Idiosyncratic risk was abundantly present. Hertz and Avis HY bonds reached new lows and sank towards deeper levels of distress. EUR HY index spreads increased towards 650bp, and yielded 6.00%. In the US, HY spreads rose to 760bp, with a 8.3% yield. As in previous defaults cycles, it will be ‘Missed interest payments’ that will drive restructuring and default events. HY companies might have enough near-term liquidity and reasonably scheduled debt maturities over the coming years. Yet, as company management faces an unsustainable, over-leveraged capital structure, it is pushed to restructure. The magnitude of the current cyclical shock will effectively force management into restructuring or, at worst, defaulting. Non-essential businesses in sectors like retail, autos/rentals (besides gaming), leisure and lodging might get hit heavily as social distancing becomes the norm.
Emerging bond markets further consolidated last week. Local Currency spreads (GBI-EM) tightened by 10bp, to 435bp. In hard currency, spreads were slightly higher. Hard Currency IG traded at 350bp (+5bp). Broad Hard Currency (EMBIG) widened by 25bp (to 640bp) and Sub-Saharan Africa spreads in Hard Currency widened by 50bp (to 950bp). Despite a weak EM currency environment, local currency is outperforming hard currency YTD in total returns.
EM currencies has had very mixed weekly performances.
Asian currencies performed well (Indonesian Rupiah (+2.0%), Thai Baht [+1.6%], Indian Rupee [+1.5%] in EUR terms), but Latin American currencies underperformed (Brazilian Real [-7.5%], Mexican Peso [-2.8%], Colombian Peso [-1.7%] in EUR terms).
Peruvian Sol was an exception in the region (+1.7%). Pensioners in Peru were allowed to withdraw money from their pension schemes. The liquidation of (mostly foreign) assets by the pension funds, was supportive for the Sol.
Bondholders did not welcome the restructuring offer made by Argentina. The blue chip swaps (i.e. the exchange rate at which foreigners can repatriate local currency holdings) are now at a discount of 85% compared to the official Peso exchange rate.
In Brazil, the popular Justice minister Sergio Moro has clashed with President Jair Bolsonaro over the president’s push to replace the head of Brazil’s federal police. This has caused an 80bp bond sell-off. High uncertainty is expected to keep Brazilian risk premia elevated.
In Sub Saharan Africa, investors mainly wonder how the countries will be able to combine both COVID-19 related spending and external debt payments.
The investment community has both confirmed and upgraded the status of the IG corporate bond sector. We expect more companies to find their way into European debt capital markets. EUR IG bonds boast an attractive expected-return profile and high resilience in periods of stress. EMU government bonds might become a second-best choice if EMU political leadership disappoints.
There is a lot of information out there for market participants. Ever-changing central bank reaction functions and complex scenario studies which try to pinpoint the size and the duration of the recovery path make for a difficult investment background. We are currently wading through a thick fog. Experienced portfolio management combined with robust risk management will pull us through.