DPAM Blog

VALUATIONS

• • A destabilising hiccup in US rates kicked off 2021. Over the first week, US 10-year rates rose by 20bp from 0.91% to 1.11%. The US treasury curve bear-steepened aggressively as 30-year rates spiked 23bp closing at 1.875%. US 2-year rates barely moved adding 1bp closing at 0.13%. Comparing what happened in US real rates leads to an almost opposite result. 2-year real TIPS rates dropped a whopping 21bp, closing at -1.98%. 10-year real rats rose about 10bp (or half the number inflicted on 10-year nominals), finishing at -0.97%. 30-year real rates rose by 15bp for a -22bp reading on Friday. A very rare market movement was witnessed over the past week i.e. we observed an inversion of the inflation break-even rates curve. The US bond market has and is prepared for a bout of higher inflation prints over the next 2 to 3 years. Our key value indicator for US bonds is the 10-year US Treasury rate 5 years forward. This indicator plotted at 2.04% before the weekend. With FED policy rates at the zero lower bound over the next 3 years, we detect value in 10-year US notes. QE taper discussions can be labelled as noise.

• • The German bund market resisted the US rates sell-off well, adding a mere 5bp on the 10-year point to close at -0.52%. The ECB balance sheet anchor is even stronger than the FED’s. Italian, Spanish and Portuguese 10-year rates were oblivious to the pressure and closed unchanged or lower by Friday. The Italian 10-year rate prepares to test the 100bp spread level to 10-year bunds closing at 104bp. 10-year BTPS dropped 2bp towards +0.52%. The Portuguese debt agency informed market participants that 2021 borrowing requirements would be far below market expectations. The 10-year PGB’s finished 4bp lower on the week at -0.02%, pulling away from 10-year Spain going out at +0.04%. The strong EMU rate convergence trend is not abating. The start of the Next Generation EU funding program in 2021 might be a catalyst that strengthens this trend. European inflation expectations received a solid lift as well. European vaccination programs must gain speed fast in order to limit disappointment. European integration (now ex-UK) grew over 2020. A successful EU inoculation process should be the top priority for the European Commission and European leadership.

• • European investment grade (IG) and high yield (HY) credit markets got off to a robust start relative to EMU government bonds. Over 2020 EMU government bonds beat European credit markets by a large margin, returning +5.15% versus +2.73% for both IG & HY sectors. Carry will have the difficult task in credit sectors to deliver the bulk of returns. Further spread-tightening in the European IG and HY sectors will require unabated ECB purchasing in the former and robust interest by institutional investors in the latter.

• • Emerging markets (EM) will continue to benefit from a powerful monetary and fiscal stimulus. They will lead the gradual recovery from the pandemic. Financing capacity and fiscal buffers will be the crucial factors for country selection.

• • EM’ debt levels have been affected by a combination of negative growth and the need for higher spending. Debt to GDP ratios have risen, but remain well below developed markets debt levels. A decreasing risk premium, a low rate environment and a weaker USD will lower the debt servicing costs for many EM economies. Notwithstanding the potential problems with vaccine availability and the challenging distribution of the vaccines in some countries, growth is expected to outpace developed markets growth during the recovery. Structural improvements in Central Bank credibility, combined with a shift towards fiscal consolidation contributed to a better convergence of long-term inflation expectations to the target, despite the negative impact of Forex (FX) pass-through last year.

• • ‘Low for Longer’ makes EM sovereign debt an attractive solution. A well-diversified portfolio invested in local currency bonds with an average IG rating yields around 5% today, far more than investments in US or EUR government bonds, IG credit and even HY credit. From a historical perspective, absolute yields and spreads are close to the bottom. However real yields and spreads in local currencies are still at very attractive levels. Looking at the ratio of local currency yields to US treasury yields rather than spreads, we are still some 50bp above the highest level witnessed during the global financial crisis! We expect this risk premium to come down further.

• • ‘A weak USD is good for EM FX’ is a general truth. There is indeed a compelling relationship between the value of the USD and EM FX. We believe that the bulk of easing is behind us, that growth will gradually pick-up and that FX volatility will return to its longer-term average. That is why we believe that EM FX will perform well. We do not adhere to a scenario of extreme USD weakness given its safe haven and reserve currency status.

• • Countries with high primary deficits, weak fiscal buffers, high debt levels or high debt servicing costs, will be vulnerable. Some countries have shallow local markets and have to rely on external financing while re-financing needs are at record high levels. They might face execution risks. That is why country selection is more important than ever before!

• • The Blue wave scenario finally played out and triggered a rise in US Treasury yields. The JP Morgan Emerging Markets Currency index slipped back below 58 to 57.77 (-0.26% during the week). The worst performers in EUR terms were South African Rand (-4.20%), on concerns over a new lockdown and adverse seasonality effect and Brazilian Real (-3.20%), on concerns regarding fiscal deficits after President Bolsonaro said it was not his fault the country was “broke”. The Polish Zloty was one of the best performers (+1.13%), despite comments from members of the Monetary Policy Council last week, signalling weaker currency ahead and possible rate cuts.