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STATE OF AFFAIRS
Thursday’s sudden risk-off moment acted as a wake-up call for investors around the globe. It was a kind reminder that the global monetary backstop supports risk assets, but does not insulate them from corrective episodes. Jay Powell’s press conference last week had an undertone of uncertainty, which served as a cloaked warning against speculative behaviour. Looking back, front-running and/or ‘buying-the-dip’ has had a pristine track record. In this regard, we do not limit ourselves to the post-global-financial-crisis (GFC)’ 11 year old timeframe. Indeed, we can easily include the 10 years preceding the GFC. During the Alan Greenspan FED presidency, they bailed out the LTCM hedge fund’s speculative misconduct and responded to the speculative internet bubble in 2000/2001 by lowering interest rate policy to 1.00%. The main difference between the pre-and post-GFC era lies in the adoption of direct intervention through asset purchase programs by central banks as part of their standard policy mix. Next, we might see explicit yield curve control (YCC) . On March 19, the Reserve Bank of Australia (RBA) cut policy rates to a new low of 25 basis points (bp). In addition, they decided to steer and hold the benchmark three-year government bond rate around 25bp. The explicitness of their decision led to surprising results. The RBA had not conducted any asset purchase since the start of May! The 3 year Australian government bond closed the week at 24.2bp. On Friday, the Australian 2y30y rate differential at 1.48% fluctuated between 1.35% and 1.7% since the launch of YCC. Mission achieved, and that without distorting market functioning by trying to control the complete yield curve. Other central banks have been following the example of the RBA by reinforcing forward guidance, implicitly or explicitly, up to the 3 year point on their respective yield curves. The Bank of Japan’s YCC program, which targets the 10 year point, might be too complicated and do little besides exacerbating speculative behaviour. This should be avoided, as financial asset inflation has already reached high, possibly-unsustainable, levels. Either way, Powell’s comments on ‘whether using yield-curve control is still an open question’ points to a change in upcoming policy conduct.
Was the sharp correction in US equity markets due to worrying developments in COVID-19 infection rates across a number of US states? Or was it due to the FED’s message on Thursday that announced an increase in repo borrowing rates by 5bp above interest paid on excess reserves (IOER) at 10bp for overnight to one-week term repo and by 10bp above IOER for one month term repo? Both were probably self-reinforcing. Lofty valuation levels across rates, credit and equity markets, reflecting V-shaped growth recovery paths, have increased their sensitivity to small adjustments in short-term funding conditions. Any unexpected tightening can generate outsized effects across market sectors.
The upwards shift of the US Treasury curve was very short-lived . Last week’s bull flattening did not surprise us either. Once short-term rates are anchored at the zero bound, any risk-on episode translates into bear-steepening. Conversely, risk-off sentiment follows a bull-flattening pattern. Treasury bond supply through the auctions of 10y and 30y Treasuries did not stop these long rates’ from experiencing an aggressive drop towards 70bp (from 90bp) and 1.45% (from 1.67%) respectively. With 2y rates closing at 19bp, the 2y30y rate differential settled at 126bp. A brief market panic pushed this indicator down by 25bp! It raises the question how US long rates would react if confronted with the equity markets giving back half of their recovery since the March 23 lows. The answer is mixed. If we take the S&P 500 equity index’ June 8 highs, this would translate to a drop towards 2750 points. The S&P 500 traded at 2750 on April 7, 8 and 21. On those days, the 30 year US long bond stood respectively at 1.30%, 1.37% and 1.16%. Only April 21’s sudden correction managed to push 30 year rates to 1.16%. Long story short: balanced portfolio managers should still expect decent US long bond protection in periods of market stress.
Strong flight to quality flows emerged as well across European Government Bonds . The German 10y Bund dropped 16bp towards its equilibrium level at -44bp. The new safe bond, which will hit markets by 2021, does not remove the scarcity and quality benefits that support German government bonds. On the contrary, if anything, we have observed a substantial amount of lingering doubt towards the European Commission’s initiatives. At the margin, rate fragmentation returned to markets, as Spanish, Portuguese and Italian 10 year rates rose 3bp to 4bp, and closed the week at 58bp, 55bp and 1.44% respectively. Interestingly, the strong performance of Swiss 10 year bonds broke the -50bp resistance and closed at -51bp. With Swiss policy rates at -75bp, and 10 year Swiss rates dropping below 1.00% in March 2020 and August 2019, we should not be surprised to see continued interest in –supposedly- the most expensive bond market in the world.
The turbulence in global markets did not impress the EUR investment grade (IG) corporate bond market . The € IG Iboxx index eked out a positive 0.10% weekly result. Market mending continued and year-to-date performance finished at -1.29%. The flight to quality government bid pushed spreads back above 140bp. Primary market activity has remained buoyant. The IG sector can count on a steady investor base. One which finds reasons to add IG corporate bond exposure the moment the market retreats. The buy-the-dip mentality is still well engrained.
EUR high yield (HY) saw its three-week recovery of 7.02% stopped abruptly . The impact was modest with a retreat of 1.23% over the week. HY investors can face high default rate levels 12 month forward. Expectations lean towards a European 12 month default rate which remains below the 7% rate, like we previously witnessed during the GFC in 2008/2009. In the US, we expect that HY defaults will hit levels between 10% and 13%. There is a strong focus on recovery and the sector’s proven ability to refinance and roll-over balance sheets. We may only reach fair value levels after another 100bp of HY spread tightening. As credit spread dispersion is high, HY professionals have to select the survivors and avoid the broken business models .
After a 10% rally from the mid-March lows, emerging markets took a breather this week . Local Currency spreads (GBI-EM) widened 10bp to 4.00%. Hard Currency Investment Grade traded was up 5bp to 2.55%. Broad Hard Currency (EMBIG) remained unchanged at 5.00%, and Sub-Saharan Africa spreads in Hard Currency retraced 5bp to 7.55%.
Emerging market currencies followed the weaker sentiment after this week’s FED announcement, but recovered some strength going into the weekend . The JP Morgan Emerging Markets Currency Index (EMCI) declined 0.85%. The dollar index spot remained stable around 96.70. Star performers were the Thai Baht (+1.4% in EUR terms) and Japanese Yen (+1.9%).The Colombian Peso (-4.60% in EUR terms), Mexican Peso (-3.2%), Chilean Peso (-2.4%) and Russian Rouble (-2.2%) were the currencies with the weakest performance.
Whilst Europe has entered its ‘de-confinement’ mode, the situation in Latin America is worsening. The global economy will contract the most since World War II. Moreover, according to the World Bank, emerging economies’ output will shrink for the first time in at least six decades. Against this background, we stay cautious in the short term, but have a positive outlook for long term investors .
The first half of June answered whether central banks would continue on their ‘whatever it takes’ path. Clearly, the answer is yes. But, as one would expect, central banks are keenly aware of the social tensions that have spread across the globe. They understand that the very existence of their asset purchase programs will accelerate the divide between the asset-rich and the asset-poor. That leaves lots of work for governments. They need to distribute the fiscal stimulus across households as well as the corporate and government sector. Employment and participation require a healthy corporate sector. Household purchasing power requires there to be enough money at the end of the month. The government sector will rise in prominence. Fiscal policy has to perform a precarious balancing act in times of rising populism and a fractured global political landscape .
Over the past three and a half months, financial markets might have tested bottoms and tops across sectors. We expect some additional rebalancing activity as we approach for the middle of 2020. This will support the quality bond bid, and prevent risk assets from surging ahead of a challenging H2 2020. Momentum investing will make room for researched security selection with a longer-term investment horizon .