17 SET

2020

Rendito fisso

Not a V, but a K, recovery?

 

The summer was quieter than expected in terms of market movements, as better economic data trickled through amidst a COVID-dominated environment. In spite of re-openings (whether appropriate or not), active social distancing and lower death levels, August certainly saw a rise in COVID cases across Europe, US and the Emerging world. Though the second wave was projected to occur closer to year-end, recent data suggest that it could be much sooner as cases rose amidst the holiday season, while hopes of a vaccine before year-end are still alive. This, along with the substantial monetary and fiscal support, contributed to a small rebound in our activity cycle index (with the US showing a more pronounced uptick and economic surprises leading the way. We still remain far from pre-crisis levels and a V-shaped recovery has certainly not been witnessed in developed economies, though central bank and fiscal support have provided some relief, particularly in the US and EU The month of August was marked by the fact that the Federal Reserve added yet another “easing” ripple by announcing a substantial policy shift during the Jackson Hole symposium. Indeed, Jerome Powell indicated that the Fed was willing to seek inflation that averages 2% over time, strengthening the forward guidance and ultimately keeping rates at low levels for a longer period of time. 2020 was marked not only by the COVID crisis but also by the sharp fiscal and monetary reaction, and the Fed’s recent announcement is yet another example of the many tools that they can use to keep rates lower. One can wonder about the choice of targeting inflation after having failed to generate sustained inflation in the past (in spite of more than a decade of low rates, liquidity injections, QE and tax cuts) in the context of record levels of debt – structurally, a powerful disinflationary force. With the alphabet soup of probable recoveries (V, W, L, etc), a new form has emerged. A K-shaped recovery would best describe the current situation as, after the sharp down leg, we saw an incomplete recovery, and subsequent bi-furcation resulting in two legs. There are, on the one hand, the winners (long duration high quality developed sovereigns, non-cyclical defensive credit sectors, and IG EMD sovereigns) that are benefiting not only from the quality bias but also from their ability to adapt to the new trends (digitization, climate change, etc.) while, on the other hand, there are losers (high-yielding EM countries, oil exporters, auto and other cyclical credit sectors).In Japan, the news of Shinzo Abe’s departure has raised questions on whether his successor will continue Abenomics and match the innovation and momentum that Abe set up. In a context where the macro is slightly improved and CB policy is highly supportive, it is important to not recognize the high level of geopolitical risks that are present. Beyond the COVID pandemic, which is far from over, the US elections loom and, with stakes being extremely high, one can expect markets to face bouts of volatility. Elsewhere, we see that Brexit negotiations have turned sour, with the significant threat of a no-deal back to the forefront, which is likely to have profoundly negative effects on both sides. 

In a context where markets are vulnerable to bouts of volatility (geopolitical risks) and increased dispersion, our selective, well-researched, rigorous bottom-up approach does seem to be essential in order to achieve our goal of delivering superior risk-adjusted returns. 

 

Positive stance on US and neutral on European Rates

Despite the positive economic surprises, we are far from a sustainable economic recovery of any form in the US. The fact that the virus continues to spread at a rapid pace in the country, which already tops the lists of the biggest number of cases and deaths, is a significant impediment to a rapid recovery. Furthermore, any significant fiscal policy is all but ruled out, with elections looming in an extremely polarised country, reflected by a Congress and a Senate that refuse to agree on much. Finally, with the Federal Reserve now having made it clear that rates will remain low, we can expect a ceiling on US rates, which will see some steepening in the wake of the central bank policy. 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 should drive our long position on the asset class. 

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 is going to increase its QE programme in a bid to keep 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, where we have seen some increase in covid cases, the virus appears to be under a higher degree of control than in the US or EM countries.  

It is no surprise that the ECB firepower (in the form of APP and the increased PEPP) is the driving force behind the low levels of core rates. As expected the ECB did not take any monetary policy decisions at it’s September meeting. The small upward revisions to growth and inflation were  perceived as slightly hawkish .  Core rates are still at extremely low levels, though it is clear that increase in rates are not to be expected in the near term. Non-core rates find favour with us as we hold a positive bias on Portugal and Italy against German rates. Peripheral sovereigns outperformed core sovereigns over May and they remain supported by the ECB’s asset purchase programmes. What is also a source of support is the European recovery fund, where we see sizeable grants to peripheral countries. Country wise we also increased exposure on Luxemburg via a green primary issue while we adopted a more prudent stance on Ireland, given the more conflictual negociations between EU and UK. Overall, our negative stance on core rates is balanced out by our positive view on non-core rates and our stance on the EUR. Duration is currently neutral.

 

Developed Market Currencies: Negative stance on USD, underweight on GBP

Our proprietary framework continues to point to a negative view on the US dollar, on the back of twin deficits that are rising. Furthermore, with rising political uncertainty in the US, and a real rate differential that no longer benefits the USD (vs. EUR), the greenback appears to be in peril of losing its safe haven status. The Fed’s rate cuts, QE programme and dovish stance also point to a weaker dollar. In addition to this, should the US economy falter as a result of the coronavirus (while the EU appears to have better results in dealing with it), the greenback could see additional declines, especially during the electoral period. In this context, we prefer to have a tactically negative position on the US Dollar, which we continue to monitor carefully.

The British Pound is likely to remain under pressure as the UK remains one of the countries to have been most affected by the coronavirus. Furthermore, the twin deficits continue to remain weak and the trade negotiations with the EU appear to be increasingly difficult. In terms of Brexit, there does not seem to be much effort made to extend the transition deadline and talks appear to be at a standstill. Finally, the Bank of England continues to maintain (and naturally so) an extremely dovish stance, which is likely to benefit our underweight stance 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 2 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 it could, by year-end, 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 deconfinement, social distancing is likely to challenge business productivity and consumption in general.

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

US IG: The Federal Reserve, in the midst its bond buying programme, is 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 temporarily hold a small overweight in the segment. However, spread tightening seems now limited as we cannot exclude some volatility ahead of US elections and the impasse on US fiscal plan. 

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 degree of economic recovery in China.








Emerging Markets: Investors’ optimism boosting the markets

EMD extended its gains into August, helped by investors’ optimism around global activity rebounds and successful vaccine trials, and despite concerns over a second pandemic wave and a US Treasury correction. 

We are now more constructive on the near-term outlook for EMD hard currency debt based on the market environment characterised by ample liquidity and good risk appetite from investors, as well as the positive outlook for commodities, the broadening Chinese and EM economic growth recovery and the extended stabilisation of asset class flows. While we retained our financial conditions score unchanged, we have become more positive on EM fundamentals. EM growth forecasts have been downgraded sharply over the second quarter and are now more likely to surprise on the upside as the global recovery expands. EM external sector balances have also improved in liquidity conditions eased in several Asian and Latin American countries. Previous concerns over EM debt sustainability have also been partially resolved as primary markets have so far this year accommodated close to $160bn of gross supply, with only around $50bn gross ($10bn net) left to fund until the end of the year. EM flow momentum remained positive in August (EMD HC inflows of $5.1bn in August bringing the YTD total to -$18.3bn), reducing somewhat the potential risks of asset class outflows for the year as a whole. The outflows experienced so far this year have been concentrated in local currency EMD (93%) while hard currency debt (7%) has recouped $17.2bn since the end of March 2020. We are more positive on hard currency sovereign debt amid a deepening recovery in the second quarter and as issuance remaining elevated. Our neutral view on hard currency debt is based on the combination of flows, supply and positioning.

We think that both absolute and relative valuations are still attractive from the medium to long term perspective. Given our more constructive stance on EM growth rebound and EM fundamentals generally, as well as our neutral technical stance, our stance on hard currency debt is also now more constructive over the near term.

We remain positive on the future trajectory of oil prices as we believe that they are likely to have bottomed as supply and demand conditions saw 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 bbd/day of US shale capacity. At the same time, exit from containment strategies globally is expected to lead to some increase in the demand for oil. While we do not expect that the oil market supply and demand imbalance will be cleared before mid-2021, or that oil prices will recover substantially above $40, we think that oil price stabilisation is a constructive development for hard currency EMD. Given the elevated uncertainty, we prefer to add oil exposure through higher-rated Middle Eastern credit issuers like Qatar and the UAE which we believe can comfortably withstand an extended period of low oil prices, as well as through a neutralised exposure to Iraq and Kazakhstan, the oil rich credit issuers which outperformed in June.

We retain our constructive medium-term outlook as the global economy exits lockdowns in 3Q and 4Q of 2020 and activity accelerates towards the year end. Over the next 12 months, we expect hard currency debt to return around 8.3%, assuming that 10 Year US Treasuries yield 1% and EM spreads at 350 bps. We continue to expect oil prices (Brent) to stabilise at around $40-$50 as the supply overhang gradually clears and global demand recovers towards the middle of 2021.

Our latest Top-down meeting resulted in the following conclusions:

Our Global Macro Score remains positive, supported by a high liquidity score and a positive view on China.

A significant development comes from a negative score on rates, although we acknowledge that pockets of value remain (Valuation score positive). In HC, the score is positive for both Sovereigns and Corporates. For Sovereigns, Fundamentals and Technicals are neutral, but Valuation positive. For Corporates, Fundamentals are slightly negative, with an expected increase in the default rate, but Technicals and Valuations are very supportive. EMFX has the highest score- +0.49. Fundamentals and Valuations are supportive, the only headwind coming from increased USD short positions (and a neutral Technicals score).

 

 

Hard Currency 

EMD HC (0.51%) extended its recovery in August, on optimism around global activity rebounds and successful vaccine trials, and despite concerns over a second pandemic wave and a US Treasury correction. The positive oil (4.6%) and industrial metals momentum (Copper/Iron ore up by 4.0%/12.0% on the month, respectively), and the weak trade-weighted US Dollar (-1.3%), enhanced the constructive environment for EM risk. Argentina followed Ecuador in reaching a debt restructuring agreement on $66bn of Eurobonds valuing recovery at $54.8 at 11% exit yield at the beginning of August, materially reducing deal and event risks for the credit. Both debt restructurings follow a similar format of roughly 50% coupon reduction and stepped-up coupons, material debt relief over the first two years and maturity extension. Primary market activity was subdued in line with seasonal trends with only $8.5bn of gross supply (Abu Dhabi, Bermuda) relative to the $156bn issued YTD and $50bn expected till year end. EM spreads completed a 71% retracement of the March move tightening another 18bps to 423bps in August while 10Y US Treasury yields rose by 18bps to 0.71% resulting in positive Spread (+2.7%) and Treasury (+1.0%) returns. IG (-1.0%) under-performed HY (2.4%) with Sri Lanka (+11.6%) and Suriname (+8.6%) posting the highest and Zambia (-5.9%) and Lebanon (-4.0%) the lowest returns. 

EMD HC valuations are attractive relative to asset class fundamentals, on absolute and relative basis. EMD HC offers a spread of 423bps, or 62bps wider versus its 5-year average. The HY to IG spread differential is trading at 539bps, or 180bps wider relative its 5-year average. The medium term case for EMD is supported by valuations, bottoming of fundamentals, abundant global liquidity and constructive commodities. The technical and flow picture is still complicated by the uncertainty around a second wave of outbreak and resolution of EM liquidity and solvency issues. On a one year horizon, we expect EMD HC to return around 8.3%, on an assumption of 10Y US Treasury yields at 1% and EM spreads at 350bps. 

We out-performed the index by 71bps, on net basis. The largest contributors to performance were the over-weights (OWs) in defaulted Argentina where risk premium compressed as a debt restructuring offer reduced deal risk materially. The over-weights (OW) in higher beta Egypt and Ukraine added to performance as EM risk premia continued declining as did the under-weights in US Treasury sensitive credit like the Philippines and Saudi Arabia as these suffered in line with US Treasuries. During the month, we added to under-performing double BB rated credits like Brazil and South Africa in recognition that the temporary fiscal deterioration of 2020 is already reflected in valuations and on their external sector strengths. We also added to fundamentally sound EM corporates like Ecopet (Colombia) and quasi-sovereigns Banco Nacional (Panama), offering value to their respective sovereigns. We reduced exposure to GCC IG credits like Abu Dhabi and Qatar on elevated supply risks and tight valuations. Our absolute (+32bps to 8.64yrs) and relative (-3bps to +0.32yrs) duration positions did not change materially in August. 

The differentiation between higher and lower quality and more vulnerable issuers is likely to remain pronounced in our view. Our near-term strategy is to continue moving our positioning away from expensive or vulnerable HY issuers (Armenia, Belarus, Iraq) and towards better value IG issuers (Chinese or Latam IG-rated state-owned enterprises). At the same time, we will be retaining exposure to distressed EM credits from Angola, Argentina, Ecuador, Suriname, Zambia amid expectations for higher recovery values. As recovery values are realised, we would be re-assessing position sizes on the basis of the balance between fundamentals, valuations and technicals.

Our strategy’s largest overweights positions are concentrated in HY credits in markets where adequate macroeconomic policies are supported by renewed IMF programs, such as those in Egypt and Ukraine, attractively valued IG credits from Colombia and Indonesia, and idiosyncratic EM credits with manageable liquidity risks, such as some of those issued in the Bahamas, Dominican Republic and El Salvador. On the other hand, the strategy is underweight predominantly what we regard as overvalued IG credits exposed to US Treasury corrections (Malaysia, Peru and the Philippines), as well as Russia and Saudi Arabia where, we believe, current valuations are extended relative to headline, geo-political and ESG risks.

In July and August, we added to Brazil and Colombia based on our assessment that the Covid-19 outbreak is decelerating in Latin America, that imminent liquidity issues seem unlikely for either markets, as well as the relative attractiveness of BB-rated credits overall. We also added to South African longer duration LC bonds, on FX hedged basis, as we believe that hedged LC bonds seem more attractively valued than their USD-denominated peers. The risk additions tie in with our more constructive asset class view and with the value in the BB segment.

We retain a 7.3% (0.2 years in spread duration terms) asset class protection position in the Markit® CDX Emerging Markets Index as a hedge against near term volatility caused by slower exit from lockdowns and resurgence of new coronavirus cases. We fully exited the defensive long US Treasury position acknowledging that the higher US Treasury issuance may not be fully absorbed by the US Fed bond purchasing programmes from July 2020 onwards which may trigger a sell-off in these ‘safe haven’ US government bonds.

Local Currency 

EMD LC was mostly stable in August (-0.33%), remaining in the summer range. FX was flat and yield widened by 9 bps, following US yields, but still outperforming them by 9 bps.

While equities were strong and the Dollar was weaker against EUR and CNY (DXY -1.3%), EM currencies showed signs of nervousness, translating both the heavier positioning accumulated since May, and doubts that EM growth could rebound as strong as DM and China, given Covid cases in the BRICS remained at all-time high.

In FX, low yielding Asia outperformed following the CNY (1.8%). CEE was mostly up, led by PLN (1.7%), following the EUR lead, while HUF (-1.8%) reflected once again a monetary policy seen as overly accommodative. While high yielding EMEA was flat, TRY sold off dramatically (-5.2%), as inflation picked up above double digit and the central bank was late to tighten the policy rate. Latam underperformed, with BRL (-5.1%) and CLP (-2.4%), except MXN (+1.4%). Yields moved within 20 bps, except Brazil (+56 bps) where Covid related death culminated above 100.000, triggering discussions to abandon the spending cap. 

We under-performed the benchmark by 51 bps on a net basis.

Performance was hurt by underperforming IRS receivers in South Africa, Russia and Brazil, while OW FX in MXN and RUB, short EUR cost as well. On the other hand OW in Indonesia, the Dominican Republic helped performance, along with the US duration hedge.

We kept the fund absolute and relative duration at the same level, 7.2yrs and 1.8yrs respectively. We increased the USD short position to 15% in the second half of the fund, after we felt EMFX found its footing. The beta of the fund increased from 1.14 to 1.18.