19 OCT

2020

Fixed Income

Markets remain on high alert

 

Although global financial conditions have eased in recent months, markets remain on high alert as the economic outlook hinges on the uncertainty from COVID-19, Brexit negotiations and the upcoming elections in the US and Germany. Other downsides relate to the rise in trade protectionism and further estrangement between Washington and Beijing. To keep volatility at bay, coordinated monetary and fiscal stimulus remains critical. To ensure sufficient liquidity and smooth financial conditions, the European Central Bank kept its accommodative stance unchanged at its last monetary policy meeting on 10 September 2020. However, with the virus returning in a second wave, we can expect the ECB to add further stimulus. 

In the United States, economic activity is starting to recover, with the unemployment rate decreasing to 7.9% in September, marking a 6.8% decline from its peak in April. However, income support measures from the government have expired and the substantial drop in personal income for American households could undermine the pace of recovery. House Speaker Nancy Pelosi and Treasury Secretary Steven Mnuchin raised the prospect of a new stimulus package but disagreements on key areas remain and a deal is far from guaranteed. Meanwhile, President Donald Trump and Democratic nominee Joe Biden had their first presidential debate, as the US election heated up. A clear victory for either candidate will provide a certain stability and support for markets.

With the volatile macro environment, fixed income spread products suffered slightly, with both European and US high yield seeing negative returns over the month of September, though the EUR investment grade segment posted a positive performance. Peripheral sovereigns were the big winners as yields dropped on the back of the ECB’s bond-buying programme. The EMD recovery faltered in the second half of September on a sharp rise of concerns over another COVID-19 wave in Europe and uncertainty around the US elections. Oil traded in line with the higher risks against a solid fourth quarter rebound while industrial metals retained a positive trajectory. The settlement of Argentina and Ecuador's debt restructurings was met by a wave of position reductions, leading to the weaker monthly performance of both credits. The re-escalation of the Nagorno-Karabakh conflict between Armenia and Azerbaijan raised uncertainty in the Caucasus. 

Neutral on US rates; positive on European rates

We believe that the recent actions of the Federal Reserve (including the desire to raise the average inflation level target) will lead to a steepening of the US curve. Furthermore, a Biden victory will support the potential economic recovery, as a stimulus package would be more likely. In this context, yields could move upwards and, as a result, we have moved towards a more neutral stance on US rates.

With this in mind, and in light of the significant geopolitical risk and volatility facing the markets, we believe that the safe-haven characteristics of US treasuries will keep rates from moving upwards too sharply and hence we continue to monitor the situation closely.

On the other hand, other rates on the dollar bloc do seem interesting, as we hold a slightly positive stance on Canadian and New Zealand rates. The Canadian sovereign curve appears to be relatively steeper and benefits from the willingness of the central bank to adopt a dovish framework, while New Zealand benefits from a supportive central bank that will increase its QE programme in a bid to keep the cost of debt financing low. A similar story of an accommodative central bank appears in neighbouring Australia, where rates are at slightly more attractive levels.

In Europe, the COVID-19 risk continues to rise as second waves continue to unfold across regions. Countries like Belgium, France and Spain are seeing significant spikes leading to enhanced measures and partial lockdowns. New restrictions will likely be announced across countries in the coming weeks, challenging further the already slow and fragile economic recovery. On the inflation front, headline and underlying measures of inflation have softened considerably in recent months, leading inflation expectations lower and challenging the inflation outlook put forward by the ECB. While the ECB firepower (in the form of APP and the increased PEPP) has been an important driving force behind the low levels of core and non-core rates, markets are expecting further actions by the Bank to offset the broad-based nature of the inflation slowdown. We expect a further increase and extension in the PEPP to be announced in December, to offset the impact of the second coronavirus outbreak and weak inflation dynamics. Core rates are still at extremely low levels, though it is clear that no increase in rates is to be expected in the near term. However, the purchases, well below capital key, of France in the PEPP programme could also reverse partially in the coming months, supporting French spreads. Non-core rates also continue to be supported not only by the ECB’s monetary policy but also by the increased European solidarity. While major economic risks remain, the resulting European recovery fund, with its sizeable grants, is clearly positive for non-core countries. Supply will be supportive for the remainder of 2020. Positioning, however, remains a negative driver, as long positioning remains high on non-cores, but to a less extreme extent than in the past. Political event risk in Italy has further receded, as local elections in six major Italian regions delivered an unexpectedly positive result of 3-3 for the ruling centre-left party PD vs the centre-right opposition coalition. In this context, we are maintaining our positive view on Italy and Portugal, while reverting to neutral on Spain. On a relative basis, valuations are less attractive, while a further resurgence of COVID-19 cases could leave Spain particularly vulnerable on the economic front. Agreeing on the 2021 budget will also be challenging, given Spain’s minority government. The short-term outcome of the EU-UK negotiations continues to be uncertain. While our base case remains a deal by year-end, the probability that an agreement will be reached could be challenged further in the near term, temporarily fuelling market concerns. We therefore prefer to tactically reduce our sovereign Brexit-sensitive Irish positions, given the good relative performance seen on Ireland since March versus core countries.

 

Developed Market Currencies: Neutral USD

Our proprietary framework continues to point towards a negative view on the US dollar, on the back of twin – rising – deficits. Furthermore, with rising political uncertainty in the US, and a real rate differential that no longer benefits the USD (vs. the EUR), the greenback appears to be in peril of losing its safe-haven status. The Fed’s rate cuts, QE program and dovish stance also point towards a weaker dollar. However, in the context of a possible risk-off scenario surrounding the US elections, we feel that the USD could see some strong volatility. In this context, we prefer to have a tactically neutral position on the US Dollar, which we continue to monitor carefully. As we believe the Yen could also be an interesting safe haven to hold in the current context, this justifies our long position on the currency.

With the New Zealand central bank easing, we believe that the Kiwi is likely to weaken, especially since the twin deficits appear to be weak. In this context, we hold a slightly short position on the NZD. 

 

Credit: Favouring European credit markets over US

Euro IG: Although we maintain our favourable view on the European credit investment grade asset class, we continue to closely monitor idiosyncratic risks and exercise a high level of selectivity. Valuations have retraced somewhat over the past 3 months but still appear to be at fair levels. The ECB’s strong QE programme has resulted in the central bank owning 20% of the eligible IG universe, of which, by year-end, it could own close to 40%. With such an important backstop, technicals are receiving strong support. However, we are paying special attention to the risk of downgrades (and fallen angels), which, we feel, are quite high on IG markets, especially since rating agencies are more active than in the past. Company fundamentals are deteriorating and, in spite of the de-confinement, social distancing is likely to challenge business productivity and consumption, in general.

Euro HY: The asset class should be supported by a-still attractive BB carry in a low-yield environment, and supply is not an issue, as companies are relying more on bank loans than on capital markets. Default rates are clearly expected to rise, though central banks and fiscal measures have been delaying this. The carry of the asset class remains a source of support. We are slightly overweight the asset class, while favouring selectivity.

US IG: The Federal Reserve is in the midst of its bond-buying program and still providing the much-needed backstop. But it is also fuelling investors’ appetite for risk and hence the strong level of supply is well absorbed. We are temporarily slightly overweight the segment. However, spread-tightening now seems limited, as we cannot exclude some volatility ahead of the US elections and the impasse on the US fiscal plan. We hold a preference for the short end of the curve, where break-evens are at more interesting levels.

Finally, we think € Convertibles should benefit from positive dynamics such as the coordinated action from the EU Next generation recovery fund, positive surprises/better visibility from quarterly results, less political noise than in the US and a partial economic recovery of China.

EMD China: We hold a positive view on Chinese sovereign bonds, where real yields are quite attractive, and the economic recovery does appear to be remarkable. Following the inclusion of the asset classes in the index, it has been supported by strong flows from foreign investors.



 

Emerging Markets: Constructive on the medium-term outlook

We retain our constructive medium-term outlook as the global economy extends its recovery into 2021, vaccine announcements suppress health risks globally and core rates remain low. Over the next 12 months, we expect hard currency debt to return around 9.3%, assuming a 10-Year US Treasury yield of 1% and EM spreads at 350 bps. We continue to expect oil prices (Brent) to remain stable, at around $40-$50, as the supply overhang gradually clears and global demand recovers towards mid- 2021.

Despite the reasonably positive medium-term backdrop suggested by our Top-down assessment, we have also noted that the external risks of an extended period of uncertainty around a contested US election or tighter lockdowns in a second COVID-19 wave are high, and may result in a deep asset class correction. We remain flexible and ready to adjust market exposure up in line with our medium-term recovery view if neither of these tail risks materialize.

We remain constructive on the medium-term trajectory of oil prices as we believe that they have probably bottomed, with supply and demand conditions having seen some improvement since May 2020. Some of the excess oil supply is expected to clear following OPEC’s production cut of 9.7m bbl/day announced in April, the additional temporary cut of 1.2m bbl/day from Saudi Arabia in late May and the forced closure of approximately 2m bbl/day of US shale capacity. At the same time, the exit from containment strategies globally is expected to lead to some increase in the demand for oil. While we do not expect the oil market supply and demand imbalance to be cleared before mid-2021, or oil prices to recover substantially above $40, we think that oil-price stabilisation is a constructive development for hard-currency EMD. Given the elevated near-term uncertainty, we prefer to retain oil exposure through higher-rated issuers like Kazakhstan, Qatar and the UAE, while reducing exposure to lower-rated issuers like Angola, Ecuador, Nigeria and Pemex (Mexico). 

Our September Top-down meeting resulted in the following conclusions 

We updated our Top-down global market and broad asset class assessment in mid-September, acknowledging favourable financial conditions with ample global liquidity, supportive developed-market central-bank policies and a constructive view on commodities (Oil, Industrial and Precious Metals, and Agricultural products). We also noted a broadening Chinese and EM economic growth recovery and extended stabilisation of asset class flows. While our financial conditions score was unchanged, we slightly upgraded our EM fundamentals score on stronger growth and external sector outcomes. The economic data in EM started to surprise on the upside, in line with our view that positive surprises are likely to follow the negative surprises of earlier in the year. We upgraded our EM external sector balances score, having noted overwhelming evidence of positive current account and trade balance trends and an easing of liquidity conditions across EM countries. Previous concerns over EM debt sustainability have also been partially resolved as primary markets have so far this year accommodated close to $179bn of gross supply, with only around $45bn gross ($10bn net) left to fund until the end of the year. EM flow momentum remained positive in September (EMD HC inflows of $5.4bn in September, bringing the YTD total to -$10.1bn), reducing somewhat the potential risk of asset class outflows for the year as a whole. The outflows experienced so far this year have been concentrated in local currency EMD, while hard currency debt has recouped $19.3bn since the end of April 2020. Despite the supportive flow momentum till September, we noted that HC Technicals are neutral, as HC sovereign positioning is at an uncomfortably high level and gross supply is likely to restart in the autumn in line with seasonal trends. We noted that HC valuations are less attractive on an absolute basis but remain attractive relative to DM credit from a medium-term perspective.

Despite the reasonably positive medium-term backdrop suggested by our Top-down assessment, we also noted that the external risks of an extended period of uncertainty around a contested US election or tighter lockdowns in a second COVID-19 wave are high and may result in a deep asset class correction. We remain flexible and ready to adjust market exposure up in line with our medium-term recovery view, if neither of these tail risks materializes.

The differentiation between higher- and lower-quality and more vulnerable issuers is, in our view, likely to remain pronounced in the near term. As our near-term strategy is to continue to rotate exposure away from expensive or vulnerable HY issuers, we have explicitly de-risked the strategy ahead of the US elections towards a beta of under 1.2 from a beta of 1.35. The risk reduction spans African and Latin American oil-sensitive credits like Angola, Ghana, Nigeria, Ecuador and Pemex, higher beta credits with elevated political and policy risks like Ivory Coast and Ukraine, and mid-beta credits with somewhat extended valuations like Brazil and Colombia. We have covered underweights in higher-rated IG or BB issuers (Dominican Republic, Romania, Panama, the Philippines). At the same time, we will be retaining exposure to distressed EM credits from Argentina, Suriname and Zambia, amid expectations of higher recovery values. As recovery values are realised, we shall re-assess position sizes on the basis of the balance between fundamentals, valuations and technicals.

Our strategy’s largest overweight positions are concentrated in HY credits with attractive valuations and idiosyncratic drivers with limited funding risks like the Bahamas, Brazilian corporates (Braskem and Petrobras), Dominican Republic, Costa Rica and Egypt, and attractively valued IG credits like China, Indonesia and Romania. On the other hand, the strategy is underweight predominantly what we regard as overvalued IG credits exposed to US Treasury corrections (Malaysia and Peru), as well as Russia and Saudi Arabia, where, we believe, current valuations have been extended relative to headline, geo-political and ESG risks.

We retain a 7.5% (0.2 year in spread-duration terms) asset class protection position in the Markit® CDX Emerging Markets Index as a hedge against the near-term volatility caused by the slower exit from lockdowns and the resurgence of new coronavirus cases, as well as a contested US presidential election result..