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STATE OF AFFAIRS
The University of Michigan published last month’s final set of US economic releases on inflation expectations. The survey gauges inflation expectations over the next year, as well as over the longer term (i.e. between 5 to 10 years). These not only confirmed their previous publications on the matter, but also surpassed them. Over the next year, US citizens expect inflation to rise by 3.20%. Over the next 5 to 10 years, inflation expectations rise to 2.70%. The gap between the market-based and survey-based inflation expectations has reached new highs. Our base case scenario calls for upward normalisation of market-based inflation expectations. Our preferred 5y5y forward inflation swap indicator closed the week at 1.77% and can be compared to the 2.70% print of the University of Michigan’s 5 to 10 year inflation expectations. Between 2004 and 2014, the average reading of these 5y5y forward inflation swaps has stood at 2.90%. We might reach this target in the next 3 to 5 years. A combination of, initially, cost-push inflation, followed by demand-pull inflation will bring inflation readings back to the central bank’s 2% targets. The monetary and fiscal policy’s continued accommodative and cooperative stance will push inflation above target. Central banks will not act by tightening policy rates, as a longer period of above-average inflation readings is required to break the back of disinflationary forces.
The COVID-19 crisis has been hard on the airline and automotive industries. We have taken these two specific industries, as Lufthansa and Renault have become two examples that have set the stage for a resurgence of the concept of ‘state capitalism’. In France, this concept never really disappeared. In a perpetuation of post-war ‘dirigisme’ (the opposite of the ‘laissez-faire’ approach), the French government has continuously sought to participate in companies such as EdF, Suez, Renault, PSA, Airbus, etc. However, in Germany, it is far less common to see the government enter the boardroom as stakeholder. The German government has granted a package of loans and equity investments totalling approximately EUR 9 billion to Lufthansa. This is a part of Germany’s EUR 600 billion state aid package that the country will release through guarantees, loans and direct investments in order to shore up its economy. The Elysée in Paris has also provided much needed support in the form of a EUR 5 billion state-backed loan to aid the ailing Renault car manufacturer. State capitalism is making a comeback. State Capitalism is defined as “[…] an economic system in which the state undertakes commercial (for profit) economic activity and where the means of production are organized and managed as state-owned business enterprises (including the processes of capital accumulation, setting wages and centralized management), or where there is otherwise a dominance of corporatized government agencies or of publicly listed companies in which the state has controlling shares.” All three forms might become common practice in order to prevent the current economic debacle from turning into a solvency crisis. Such a solvency crisis typically has a long-lasting impact, and directly results in high and sticky unemployment. This is not an ideal outcome due to the presence of political fragmentation. Investors should take note that government support might impact valuations across the equity and debt capital stack. Risk premiums might need to rise in line with government control increases.
Last week, the European Commission (EC) proposed two historic plans: a ‘Next Generation EU’ plan between 2021-2024, and ‘A reinforced long-term budget of the EU’ plan, which will run from 2021 to 2027. The overall Next Generation EU plan is a temporary reinforcement instrument in the shape of a EUR 750 billion recovery fund (EUR 500 billion in grants and EUR 250 billion in loans) that will spearhead the response to the COVID-19 crisis. This fund initiates risk sharing and joint issuance through the EC. The financing structure is appealing, since most repayments will take place between 2028 and 2058. The EC also proposes a number of new own resources consisting of a CO2 border tax and a new digital tax. The new EU budget envelope consists of a multiannual financial framework of EUR 1.1 trillion. These initiatives, which will be agreed upon by the end of 2020, essentially cement the Euro as a reserve currency. It set us up for the establishment of a true safe bond asset and a corresponding proper Euro risk-free yield curve. Expect the intra-EMU rate convergence trend to strengthen over the next few quarters.
The US yield curve has been steady thanks to the FED’s flexible quantitative easing (QE) support. At the margin, we note that curve steepening is percolating under low volatility conditions. The 2 year and 10 year notes remained unchanged by week’s end (i.e. around 16 basis points [bp] and 65bp respectively). The 30 year bond increased by 4bp and closed at 1.41%. As the 2s30s steepness rises to 125bp, we have our eye on a potential 150bp upper target. That might occur under conditions that require a successful reopening of the US economy. It might reduce further US FED QE intervention, and consequently pressure the long end of the Treasury curve.
German 10 year rates retraced to -45bp as the longer-term impact of the EC proposals trickled down. Spanish 10 year rates dropped 6bp to 0.57% far outpaced by Portuguese 10 year rates finishing 22bp lower at 0.50%. Italian 10 year BTPs dropped 12bp to 1.47%, breaking a heavy 1.50% technical downside resistance. We can confidently put the revival of a European debt crisis to sleep. We expressed some doubts last week, but these were merely caused by an general sense of excessive prudency concerning EU and EMU progress. We want to add that the Recovery Fund will mostly benefit Spain, Greece, Cyprus and Poland. We expect the ECB to top up the PEPP instrument next Thursday. The commission will likely add in anywhere between EUR 500 billion and EUR 750 billion, in order to take the duration towards the end of 2021. Markets have nearly fully priced in such an event. However, they potentially still overlook the fact that the PEPP could include recently fallen angels, which entered the high yield universe. TLTRO III & PELTRO conditions might be relaxed further. We are looking forward to 2020, 2021 and 2022’s core inflation projections.
EUR IG corporate bonds added another solid weekly performance and climbed 75bp. Over the first 5 months the sector dropped 2.52%. The tidal wave of new issues has continued to broaden the investable universe. However, we repeat that the ECB is buying 100% of new net supply through its Corporate Sector Purchase Program. Such direct intervention ensures that the EUR IG corporate bond market stays resilient. Then again, at a cash spread of just below 170bp, we have entered fair valuation territory (taking into account earnings uncertainty in recession times, and the resulting increase in a company’s debt leverage). In the US, the new issues for the IG market passed USD 1 trillion. Last year, we only managed to reach a similar level in November/December. In both Europe and the US we expect to see a marked decline in primary activity over H2 2020. We will likely see higher leverage conditions as long as earnings are in the recovery phase. Central bank purchase programs might tighten spreads. However, we are in the neighbourhood of longer-term fair value at current IG risk premia.
With a 2.41% weekly gain, EUR HY has recovered aggressively in May, and finished at a -6.79% year-to-date performance. The historical correlation with equity markets has driven HY to a point where one wonders when increasing defaults will filter through. At a current spread of approximately 5.70% for EUR HY and 6.45% for USD HY, we are not sure whether both sectors are sufficiently insulated against a protracted default cycle. We do expect that more fallen angels will require investor sponsorship and a genuine reopening of EUR HY markets. ECB support might be a key requirement. The USD HY sector took a more promising start, and has shored up its balance sheets since March, after the FED and the US Treasury came to its rescue.
Emerging markets (EM) continued to rally last week, but were mainly pushed on by EMFX. Local Currency spreads (GBI-EM) tightened 5bp to 395bp. Hard Currency Investment Grade eased 5bp, and traded at 295bp. Broad Hard Currency (EMBIG) tightened 5bp and ended at 545bp. Sub-Saharan Africa spreads in Hard Currency remained unchanged at 805bp.
EM currencies had a very good week once again. The JP Morgan Emerging Markets Currency Index (EMCI) closed at 54.77, with a weekly gain of 1.44% and a month-to-date performance of 3.73%. The Brazilian Real (1.8% in EUR terms), Polish Zloty (1.5%) and Czech Koruna (1.2%) were the best performing currencies last week. The Dominican Republic Peso (-5.4% in EUR terms), Argentine Peso (-2.1%), Ukrainian Hryvia (-2.1%), and Ghana Cedi (-2.1%) were amongst the weakest currencies. As mentioned last week, we will continue to keep a close eye on US-China tensions. The Offshore Deliverable Renminbi exchange rate versus the US serves as a good barometer. After trading close to the psychologically important level of 7.20 on Wednesday, it climbed back to 7.133 by weekend’s close. Most of this move can be explained by a weakened USD. The dollar index spot seems to have settled below the 100 level, and closed the week at 98.344.
We believe that EM will continue to do well in the weeks ahead, mainly on the back of solid EM FX performances. We keep a negative stance on Brazil. President Jair Bolsonaro has used social media to raise the possibility of a “punctual military intervention” in the constitutional branches following his conflict with the country’s Supreme Court. In the meantime, Brazil reported more than 30.000 new daily COVID cases this weekend.
I invite the readers to consult EC President von der Leyen’s speech on the EU Recovery package. It propels the EU and EMU into a new and promising political and economic dynamic. She proclaims that ‘This is Europe’s moment’. Investing in the EU definitely took a turn for the better last week.
In stark contrast to the EU, the US has been riddled by chaos and violence caused by ethnic confrontations and questionable US leadership. In addition, China has halted US soy imports after the latter used diplomatic and economic threats against Chinese officials and the Hong Kong financial sector. These came on the back of new Chinese security laws which affected Hong Kong. The US-China commotion endangers a crucial part of the phase 1 US-China trade agreement. We start to see further moves towards regionalisation. The collateral damage of deglobalisation will become increasingly apparent as we move forward.