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STATE OF AFFAIRS
We have been confronted with various reopening scenarios for global economies since Easter. We have learned that the reopening will be gradual. We have also started to realise that the reopening will likely need a perfected vaccine and a high percentage of herd immunity (70% to 80%?) before we can start talking about ‘normalisation’. Moreover, because all countries apply different confinement and lockdown procedures, we know that the normalisation process will be littered with retreats as well as optimistic evolutions in infections. If we define our recovery target as end-of-2019 GDP levels, it is fair to say that the damage inflected in terms of global, regional or country real growth in 2020 and 2021 will likely take us into 2022, and the recovery will likely take on a V-, U- or W-shape. When the reopening estimates (or guesses) are delayed, getting to the recovery state will take more quarters. We emphasise that investors should remain patient and realistic. The market crash in March, followed by its impressive rally is only the first chapter in the COVID-19 book. The next chapters could surprise both negatively or positively.
The acceleration and growth phase of COVID-19 infections and casualties has been countered by an unprecedented, global policy response. The FED, the US Treasury and the SEC response has cushioned the impact on the US economy. Never before have market participants been confronted with such a complex puzzle of overwhelming stimuli, regulatory relief across financial market sectors, and direct financial aid to households, companies, states or local public authorities. Although the US has encountered few governance issues in the decision or implementation-process thereof, the EU and EMU has turned into a veritable governance battlefield. The ECB, the Eurogroup, the EU Council, the EC, the EIB, the EFSF, the ESM, the European debt agencies, as well as national fiscal and regulatory authorities compete for optimal impact. This whole situation, and especially the rate fragmentation across Eurozone government bond markets, has further confused market participants. Currently, the ECB seems to be the only institution which manages to effectively tackle this crisis. We can only hope that we will solve this medical and humanitarian crisis before we reach the breaking point of the EMU construct.
In the meantime, market participants are front-running central banks’ purchase program announcements. It is our duty to reflect long-term, sustainable valuations across government and credit sectors. We repeat that one should refrain from relying on exaggerated extrapolations. Except for the government bond sector, one should not realistically hope to achieve January 2020 valuations at this current time. The global policy response should not become a panacea for the lowering risk premia. On the contrary, we call for a prudent investment style (read: ‘not falling for investment traps’). We apply extensive diversification, as we are still dealing with a lot of uncertainty. The black swan is still around and can make a sudden reappearance.
To a certain degree, we have started to see the implementation of Modern Monetary Theory (MMT) in the US. The well-orchestrated dialogue between the US FED and the US Treasury does blur the lines between monetary and fiscal authority. In normal times, the FED steers policy towards their objectives by raising or cutting policy interest rates. This should then lead to potential real growth with optimal employment levels and stable inflation conditions. Under MMT, fiscal authorities take the lead and steer policy towards the same objectives. However, instead of relying on interest rates, they do so by raising and lowering tax rates. As soon as the economy overheats and creates unwanted inflation outcomes, they raise taxes. The scale of the current monetary and fiscal pre-emptive response to the crisis has never occurred before in the US. One wonders who is really in charge today? The list of fiscal initiatives is long and costly. The FED is at the zero-bound and intervenes, supports broader government funding. In addition corporate funding, as well as parts of the financial industry (ETFs) is currently on FED/Treasury aid. The US Treasury acts as first loss taker by putting in the equity capital. We have not entered a de facto era of MMT. However, creative destruction is put aside. Government is gaining influence over the private sector. When one invests in private sector debt, it is important to consider the support and influence that comes from the government. Defaults and debt restructuring will occur, but we will have to carefully analyse the structure of the victims in this perspective.
The US yield curve bull-flattened last week. 10y and 30y rates dropped about 8 basis points (bp) towards 0.64% and 1.26% respectively. Meanwhile, the 2y note lost only 2bp and finished at 20bp. Our base case takes into account implicit yield curve control by the FED. They have frontloaded the QE effort in the Treasury markets over the past month. Still, the pace at which they have been completing these purchases is wholly unsustainable. So, unless the Covid-19 pandemic in the States worsens, we should witness steepening pressure into the month of May. US TIPS (i.e. inflation linked bonds) took a beating this week, with break-evens selling off aggressively. 5y inflation expectations shed 28bp from 0.92% to 0.64%, whereas 10y break-evens ended at 1.02% versus 1.29% on Easter Monday. This move does not fit the buoyant markets in equity, IG or HY corporate bonds. Did market participants decide that we reached correct selling levels around Easter? Can this move be earmarked as a (re)positioning clearing or was it a fundamental move, taking into account that the future will bring even lower inflation expectations? We classify it as a (re)positioning occurrence, and call for higher inflation expectations over the medium to long term (see last week’s note).
German 10y rates drifted back towards our floor of -50bp and closed at -47bp (down 12bp). Spread volatility between the core and the South of Europe was high. The ECB only managed to limit the damage by the end of the week. Italian 10y rates closed at 1.78%, 8bp above our predicted cap of 1.60%-1.70%. The attack on the 2.00% level was short-lived. It also underscores our thesis that the ECB will cap Italian long rates in order to prevent fragmentation and debt unsustainability. It strengthens our base case that calls for intra-EMU rate convergence. Next Thursday (April 23) is another big moment for the EU and EMU, as the EU Council will convene. Everyone understands the scenarios at hand: If the council can agree on a governance framework for the future EU and Eurozone, political decisions regarding fiscal transfers could succeed over time. Do we only want to resolve the medical crisis in the short term, or do we want to also work on long-term, robust fixes for the EU and EMU? Hopefully, they will manage to strike a good balance between national (budgetary) responsibilities and solidarity between nations. This would allow for constructive progress towards a reconstruction or recovery fund that is supported by the ECB, but resides as mutual debt on the ECB balance sheet. We already mentioned this implicit mutualisation through the ECB’s QE purchase program of the past five years. It becomes clear that we are on a steep and long path. Subsequently, rate convergence trends will also only crystallize slowly.
The positive momentum of IG corporate markets continued after Easter. EUR IG corporate bond spreads grew past 200bp with a 1.41% Iboxx yield. In yield terms, this puts us at levels similar to the start of 2019. We expect continued support for the IG corporate bond sector, as the lack of EMU progress has fragilized the EMU government sector. EUR IG sits around -4.00% return YtD. US IG tightened aggressively to 2.04% with a 2.7% yield and a 1.1% positive return YtD.
From Easter until April 17, we witnessed a steady recovery in EUR HY credit. EU HY added 1.7% on index level, passing the -10% return mark and finishing at -9.7% YtD. The European HY primary market reopened. This has been a crucial step in the mending of the market, as it tightens bid-offer spreads and market depth. Potential ECB support will require extreme market stress. EU HY spreads at 6.25% commands a yield of 5.8%, which puts EUR HY in the 33% percentile of cheapness since the start of EUR HY markets. Currently we hold onto our neutral call. US HY has a spread of 7.17% and a yield of 8.00%, which also puts the sector at the 33% percentile of attractiveness. US HY posts a -8.1% YtD result. We remain more prudent given the high energy content.
Emerging bond markets posted a good performance last week, especially in local currencies, which saw spreads (GBI-EM) tightening by 25bp towards 4.45%. Spreads where stable in hard currency: Hard Currency IG traded at 3.45% (unchanged). Broad Hard Currency (EMBIG) tightened 5bp to 6.15% and Sub-Saharan African spreads in Hard Currency widened by 10bp (to 9%)
Emerging market (EM) currencies had mixed weekly performances.
Asian currencies performed well: Indonesian Rupiah (2.4%), Thai Baht (1.3%) and Philippine Peso (0.5%) in EUR terms. However, Latin American currencies underperformed: Mexican Peso (-1%) and Brazilian Real (-1.6%) in EUR terms.
The worst performing currency was the South African Rand (-3.7% in EUR terms). EM central bank assets held in custody at the Federal Reserve dropped by USD 124 billion last month, which shows that central banks have been intervening in recent weeks.
Demand and supply recovery times are highly uncertain but will exhibit asynchronous pattern.
The G20 announced debt relief for 76 low-income countries. Argentina launched an offer to restructure USD 83 billion of foreign debt and Ecuador received bondholders’ consent to delay interest payment on USD 18 billion of debt until mid-August. A long list of EM countries has been downgraded (Bolivia, Mexico, Sri Lanka, Tunisia, Bahamas, Belize, Zambia, Suriname).
We clearly observe a potential for sustained lower volatility levels in core rate markets, as central bank control is high. Some steepening would create an even better background. The longer this condition lasts, the higher the potential for continued support in IG, HY, EMD and convertible bond markets.
Robust diversification is the only recipe which will pull investors through this unchartered episode in financial history. Capitalism and private/public cooperation is getting redefined. Let’s hope capitalism survives, reinvents itself and resurfaces with an stronger focus on sustainability.