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STATE OF AFFAIRS
It’s this time of the year that strategist teams of investment banks release their market outlook, predictions on valuations and their corresponding performances over 2021. On balance we notice a high degree of consensus. With the arrival of effective vaccines in early 2021, the US and Europe would reach high herd immunity by Q3 2021, Q4 2021 at the latest. Such optimistic path of events would percolate through markets not only over 2021 but extend into 2022. The risk-on call is loud and clear.
Across equity markets strategists expect double-digit returns over 2021 and 2022. Within credit, investors should go down in quality and pick-up some attractive spreads in long maturities. For European investment grade (IG) credit markets, deeply subordinated corporate hybrid bonds offer substantial value, confronted with a universe that sees an astonishing 36% of the universe in negative yielding territory. This corporate hybrid niche offers yields ranging between 1.5% to 2.5%. Bank T2 (dated) subordinated bonds come second in line. Overall strategists see IG corporate bond credit spreads tightening by another 15 basis points (bp) to 30bp. The search for yield would be sustained over 2021. Such positivity spreads towards the high yield (HY) sector where spread compression ranges between 60bp to 90bp. Small positive returns are expected for IG credit, whereas HY might reach for a 5% return goalpost. The all-important core government rates would rise and make for a difficult 2021. With somehow more divergent views on average, we should expect that 10-year government rates finish 2021 well above their forwards 1 year out that sit at -50bp for 10y Bunds and around 1.00% for 10y US rates. Consensus put 10-year Bunds around -30bp versus 10-year US rates at 1.20%, meaning these reference rates would rise by about 30bp from last Friday’s closing levels. That would push total returns for EMU government bonds over 2021 down between 2% and 3%, depending on the behaviour of Southern EMU government bonds markets. A similar fate would befall the US Treasury market. Emerging market (EM) government bonds would stride in the path of higher yielding credit and aim for positive mid-single digit returns. The best thing about consensus is that one can hide and feel protected by the call of the majority.
However, the stark and sobering reality is that we cannot predict the future. Essentially, above analyst predictions allow us to assess how strong or weak convictions are coming through. It also, in reference with what I wrote last week, shapes the strength of the underlying trend and the robustness of the positive or negative bias. Above calls are built on the belief that, over 2021, central banks will continue to push the right amount of liquidity into the financial system that would inflate financial assets even more than has been the case over 2020 and over most of the past decade. Such (great) results are always achieved as credit, portfolio rebalancing, exchange rate and consumption-investment channels are kicked into higher gear. This channel cocktail should lead to higher growth and higher inflation and inflation expectations. However as Yogi Berra once stated: “In theory, there is no difference between theory and practice. But, in practice, there is.”
It is right here that I want to list the Known Unknowns that we face over the next quarters. We also venture into the Unknown Unknowns. Pure guess work, but an essential exercise in order to increase portfolio robustness. For each of the below bullets one can attach probabilities. Markets are built on aggregate weighted probability frameworks.
The known unknowns stack up as follows (not exhaustive):
The Biden-Trump transition period. When will Trump concede? Can we expect a smooth handover? What is the importance of the Georgia run-off elections on 2 US Senator seats? Do we follow the split Congress consensus, or is a Blue Sweep still a possibility? What will be the set of policy priorities of a Biden-Harris administration? Does he surprise with an early higher taxation plan for corporates?
Can we expect the FED and the ECB to surprise markets with higher than consensus increases of larger scale asset purchase programs? Will the backstop in credit purchases become less prevalent than the support for government and supranational paper? How will markets welcome Next Generation EU new bond issuance?
How will markets welcome a hard Brexit versus a light Brexit outcome?
How will markets react on ECB policy review results? Will the BoE adopt a negative interest rate policy over H1 2021?
Will the economic growth recovery path be as steep as consensus is pencilling in today? Will the administration of vaccines shift human behaviour towards pre-COVID times?
How will EM economic recovery fare given an uneventful 2021 election calendar?
The unknown unknowns might disturb or surprise (I invite the reader to think the unthinkable):
A surprisingly rapid or disappointingly slow vaccination administration process that shifts consensus growth recovery templates.
The political gridlock in US politics increases the political divide and polarisation across the US population with continued social conflict and uprisings.
Surging climate-related natural catastrophes
(Escalating) military conflict across the current global hotspots: Middle East (Iran-Iraq-Syria-Lebanon), South China Sea, India-Pakistan, Turkey, South America…
Increasing terror activity across the EU and Africa…
Increased tension in the EU as member states such as Poland and Hungary ponder exit
Political leaders adhering to populist agendas rise in the charts and fragilise democracies.
US Treasury markets performed solidly over the past week. We witnessed an aggressive bull flattening. 10-year rates dropped 7bp towards 0.825%, whereas 30-year rates dropped an impressive 13bp, closing at 1.52%. Twice over the past 6 months, we have observed healthy US Treasury interest the moment 10-year rates approached the 1.00% handle and 30-year rates the 1.75% marker. US inflation expectations are in a consolidation pattern. We do not expect a lot of change over the next quarter, although, from a historical perspective, US TIPS are cheap.
European government bond markets surfed on the positive windfall from US rates. The sector added 35bp to the performance tally, jumping towards 5.02% YtD. The fact that the EMU government index sits in negative territory is not scaring investors away from the sector. The portfolio insurance value combined with the still-attractive yield curve steepness to be found in Southern EMU country yield curves refrain investors from orphaning the European government sector.
European IG corporate bonds really sound like a broken record. The Iboxx index continues to surprise adding another 31bp to finish at around 2.50% YtD. The optimism expressed for 2021 is already having an influence today. The promised good times over 2021 are becoming reality today. Primary issuance that hits the market is placed without much effort. High demand is leaving little new issue premium to be harvested.
The Christmas rally has started for European HY. Over the week another 0.79% brings investors towards a correct 1.09% YtD result. The iTraxx Crossover index closed at a spread of 282.5bp. One starts to wonder if HY investors want to tackle the 225bp spread levels seen over January and February before year-end!
Another good week for EM, despite stable spreads. Local currency spreads (GBI-EM), traded at 368bp (+1bp). Hard currency Investment Grade is now at 205bp (-1bp) and Broad Hard currency (EMBIG) at 411bp (-1bp). Sub-Saharan Africa spreads in Hard currency tightened 2bp to trade at 640bp.
The gains are in currencies, with the JP Morgan Emerging Markets Currency index firmly above 56.00. We repeat that the Biden-Harris win and the positive news on vaccine effectiveness are two important catalysts for performance. The former will be positive for currency volatility, the latter might be positive for global growth. EM FX volatility has decreased from 12.00 to 10.25 since election day and is well on track to return to its 2015-2019 range between 6.00 and 8.50. Brazilian real (+2.6% in EUR terms), Russian Rubble (+1.5%), Peruvian Sol (+1.5%) and Mexican Peso (+1.0%) are the winners; Pakistan Rupee (-1.6% in EUR terms), Ukrainian Hryvnia (-1.5%) and Nigerian Naira (-1.4%) are the laggards.
Finally, the Central Bank of the Republic of Turkey did meet market expectations with an orthodox rate hike of 475bp to set the one-week repo rate at 15%. In addition, the bank said that all funding will be provided via this facility going forward. This is a step in the right direction, but, if we consider the weighted average cost-of-funding provided by the bank prior to the decision (14.8%), the move seems less impressive and probably not sufficient to help provide disinflation and solve huge external imbalances. Given the current consumer price index YoY is around 12% and expected to increase in Q4, real rates seem way too low to help cure the Turkish New Lira from capital outflow pressure. In our view, this show of goodwill looks like a desperate attempt from authorities to prevent a balance of payment crisis. They might also be trying to capitalise on this show and the current improved global risk sentiment to come tap the Eurobond market sooner than later, driven by their thirst for FX funding.
Indonesia and the Philippine central banks did surprise markets by cutting their respective policy rates by 25bps. The cuts were not totally unexpected, but many economists were expecting them to happen in 2021. It seems like an opportunistic move from the banks to take advantage of recent currency strength and improved confidence towards EM local assets. Those cuts will boost their domestic economies, which are still struggling and recovering to pre-COVID levels. This cut will also lessen the cost of burden sharing for the Bank of Indonesia.
Apart from Zambia, which became the first African country to default on its Eurobond payment since the COVID-19 crisis, and Ethiopia, due to the Tigray conflict, SSA credit enjoyed a strong week, as investors are increasingly seeking for high spreads and laggards in the HC sovereign credit space. We’ll closely watch the G-20 meeting this weekend, as we are awaiting further clarification on debt reliefs (DSSI+). The fact that China has allowed the suspension of USD 1.35 billion worth of debt service payments from 23 African countries is a step in the right direction that should help the good momentum in SSA credit.
In terms of supply, EM debt funds saw the strongest week on inflows this year according to Morgan Stanley Research and based on EPFR data. The inflows were equivalent to USD 3.55 billion, with local currency inflows outpacing hard currency, which confirms the increasing appetite investors have for EMFX. EM issuance picked up as well, the YtD sovereign supply is now above USD 200 billion, with notably Mexico, China and Uzbekistan tapping the market.
2020 is coming to a close. We can expect that market activity and volatility will start to dwindle over December. Central banks will finish 2020 as they started, translated by their strong resolve and confidence that all will get well. However, above lists should keep investors awake behind the wheel. The list of known unknowns is getting longer and longer. In fact, the growth in known unknowns is linear to the growth of central banks’ balance sheets.
The unknown unknowns will keep the uncertainty premium high across 2021 and beyond. Our world is not becoming less complex. On the contrary, the US elections have, once again, clearly shown that the divide between facts and fiction has become uncomfortably blurred.