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STATE OF AFFAIRS
Before diving into the ‘Secular stagnation’ theme of this weeks’ letter, I want to direct your attention to a report ‘Task Force on Financial Stability’ that was issued by the Brookings Institute on Tuesday, June 29. I addressed some of the risks that feature in their analysis in the Fault Lines letter of last week. In short, co-chairs Glenn Hubbard and Donald Kohn express concern about the frailties of non-bank finance in general, and the provision of credit through markets specifically. With historically low interest rate levels that might persist for longer, excessive risk-taking is induced. This raises the probability of financial instability disruptions, resulting in adverse effects on economic activity and employment. They call for the adoption of the financial stability mandate by a broader range of public institutions (read ‘regulators’). Today, only the FED holds market stability as a key objective. A host of regulators are called upon to rank or push financial stability higher on the agenda. Regulators should adopt a dynamic approach, rolling out ongoing assessment processes, instead of falling back on periodic, static snapshots provided by asset managers and owners (pension funds, insurance companies, sovereign wealth funds…). They point to the importance of regulatory processes and procedures that can spot future risks as well as remediation actions in order to prevent a potential fall-out. In asset management, most mutual funds provide for daily liquidity. That has often led to negative externalities in moments of stress, as market infrastructure cannot cope with the demand and forced requirement for liquidity. So, not all funds should have daily liquidity and opt for longer (weekly, monthly…) liquidity windows. Swing pricing on funds’ Net Asset Values should steer the behaviour of fund selectors. Potentially, fund managers might have to bear higher costs when engaging for liquidity during market upheaval, as sell-side market makers cannot absorb too much risk on their books. Next to addressing Treasury market resilience and mutual fund liquidity, the report comments on better oversight of housing finance and a larger adoption of central clearing counterparties (CCP’s).
Secular stagnation is a term that has a long-term anchor. It refers to a state of little or no economic growth as a result of an increased tendency towards saving and a persistent lack of investing. Secular stagnation becomes engrained the moment government fiscal policies (government spending & investments) lack aggressiveness. When discussing this theme, one should not look at the aggressive fiscal programmes that are currently in place nor at the growth estimates over 2021, 2022 or even 2023. We deal with outcomes over the next decade. Clearly, unconventional fiscal policies are required to combat the effects of a global health crisis, as are unconventional monetary policies. There is broad-based consensus on the positive effects to protect employment and demand over the short-term. Accommodative monetary policy is required in order to close output gaps as well as prevent the disinflationary forces that have been in place over the past two decades from taking root again. But the secular stagnation thesis is assessed over decades, not years. However, it does limit the breadth of potential scenarios and cuts off a return to long-term rate levels that were in place in the era before the GFC of 2008-2009.
The key indicator and guide of the secular stagnation paradigm lies in the presence and persistence of negative long-term real rates. Developed market (DM) real government rates convey secular stagnation. With 10-year real government rates around -1.60% in Germany, -0.90% in the US, -1.50% in Sweden and -2.66% in the UK market, investors should track and monitor these levels continuously. The level of long core DM real rates is a major input factor in valuation models across asset classes. As stated in previous letters, inflation expectations might be taken as a residual. The moment the QE instrument became widely adopted as the main monetary policy instrument (around 2015), the move towards deeply negative real long-term rates accelerated and became persistent. The only exception so far has been Japan. Accumulating aggressive fiscal programs, one after the other, greatly improved the Japanese infrastructure and overall welfare, but ultimately led to the demise of inflation expectations and low inflation prints dotted around the zero line. Japanese indebtedness (debt/GDP above 225%) was not and is not a major worry, as most of the Japanese debt is held domestically. The introduction of explicit yield curve control back in September 2016 drove 10-year inflation expectations from an already-poor 50bp all the way to zero making a low at -0.35% over March 2020. Today, mimicking the move of most DM markets, Japanese 10-year inflation expectations recovered by about 65bp, but sit at a disappointing 30bp. Under a scenario where the Bank of Japan succeeds in their efforts to take inflation towards 2.00%, we might see 10-year real Japanese rates converge to levels currently witnessed in Germany (i.e. -1.60%). The point I make is: ‘yes, Japan did improve its infrastructure through intense investing. However, this did not lead to improving inflation data’. I wonder how base effects will play out over Q2, Q3 2022…let’s hope we still print around 2% in the US. The surprise outcome might be closer to 0%.
At this juncture in the economic recovery, the demand for safe assets is well intact. Savings still find their way into public risk-free government bonds and high-quality credit, be it investment grade (IG) or high yield (HY). The share allocated to private debt and infrastructure debt is steadily grinding higher. Regulation impacts & steers banking investment books into 0% risk-weighted government bonds. Regulation has cemented fixed income allocations by (re)insurers well above 90%. Sovereign wealth funds scratch each other’s backs by allocating important portions towards sovereign and supranational local and hard currency debt issues.
The current mix of geopolitical, climate and societal risks at large strengthen risk aversion. Morphing from a secular stagnation paradigm into a more investor-friendly and ‘growth’-oriented long-term business cycle will require heavy lifting. Critics or doubters of secular stagnation contest the exaggerated savings argument. Cynically enough, they point towards government regulation and fiscal intervention as the main cause for secular stagnation. Apparently, most roads lead to a similar outcome.
US Non-Farm-Payrolls coming in above expectations at +850,000 did not derail a strong US Treasury market. 10-year rates finished at +1.425%, down 10bp over the week. The unemployment rate at 5.9% disappointed. Lack of labour participation improvement is becoming a serious headwind. The fabric of the US labour market is changing. Challenges outpace opportunities. As a result, the UST yield curve added another bull flattening push. 30-year rates lost 11bp, ending at 2.04%. Positive momentum is intact and an attack to break below the 2.00% level is only a matter of time. Especially against a background of higher highs in US equity markets. The US TIPS market is in good shape, as investors felt well-insulated over H1 2021. The second half of the year will be less comforting, as inflation prints most probably start to plateau into year-end.
A robust performance in US rates markets inspired EU government bonds. We pencilled in the best week of 2021 with total returns at +0.84%. That pushes the YtD marker towards -2.84%. Manageable for sure, as, since the end of 2019 or on 1.5-year horizon, investors advanced by 2.17%. 10-year bunds dropped 8bp towards -0.235%. Italian 10-year rates saw a strong staging, ending the week at 0.77%, down 15bp. Expect more EMU rate convergence. We noted that the NGEU (Next Generation EU) funding program would put the brakes on the convergence trend. However, investors correctly focus on the destination that reveals more fiscal solidarity among Eurozone countries.
European IG & HY are confronted with the law of diminishing returns, as the grind in credit spreads continues. When the IG credit universe posted a +32bp result over the week, settling for a YtD result around -0.52%, we noted a mere +2bp for HY. European HY already boasts a +3.03% result since the start of 2021. Positive technical demand-supply conditions keep most investors at ease. The summer might be boring and just the perfect set of conditions for corporate bond investors. Unless the Q2 earning season spoils the party.
No clear direction for Emerging markets debt this week. Returns of local debt in EUR have been slightly positive, while the strength of the US Dollar has weighed on returns in USD terms, with a slight increase in FX volatility to 8.68%. Local yields have decreased by 4 bps finishing at 5.00% for the JPM GBI-EM GD index. Spreads of hard currency debt (JPM EMBI GD Index) have increased by 3bps to 339bps over US Treasuries, mainly led by a rise in the credit risk premium of HY components.
The Constitutional Court of South Africa found former President Jacob Zuma guilty of contempt and sentenced him to 15 months in jail. However, it has been reported in the press that Zuma will file an urgent application to block his arrest. While the incarceration would demonstrate the current administration’s commitment to upholding the rule of law, it could trigger divisions within the ANC and unrest in his home province of KwaZulu-Natal. This week also, the country raised the social restrictions to level 4, as the 7-day average of new infections is close to overtake the peak seen during the second wave in January. Gauteng province, the economic hub of the country, is particularly hard-hit, with bed occupancy exceeding 90%. While this will slow down the pace of recovery, some officials from the SARB don’t see current measures derailing it and stated the bank could revise its 2021 growth forecast upward due to a stronger Q1. The market seems to be sharing this view, as the implied pricing of policy rates has moved upward this week and is now hinting at more than two 25bp hikes by the end of 2021. Also, recent comments from the SARB about debating a tighter inflation range might have helped push front end rates higher.
This week marked the 100th anniversary of the Chinese Communist Party which has been the occasion to emphasise the importance of the Party in the country’s destiny, with Xi Jinping being called the “People’s Leader”. On the economic side, data released for May showed a deceleration in Chinese growth momentum, especially through a disappointing consumer recovery with a large miss in non-manufacturing PMIs at 53.5 vs 55.3 expected. Chinese stocks have lost ground since the celebration, as the PBoC tightened the interbank funding environment quarter-end.
Pulling away from secular stagnation market conditions will not be easy. Intensifying regulation next to lingering doubts around fiscal multipliers backing government investment programs are two factors that require scrutiny by investors in order to construct balanced portfolios. Deeply negative real long-term rates are one of the most important market indicators to monitor. The moment they show genuine tendencies to move up towards 0.00%, markets will become highly volatile.
Risk aversion is here to stay. The multi-polarity of the world economy is driven to a state of constant alert, readiness or tension. That will keep investors flocking towards genuine risk-free fixed-income markets irrespective of the level of rates.