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STATE OF AFFAIRS
A key attribute of successful investing relates to one’s capacity to take some distance. 2020 has been littered by an enormous amount of less relevant data points. The growing attention to mobility data series is a case in point. This kind of analysis leads to economic recovery forecasts in V, W or K shapes, and derivatives thereof that would alter your investment strategy. Truth is that the boom in financial market assets, since the sharp bust over March 2020, has mainly been driven by the combined and reinforcing effects of the extraordinary global monetary and fiscal stimulus measures. So what do we see from 30.000 feet?
Profitable business models built on digital platforms witnessed an acceleration of their valuations as the pandemic-led change in consumer behaviour will be sticky. Such growth/quality business models possess a high future-proof DNA. People-intensive or asset-heavy business models will remain fragile against disruption. A rising interest rate environment would not alter such condition.
Over 2020, expected returns in EU and US government bond markets as per end of November have collapsed to new lows. Indeed, in the less-fragmented EMU rate markets, we tumbled towards an expected return of 0.32% over an investment horizon between 8 to 9 years. Investors that hold their interest rate sensitivity intact profit from curve steepness and corresponding roll-down return to eke out a positive expected return. Surprising maybe, as the EMU government index yield shows a -0.22% level. Today, EU rate markets fully align with expected returns in Japanese government bonds that sit at 0.32% as well. On the other side of the Atlantic, US Treasuries offer an expected return of 1.21% over an average 7.5 year investment horizon.
Moving up the risk ladder, we notice that European investment grade (IG) corporate bonds deliver an expected return of 0.55% over a shorter 5.25 years investment horizon. The unabating ECB corporate bond purchase program pushes the sector closer and closer towards uninspiring EMU government bond returns. US IG corporate bonds offer a decent 3.18%, respecting a 7 years+ investment horizon. European high yield (HY) has to settle for 1.51% over a 3.5 year horizon, whereas US HY sits at 3.42%. Both HY sectors suffer from historical default data points as well as negative migration impact. Without those elements, European HY index boasts an interesting 3.00% yield and US around 4.00%. Clearly, active management allows for correct return expectations conditional on the ability of the manager to escape defaults and avoid bad security selection.
Emerging market (EM) local currency government bonds offer a handsome expected return of 4.24% thanks to fairly low default risk.
This brief helicopter view exercise reveals that expected bond returns across EU and US markets have adjusted to the point that investors that refrain from broadening the investment scope fall into despair. However, global bond markets offer solutions. From an Atlantic-centric bond focus, investors are invited to rotate more into EM debt (government & credit) in general, and towards Asia specifically.
Given to the recent focus on the US elections tribulations, little was written on the November 19 signing of the Regional Comprehensive Economic Partnership (RCEP) across 15 states in broader Asia. The 10 countries of ASEAN (Association of Southeast Asian Nations) and 5 Asia Pacific countries (Japan, South Korea, China, Australia and New Zealand) signed a free trade agreement (FTA) that spans 30% of the global population and, yes, 30% of global GDP. In importance I would put this multilateral cooperation partnership next to the creation of the European Union, to a lesser extent to the renewed USMCA trade agreement. Fact is that the US nor India are part of this historic agreement. I copy the following brief description that featured on the EU website because it suitably summarises the scope and the potential for the region:
The main effect of the RCEP is to have bundled together the various Free Trade Agreements that ASEAN has with the five other Asia Pacific countries into a single framework. It covers trade in goods but does little to reduce non-tariff barriers. It excludes most services but also agriculture, which is a sensitive sector. It is a ‘shallower’ agreement than the existing EU FTAs with the region. And it cannot be compared with our own Single Market. But that was never the point.
More than 30 negotiating rounds over eight years, numerous Ministerial meetings and three Leaders’ Summits have resulted in a significant achievement and, as the Asian leaders said on Sunday, brought “an unprecedented mega regional trading arrangement that comprises a diverse mix of developed, developing and least developed economies of the region.”
The RCEP is a game-changer. Asset allocators across the main bond-equity divide will redirect funds towards this enhanced economic growth pole.
In a short Thanksgiving week, Treasuries stood their ground. US 10-year rates closed a mere 1 basis point (bp) higher at 0.837%. The very long end received less support, pushing 30-year rates up 5bp towards 1.57%. In real rates, action was somehow more revealing, as we observed renewed strength in inflation expectations. 30-year break-even rates finished at 1.89% but also shorter tenor break-even rates pushed higher. 5-year break-even rates closed at 1.68%. As US TIPS belong to the overall FED QE program, the FED minutes, released on Wednesday, preparing us for increased large-scale purchases to be announced on December 15, will have enticed underexposed investors to increase their allocations.
Within European rates, IG and HY, the search for yield was buoyant. Italian 10-year rates closed at a historic low of 0.59%. Same for Portuguese 10-year rates that are about to drop in negative territory finishing at 0.01%! Spain tracks just behind, printing 10-year rates at 0.05%. The destination of periphery and semi-core spreads versus 10-year German bunds eventually will take us back to pre-GFC times. The EMU architecture took a defining positive turn over July. German rates closed at the same absolute level as Italy, barring the negative sign of course. The reference rate sits comfortably back in a -50bp to -70bp range ahead of December 10 ECB accommodation.
European IG corporates added 5bp, putting the year-to-date tally at +2.63%. The ECB draining leaves this market with only one option and that is to inflate further. The number of quality companies that fund at 0% coupon rates is growing steadily. The fragmentation with small and medium sized companies is exploding. The inequality becomes shameful.
European HY corporates put in another stellar weekly performance at +75bp. The monthly performance sits at +4.26%, lifting year-to-date numbers towards +1.84%. In the meantime, 2021 default expectations remain depressed. All public markets receive central bank protection. I reckon thinking about QE exit strategies is premature. Even more, should we still consider life after QE or just accept that central bank balance sheets will keep on growing…
In search for carry, cash rich investors rushed into EMs last week. Inflows into EM bonds totalled around USD 3.5 billion, of which USD 2.0 billion was in local currency. All spreads remained more or less stable, except Sub-Saharan Africa spreads that tightened 25bp to around 6.15%.
Currency performance, when measured in EUR, was slightly negative, but when measured in USD, the EMFX performed well. The JP Morgan Emerging Markets Currency index sits firmly above 56.40 now and EM FX volatility has decreased further from 10.25 to 10.10. Czech Koruna (+0.7% in EUR terms), South-African Rand (+0.5%) and South-Korean Won (+0.3%) are this week’s top performers. Nigeria Naira (-3.6% in EUR terms), Turkish Lira (-3.40%) and Argentine Peso (-1.2%) are this week’s laggards.
In recent years, Serbia has undergone an economic metamorphosis. The opening of 18 of 35 chapters for EU accession has resulted in structural reforms and strengthening institutions.
Prudent fiscal policy has improved fiscal balances from a deficit of 6.2% in 2014 to surpluses since 2017. Significant tax increases and reduction of the expenditures, have put public debt (56.7% of GDP) on a downward trajectory. The Serbian economy has been hit less than peers during the pandemic (-1.0%!) and the rebound is expected to be quicker as well (6% in 2021). The result is that debt to GDP (which is legally capped at a maximum of 60%) will suffer less than many other EME’s. In a world of downgrades, Serbia is one of the few with improving credit ratings.
Ivory Coast became the first Sub-Saharan African country to issue Eurobonds since the beginning of the COVID-19 crisis. Investors overlooked the political situation in the country and the issuer was able to place EUR 1 billion at 5% yield with a book on final terms above EUR 3 billion. While the question of private-sector involvement in debt relief for Lower Income Countries has been lingering since the summer, the Economy Minister of Senegal, Amadou Hott, insisted that for his country and other economies with strong fundamentals “there is no need to force any participation from private creditors. Our priority is to maintain our relationship with private investors that are key long-term partners to bridge our financing gap.”
Inflation in South Africa has picked up with 3.3% YoY in October vs estimates of 3% only, mostly due to higher food costs. As a reminder, the South African Reserve Bank left rates on hold last week and signalled that its quarterly projection model hinted at two 25 hikes at the end of 2021. However the uncertain growth and inflation outlooks made the bank signal the door is still open to easing. Meanwhile, the Treasury did surprise markets this week with a last minute cancellation of a switch auction. Markets reacted by anticipating a lack of duration supply until year end, causing the SAGB curve to flatten aggressively.
The Malaysian Prime Minister Muhyiddin Yassin must have welcomed the approval of the 2021 budget he presented to the Parliament, after facing pressure from his allies to hold a confidence vote and battling with the King over his request to declare a state of emergency. The USD 78 billion spending plan is set to be the nation’s biggest budget ever. Challenges remain though: now each portion of the bill will be analysed by the lower house, which means several more rounds of voting before the end of the year.
The narrative around the absence of opportunity in bond investments is spreading. Unsubstantiated at best, misguided at worst and in most instances such comments are delivered by non-bond market commentators. Correct returns can be realised. In order to dress up a robust and return-rich bond component investors are invited to get more detached from classic allocation schemes.
Investors should embrace the colourful, broad and developing bond markets across Asia. Within this decade China will become the N°2 bond market after the US. Bond market indices get impacted today. Active managers should embrace this moment and act accordingly.