DPAM Blog

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.

• • …