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STATE OF AFFAIRS
COVID-19 has been the catalyst of broad-based financial assets deflation across the globe and across all public market sectors.
The traditional flight to quality sectors have seen V-shaped reversals as of March 10th 2020. Technical flows drove long US and German rates to historic lows but rate markets started to focus on impact of monetary and fiscal initiatives.
These monetary and fiscal initiatives have not been able to stabilize markets yet. The latest ECB and BoE decisions leave however little room for doubt. Liquidity stress will abate. Government bonds will profit first. IG credit markets will track closely. HY markets will require longer mending. Trust in HY is heavily dented. However the impact versus equity follows the same path as 2008/2009. Still about half of the year-to-date correction. Funding support is in place for financial institutions and corporates (large & small). Commercial paper support programs are essential to maintain working capital levels.
The ECB through the Pandemic Emergency Purchase Program has addressed fragmentation in EMU government bond markets. Flexibility in timing, scope and size is present. The € 750bn + € 120bn + € 20bn existing monthly program + reinvestments of redeeming bonds has drawn a line in the sand. We expect intra-EMU convergence of rates. These circumstances will also help in discussion among EMU political leadership to reopen European Bonds issuance. European investors have the right to a safe asset. Solidarity is required to tackle the health crisis. Solidarity is also required in the EMU government funding domain
Over the past month we encountered the Big Reset of the debt financed episode. This episode started in March 2009. Another Black Swan came along. This time the speed of impact has been tree times as fast as in 2008/2009. The unknown unknowns factors are still present but correct valuations have resurfaced as well.
US nominal Treasury curve rates has steepened nicely and offers fair value. We expect consolidation of 10 year Treasuries within a broad 75bp to 1.50% range. Current volatility indicators warrant caution.
German 10 year remains expensive at -17bp. Expect continued ECB support for periphery versus core bonds. We repeat that the flexibility of the ECB is important, they can easily frontload the €750bn package. Longer term we assess that the possibility of European Bond issuance has also risen markedly. That will support intra-EMU convergence.
US TIPS are at levels witnessed during Q4 2008, Q1 2009. On the back of massive monetary and fiscal reflation valuations are cheap. 5 year & 10 year US break-even rates at 15bp and 50bp contain high option value i.e. lock in high real rates and buy inflation expectations at secular lows. Same picture across European inflation linked bonds. Japanese style linker valuations.
€ IG credit spreads (Iboxx universe) fluctuate between 225bp and 250bp (March 19th ) versus a high of 180bp at the end of 2018. The ECB increased the CSPP 2.0 program last week. When we add to this further support coming from this morning’s announcement it becomes clear that the ECB becomes not only the net buyer in IG credit month over month but also the dominant buyer. High quality IG credit is cheap for long term investor with index yields close to 2.00%. That takes us back to 2013, early 2014 levels, the time just before the ECB started QE. QE will become a permanent condition. Liquidity conditions will start to improve the moment liquidity in government bonds normalizes. The bond volatility indicators require monitoring.
€ HY index shows a spread level of 885bp for an index yield of 9.42%. That takes us back to Q3 2008. Liquidity conditions are not well. This is an understatement. ETF discounts across bond sectors ranges from -5% to -27%. Yes, the latter is HY. So better invest in an active, well analysed and risk managed HY solution. At current valuations investors can withstand almost 50% cumulative defaults over a 5 year period at a 40% recovery rate.
Emerging Markets spreads moved higher than levels witnessed in early 2016. Local currency spreads (GBI-EM) moved 110bp (from 395 to 505), Hard Currency Investment Grade 160bp (from 235 to 395). Broad hard Currency (EMBIG) moved 285bp (from 380 to 665) and Sub-Sahara Africa spreads in Hard Currency by 455bp (from 545 to 1000).
Despite general EM FX weakness, local currency EM is doing better than Hard Currency. The index yield within LC Emerging markets sits just below 6% at 5.92%. In EMD LC space we remain defensive via our sustainability approach and the de-risking at the beginning of the year, by selling low quality hard currency issuers, especially in the Sub Sahara region and by adding high quality local currency in Central Europe. Although we see pockets of value appearing, we think one should be careful as market sentiment remains negative for the time being.
So the 2020 dislocation is not finished and will require a turn in the COVID-19 infection rate. We call for a turn over April – May.
Monetary policy is in full force and might surprise further.
Fiscal support should increase and reach 5% up to 15% of GDP on country or regional basis.
Expect extreme volatility conditions across bond sectors to abate as the lockdowns start to curb infection numbers.
Expect curve steepening that occurred over past week to consolidate the moment volatility dissipates.
It will take a long period of time to bring back confidence in global financial markets.