DPAM Blog

STATE-OF-PLAY

• • 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.