From the Great Retracement to the Great Re-Opening


By Peter De Coensel,
CIO Fixed Income at DPAM


    • April 2020 will be remembered as ‘The Retracement Month’ in discussions about performances. EUR sovereign and USD Treasury markets added 0.4% in April to post year-to-date (YTD) gains of 0.8% and 9.3% respectively. UK gilts took the lead in the government sector with a gain of 3.1% in April and 10.3% YTD. Emerging market government bonds sustained a YTD loss of 10.9% after an unimpressive April recovery of 3.2%. In corporate bonds, EUR investment grade (IG) rebounded 3.7%, reducing the YTD decline to an acceptable 2.7%. EUR high yield (HY) rallied a solid 6% over April, with a YTD loss now a smaller 10.1%. In the US, the corporate bond rally had already started in the second half of March. Thus, there was less progress in April, but resulting YTD numbers are solid with US IG up 1.1% and US HY down 8.9%. Despite its high exposure to the energy sector, US HY posted better returns than EU HY. The EU-US contrast was even greater in equities. The EUR DJ STOXX 600 rose 6.7%, leading to a YTD decline of 17.3%, while the S&P 500 recouped 12.8%, reducing its YTD drop to 9.3%. The NASDAQ rallied an impressive 15.5%, thus shedding just 0.6% YTD, a relatively flat performance.

    • The main reason for this EU-US performance divide is central bank strategy. The US Fed had opted to go all-in on March 13, announcing unlimited quantitative easing, while the ECB scrambled, keeping its usual stop-and-go modus operandi. Understandably, the ECB is refraining to use the all-in option, as this would generate more decision paralysis by EU/EMU political leaders. Instead of convergence, this would result in even greater imbalances between monetary and fiscal action.

    • The April rebound is directly linked to the unprecedented size of the global monetary and fiscal policy response. It is also fed by FOMO or the Fear of Missing Out that usually affects retail (but also institutional) market participants. However, financial history has not been kind to early bottom-fishers. Most bear markets are built on rebounds that lift spirits and hopes but are followed by even harsher corrections on the back of disappointing recovery data flow. The ECB President forecast a 2020 growth deceleration of 5.00% to 12.00%. Effectively, she is warning that visibility is non-existent and Depression-like outcomes are likely. This would put us in a reboot scenario that would start, let’s say, when overall activity is down 10%/sitting at 90%. In order to recover from 90% to a pre-pandemic 100% activity level, we would have to assume that human consumption patterns would jump back to 2019 levels. This will not happen. Demand and supply functions have been severely disrupted. We might only be able to talk about an effective return to normality when Wembley or Nou Camp football arenas are full once again. This takes us at best to 2021, at worst to maybe 2022… 2023. Remember that over the 2008-2009 Great Financial Crisis, US GDP fell about 4% to a trough activity level of 96%. Today, consensus points to a US real GDP down 6% to 8% and with 15% unemployment. Over the past seven weeks, 30 million US workers, or 20% of the US labour force, sought unemployment benefits. Expect record budget deficits and debt figures rising by record 20 to 30 percentage points. The bulk of debt issuance will be bought by central banks and mature or get reinvested through their balance sheets. In addition, central banks will credit Treasury departments with the accrued coupon benefits. It’s not called monetization because central banks are tapping the primary and secondary public markets. In sum, dire record-breaking metrics and conditions warrant a high level of alertness and caution. US money market funds’ assets under management have surged by more than USD 1 trillion over the past six weeks!

    • Whereas the US Fed confirmed its pre-emptive policy over the past week, the ECB confirmed its reactive policy. As expected, the ECB is keeping pressure on EU/EMU leaders to step up their fiscal response. An expansion in size and duration of the EUR 750 billion Pandemic Emergency Purchase Program will be on the docket of the next ECB meeting on June 4. At a press on conference, it became clear that Outright Monetary Transaction (OMT) was no longer the instrument of choice. OMT was an instrument of the 2011-2012 period. Most people forgot this, but according to OMT rules, transactions could only impact and lower funding conditions for 1-year to 3-year rates. Effectively, that objective is attainable, since the ECB has decided to increase the attractiveness of funding conditions for its third Targeted Longer-Term Refinancing Operations program (TLTRO III). If banks reach lending targets, they can borrow at a very attractive rate of -1.00%, at a rate of -0.50% for classic longer-term funding and -0.25% for pandemic-related funding. These measures will intensify intra-EMU rate convergence for debt of up to 3 years. This will positively influence and spread out to support 5- to 10-year EMU rate convergence. Convergence of yield curves at the long end might take longer, as a fiscal union is not in the cards in the near future.

    • Meanwhile, in emerging markets (EM), we are witnessing a fundamental shift in EM central bank policies compared to previous downturns. Emerging central banks are cutting policy rates aggressively despite an environment of foreign exchange (FX) depreciation. They are forced into deep rate cuts, as the monetary transmission mechanism (the impact of lower rates on growth) is weaker. This change in policy has been the major driver behind the EM FX depreciation observed between mid-February till today. We believe that by now, markets have priced in this new reality. Overall, EM FX adjusted by 11.3% versus the USD. By the end of April, the BRL had lost 26.7%, the ZAR, 24.4% and the MXN, 21.7% versus the greenback.

    • We believe that the rates component will continue to perform, as a result of these central banks’ actions. This will lead to further steepening of local curves. In order to make this process smoother, some countries (e.g. Mexico) have started to offer swap facilities, allowing investors to swap long-dated debt for short-dated debt. We repeat that on the FX part, markets have moved ahead of central bank action and EM FX will start bottoming out from current levels. For frontier EM economies, G20 and IMF programs are providing support via a postponement of interest payments on existing debt or outright debt restructuring.


    • US Fed policy is shrinking the overall size of the US Treasury market. The Fed bought about USD 2 trillion in US Treasuries over the past two months, increasing the central bank’s balance sheet to above USD 6.5 trillion or 30% of US GDP. The US yield curve did not move up to the 10-year point. Thirty-year rates rose about 8 basis points (bp) to finish at 1.25%. Given the aggressive Fed intervention over the past months, it is surprising to see 10-year rates at 60 bp, a mere 15 bp lower than the 75 bp average since the start of March. Expect more steepening pressure at the longer end of the US yield curve. Clearly, US Treasury investors are not buying into the scenario of a deflationary long-term outcome. They are pricing in a disinflationary outcome. They fear an inflationary outcome. The (changing) weighted average of probabilities for each of these scenarios is reflected in supportive, but still historically cheap, market-based inflation expectations (break-even rates). US 10-year Treasury Inflation-Protected Securities are pricing in an average annual US CPI of 1.07% over the next 10 years. We consider this cheap given the “unseen” growth in money supply and disrupted aggregate supply and demand chains. US inflation expectations have a higher sensitivity to growth, while EU inflation is less volatile and more persistent because it is linked to government regulation. We invite investors to closely track expected inflation indicators over the next quarters and years.

    • German 10-year rates dropped a remarkable 11 bp to -59 bp. Intra-EMU government rate convergence was evident in semi-core markets as well as in Spain and Portugal. Short-end Italian rates did well, but 10- and 30-year rates lagged. Ten-year Italian rates finished the short week down 8 bp at 1.75% against an unchanged 30-year rate of 2.60%. Market consensus is moving the cursor on 10-year bund fair value. With the TLTRO III opening up the road to funding at a rate of -1.00%, we are entering another ECB accommodation phase. Clearly, 10-year German rates will remain negative for longer than we had expected or wished.

    • EUR IG corporate bonds ended the month of April on a high note. With spreads below 2.00% at 1.93%, offering a 1.30% yield, the recovery from spread highs of 250 bp to 260 bp and yields of over 2.00% has been fast and furious. However, rating agencies have also stepped up the pace of their re-rating activity. We must prepare for more pressure on the BBB-rated cohort. Higher selectivity will start to impact the IG bond universe and translate in an up-in-quality investor preference. This segment remains our preferred universe across fixed income sectors due to its resilience and the central bank backstop. US IG corporate bonds profited briefly from the Fed credit-easing announcements. We will monitor if the Fed improves financial conditions the moment it actively starts intervening.

    • As the number of fallen angels (companies losing their IG rating) will keep on rising, we expect higher credit spread dispersion across the HY universe. The high uncertainty levels will keep the retail bid out of the market for longer. This also means that institutional confidence and demand will drive HY spreads over the coming months. Given HY’s 50% correlation with equity markets, we sense that HY is not out of the woods yet. Any new correction in equities over the next months will be felt in the HY space. With a yield of 5.8% and spreads of 630 bp in Europe, long-term investors should be shielded from the upcoming default cycle. The same can be said for US HY with a yield of 8.2% and a spread of 758 bp.

    • Emerging bond markets closed the month on strong footing. Local currency spreads (GBI-EM) tightened 5 bp to 430 bp. In hard currency, spreads were slightly tighter as well. Hard currency IG traded at 345 bp (-5 bp). Broad hard currency (EMBIG) tightened 10 bp (to 630 bp) and spreads of debt from Sub-Saharan Africa in hard currency tightened by 15 bp (to 935 bp).

    • Emerging market currencies have finally found support. The South African ZAR (up 4.9% in EUR terms), Mexican MXN (up 4.9%), Brazilian BRN (up 4.2%) and Indonesian Rp (up 3.0%) were star performers last week. At the other end of the spectrum, we find the Dominican Republic’s RD$ (-0.9% in EUR terms), Ghana’s GHS (-0.9%), Argentina’s ARS (-0.8%) and Turkey’s TRY (-0.6%).

    • YTD, the Philippines (up 10.5%) is the best performing market, when looking at the total return. The top four countries are all in Asia: China (7.2%), Singapore (4.6%) and India (3.5%). Worst performers were South Africa (-25.8%), Brazil (-21.0%), Mexico (-15.8%) and Colombia (-15.4%). South African bonds seemed to have found a bottom last week. They tightened 60 bp despite their (WGBI) index exclusion.


    • As bond investors, we closely track equity markets these days and reflect on the infamous saying: “Sell in May and go away … don’t come back until St Leger Day!” Over the past 10 years, the S&P 500 has been positive 60% of the time, but monthly performances were lower, taking the average performance to -1.23%. The technicals remain negative. It will all boil down to longer-term earnings estimates across sectors, multiples estimates and news flow on the containment of the virus outbreak. The world will be tracking data out of Georgia, one of the first US states that is opening for business, followed by Texas mid-May. In Europe, some countries will start experimenting with easing confinement measures. The fate of the equity market might steer core rates over May-June as well. Might… as we are entering unchartered territory…

    • Over the past 20 years, the equity-bond performance correlation has been negative. Any negative equity performance episode was countered by positive bond performance. Balanced portfolio managers profited nicely. Diversification across the bond-equity divide was the rule. With global developed market policy rates that are “zero-bound”, that rule might get questioned. Under stable disinflationary conditions, we could possibly continue to receive some protection from bond allocation. However, the correlation could turn unstable under deflationary conditions or under inflationary conditions with inflation above 2%-3%. Positive performance correlation episodes occurred in the 70s and part of the 90s. Equity markets suffered, while rates were rising, creating hardship for bond investors as well. Correlations do not change overnight, but investors should be wary of possible surprises once the disinflation goldilocks phase is over.


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