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STATE OF AFFAIRS
In this week’s edition we want to draw your attention to the potential structural impact global quantitative easing (QE) policies have on financial market volatility. Between the end of 2008 till the end of 2019, large-scale asset purchases started as temporary and measured interventions geared to improve financial conditions, without unduly disturbing market functioning and pricing. During this episode the number of central banks engaged in QE was limited. We can state that the volatility regime over those 11 years has been suppressed by the cyclical and asynchronical nature of QE. The only exception featured 2011, early 2012, with the eruption of the European Government Debt crisis, the Fukushima Nuclear disaster and the US debt downgrade. That period was effectively the last extended stretch of persistent volatility across market sectors. Since then and until end of 2019 volatility indicators across equity and bond markets tested historic lows. At times, we had a bump in the road with a slight uptick in volatility only to retest the lows after a couple of weeks or months. Goldilocks was the name of the game. Everyone enjoyed the ride.
Undoubtedly, the COVID 19 pandemic has catapulted us into another high volatility chapter. But will it pass as was the case back then? A firm answer would be misplaced, but we fear that a series of disturbing factors might uphold volatility for much longer. This time around, we are confronted with synchronized, global QE. The unconventional, large-scale asset purchases have become truly conventional. They have become permanent and limitless. From a temporary monetary instrument that would counter cyclical headwinds, it has morphed into a structural instrument that connects both monetary and fiscal policy. I dubbed it QE squared, as the acceleration in QE intensity mimics a quadratic function. Moreover, a quadratic function is parabolic, meaning the moment central banks decide that QE tightening is in order, we might see a similar effect but the other way around. From excessive loosening of financial conditions, we lapse into an excessive tightening of financial conditions. The current episode might feature persistent high volatility levels. The US equity market volatility barometer, the VIX, has tested the 20 level during the summer, but is currently back above 30. The average over 2020 has been around 30, implying almost 2% daily moves in the S&P 500. In rates, the volatility spike over March was countered by unprecedented central bank bond purchases, driving volatility towards historic lows. However, over the past month we noticed a substantial rise in US rate volatility. Many market observers link this to the upcoming US elections on Tuesday, but when we look to longer term volatility pricing, we note that pricing of volatility remains very elevated into 2021. Across FX and commodity markets the volatility surface remains elevated as well.
A high volatility environment will be welcomed by universal and investment banks that have important trading operations. We were witness of impressive results in that area over the past weeks. On the other side of the spectrum, retail and institutional investors alike should buckle up. The goldilocks track record will not be repeated. Expect increasing return volatility across bond, equity or balanced investment vehicles. Given tight cooperation between monetary and fiscal policy where central banks play the role of guardian keeping rates at ‘manageable’ levels for governments, investors should be attentive and not miss out on the opportunities presented when long rates rise towards attractive levels. The US Treasury market slips towards attractive entry points. European bond markets remain stretched with no end of the bull market in sight. Sustained high volatility might test financial market participants. It remains to be seen if central banks can avoid a comeback of systemic financial risk, the moment speculative waves break up or melt up…
A mixed bag of US Treasury auctions kept the US yield curve in the defensive. The curve gently bear steepened. US 2-year rates remain anchored around 15 basis points (bp). US 5-year notes backed up 1bp to 38bp. The key 10-year point added 3bp, finishing at 0.875% and closing in towards the early June high of around 0.90%. The 30-year only added 2bp, closing at 1.66%. Indeed, the 10s30s rate differential just below 80bp is attractive, compared to other OECD government curves. The German 10s30s offers a meagre extra 40bp term premium. The stock bond return correlation is still negative. Higher lock-in levels might offer higher hedging effectiveness.
No bear in sight for EMU government bonds. German 10-year rates clawed back the lost ground, and closed 5bp lower at -62bp. During the ECB meeting, president Lagarde was firm on the resolve of the ECB council not to let fragmentation reappear. Italian, Spanish and Portuguese 10-year rates dropped 3bp, 8bp and 8bp towards 75bp, 11bp and 9bp respectively. Italian rates clearly suffer from the presence of a liquid interest rates futures contract. More soothing comments from rating agencies are required to push this legendary spread towards new lows. It’s a question of when not if.
European investment grade (IG) corporate bonds are resilient, but start to show fragility. The acceleration of the pandemic is pushing spreads higher. The synthetic Itraxx indices have pushed higher in a rather aggressive fashion over the past week. The Itraxx Main CDS (125 IG names) index pushed 10bp higher from 55bp towards 65bp spread levels. As EUR IG corporate bonds have become a crowded sector over the past seven months, we might see more defensive action by investors that want to lock in a positive, correct performance as we engage for the final two months of 2020.
The European high yield (HY) sector hit a serious bump in the road, losing 1.05% over the week and falling back towards -2.31% year-to-date. Effectively, the Itraxx Crossover index (75 speculative grade names) saw spread levels rise from 3.28% towards 3.68%. Indeed, increasing equity volatility has an immediate impact across HY names. The usual suspect sectors (leisure, energy, hospitality, subordinated financials) might have a difficult year-end ahead.
Emerging market (EM) spreads underperformed last week. Local Currency spreads (GBI-EM), traded at 3.83% (+5bp). Hard Currency IG is now at 2.26% (+7bp) and Broad Hard Currency (EMBIG) at 4.54% (+10bp). Sub-Saharan Africa spreads in Hard Currency traded unchanged at 7.14%.
EM currencies posted a positive weekly performance when measured in EUR (+0.75%), but when measured in USD, the average return was negative (-0.70%). The Chilean Peso (+2.1% in EUR terms), Pakistan Rupee (+2.1%) and Thai Baht (+1.8%) were the winners, contrasting with laggards such as the Turkish Lira (-3.3% in EUR terms), Russian Rouble (-1.9%) and Brazilian Real (-1.5%).
Polish Zloty (4.62 versus EUR) slipped to its lowest level since the global financing crisis, cheapening 8.5% in EUR terms since the start of the year. Poland was very quick to react to the pandemic and weathered the crisis better than peers (2Q20 -8.9 quarter on quarter). Also, lending was conducted directly through the sovereign investment fund (PFR) and the development bank (BGK). This has been very supportive for local rates, trading now flat to Czech rates. Foreign investors have been net sellers of POLGB and now hold only 17.7%, the lowest level in more than 10 years. Whilst we believe that rates have little room for further outperformance, the support from local banks is high and the NBP is allowed to purchase bonds in the market. Polish exporters will welcome a cheaper Zloty, even if the currency was already one of most competitive before the crisis. October inflation printed 3.0% this week, and has now been back within the central banks’ inflation target band (2%/4%) since a couple of months. We would be tempted to go long PLN, but expect further weakness ahead given very negative real rates, the on-going conflict over abortion rights and the second wave of the pandemic.
In South Arica, the long-awaited MTBPS has been delivered and left us with a mixed appreciation. The GDP and revenue assumptions are, in our opinion, quite realistic. We find the projected trajectory of the debt/GDP ratio (reaching 95% in 2025), revised upward to land in between the previous “active” and “passive” scenarios presented in June, closer to reality. However, the fact the bulk of the savings arise from curbs on public wages makes the execution risk of the plan very high in our view, especially at a time of increasing social discontent. The government also said it does not anticipate increasing auction levels of SAGBs in the current year, which is good news given the fact they have been easily absorbed and the recent demand has been quite strong. All-in-all we think it should provide support for government bonds and we continue to find valuations attractive given the low inflation backdrop in the country.
Over the past 10 years, volatility across markets got suppressed by tactical rounds of QE. In retrospect, the base case scenario was known as ‘goldilocks investment conditions’. Solid risk taking got well rewarded. The risk scenario only required little attention. The start of structural, global and permanent large scale asset purchases might have kicked-off an episode of above-average volatility. If that is the case, I invite investors to reflect on possible outcomes and solutions. Base case scenarios and risk scenarios might close in on each other.
Over the past months, respectable financial institutions have announced the demise of the 60%/40% bond-equity portfolio construction. Bonds would lose their hedging capabilities and warrant a lower allocation. I call for prudency in this field. German government bonds have rendered proof that crossing the 0% yield line is easy. It worked as an example for many more EMU government bond markets. More markets will fall victim. The UK might follow the ECB in early 2021 and also adopt negative policy rates.
QE2 is pushing against the boundaries of correct market functioning. Disrupted market valuations can endure for longer and depart from reality. We might have entered a new market regime. A regime that might surprise many in its aggressiveness and potential outcomes. Sustained high volatility will be its middle name.