All in all, it was still a strong 4th quarter for fixed income assets, with a very strong rally once news of potential vaccines percolated. Nearly all sovereign bond markets delivered positive returns and, while this was largely expected for core markets (in line with low growth and inflation), peripherals also joined the party, with Greece and Italy leading the way. Spread products (including IG, High Yield and EMD), which suffered substantially in the first quarter, witnessed a very strong rally over the rest of the year, ending with comfortably positive performances in a context where equity markets were the clear winners.
While the path towards victory in the US election appeared to be a tricky one, a clear winner did emerge, as Joe Biden is now President-elect and so recognized by a large majority of the electoral college. Though challenges continue, in the form of court cases, the fact that nearly all these were rejected, or seen as frivolous in the first place, has spared the markets instability and volatility. The new government is also likely to inherit a US activity cycle that we consider to be improving and that is in the recovery stage (compared to what it was a couple of months ago). We believe, similarly, that, in terms of inflation, the US is ahead of the rest of the G4, though each country also appears to be making progress. Clearly, this progress can be largely attributed to the extreme accommodation provided by monetary authorities, and we estimate the aggregate balance sheet of G4 central banks to reach close to 60% of the combined GDP. This historic support has resulted, of course, not only in low rates but also in sharp spread compression in credit markets, leading to positive performance for most fixed income asset classes – remarkable in a year where economic activity halted for several months amidst the COVID crisis. We expect economic growth to be stronger going forward, supported by liquidity, with the ECB expanding their programme by EUR 500 billion until March 2020, as well as potential fiscal stimulus, especially in the US.
It will, however, be important to monitor key factors, the biggest of which will be the evolution of the vaccines as well as their distribution and effectiveness. Some of the scars of the COVID crisis are also likely to linger, as job losses and debt sustainability (especially for high-yield companies, which have seen leverage rise). Finally, we are keeping geopolitical risks in mind, as Brexit remains a source of angst and trade wars are still a concern, as populism remains rampant and the US and China remain at loggerheads. One cannot conclude without addressing some of the longer-term concerns, such as the political risk in Europe at year-end 2021 and 2022, when France heads to the polls to elect a new president and Germany decides on who will replace Angela Merkel. Furthermore, we expect that it is over this longer-term time horizon that the effects of the current strong monetary accommodation are likely to start fading and when central banks could ponder the potential tapering of their bond-buying programmes.
Neutral stance on US rates and European rates
The return of growth and inflation are welcome in the US, and could continue, following the additional fiscal stimulus that could be voted by Congress and that could lead to an upward movement of a curve that has already steepened on the back of recent Fed policy (to tolerate inflation at target levels for a longer period of time). Furthermore, a Biden victory will support the potential economic recovery, as a stimulus package would be more likely, though this will depend on Congress. In this context, yields could move upwards. This rise in rates, however, is not only capped by the QE programmes (that includes $100 billion/month of purchases with a possible extension in duration) but also by the fact that the new administration will be facing challenges such as a particularly disruptive transition. In such a context, we hold an overall neutral view on US rates, while adopting tactical short positions.
On the other hand, other rates on the dollar bloc seem interesting, as we hold a positive view on Australia on the back of an accommodative central bank and rates that are at slightly more attractive levels. Our previous positive exposure to New Zealand rates has been reduced to neutral, in the wake of positive economic data and tapering of monetary support in the form of scale backs in central bank asset purchases.
In Europe, while new lockdown measures have been effective in curbing the spread of the coronavirus in recent weeks, the second wave of the pandemic remains severe, pressuring further the economy. In spite of the announcements on vaccines, there remain significant concerns on the distribution and willingness of the population to have themselves injected. Overall, the growth & inflation picture remains weaker than in the US and should continue to suffer over the winter quarters from the restrictions and the health situation. The budgetary cycle remains a negative driver, as budget deficits are likely to remain large across Eurozone countries. Monetary policy, on the other hand, remains exceptionally accommodative, driven by the APP, PEPP and expectations of a further increase in, and extension of, the PEPP announced this week, to counter the impact of the coronavirus outbreak and weak inflation dynamics. For core markets, fair-value indicators continue to point to their expensiveness. Net flows for Euro sovereigns will remain negative for the remainder of the year. Also, for 2021, supply dynamics will remain an important driver while EU issuance will also lighten funding pressure on sovereigns. Investors’ positioning remains a negative driver as positioning remains close to multi-year highs. While economic risks are more heavily affecting non-core countries, the sizeable grants made available by the European recovery fund should clearly be positive for non-core countries. Supply will also be supportive for the remainder of 2020 on non-core. In this context, we prefer to have a negative stance towards core Eurozone sovereign bonds while continuing to favour non-core sovereigns. We remain active in the management of our non-core holdings, where positioning will remain a negative driver for as long as it remains high on non-core.
Developed Market Currencies: Neutral USD
Our proprietary framework continues to point towards a negative view on the US dollar, in the wake of rising twin deficits. The Fed’s rate cuts, QE programme and dovish stance also point towards a weaker dollar. However, in the context of a possible recovery of the US economy (subsequent to a potential fiscal programme), we feel that the USD could be subject to appreciation. In this context, we prefer to have a tactically neutral position on the US Dollar, which we continue to monitor carefully.
Credit: Favouring European credit markets; overweight convertibles
The improvement of medium-term perspectives, thanks to rapid advances in curative and preventive solutions against COVID-19, as well as ample monetary support, have decidedly come down on the side of risk. Through our in-house, bottom-up analysis of issuers, we continue to target the highly liquid assets of high-quality companies with strong internal credit ratings and low leverage, as balance-sheet repair will represent a major challenge for corporates in 2021. The demand for spread products will stay strong, while supply will remain negative on a net basis, favouring compression trades, especially in the High Yield segment. The Default Rate could peak in Q1 2021 and decrease thereafter, as progressive herd immunity is achieved through vaccination programmes. This will, in turn, support more cyclically exposed sectors.
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 significantly over the quarter. The ECB’s direct purchase programme will act as an important backstop, with technicals receiving strong support. However, we shall pay special attention to the risk of downgrades, which we feel is 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
Eur. HY: The asset class should be supported by a still-attractive BB carry in a low-yield environment; nor is supply an issue, as companies are relying more on bank loans than on capital markets. The carry of the asset class remains a source of support. We hold a slight overweight to the asset class, while favouring selectivity.
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 US and some economic recovery in China.
Emerging Markets: Favouring EMD Local Currencies
The current outlook for emerging market debt (EMD) is positive. The asset class benefits from ample liquidity, supportive central bank policies and a positive outlook for commodity prices. In China, and across other emerging markets, there are signs of a broadening economic growth recovery.
We expect that the global economy will continue its recovery from the COVID-19 pandemic in 2021 as we gradually exit the health crisis. The recovery is likely to accelerate in 2H 2021 as vaccine distribution broadens and the need for containment declines. A positive scenario of accommodative monetary and fiscal policies, low core rates, ample global liquidity and search for yield will all likely benefit the performance of emerging market debt in 2021.
However, the differentiation between higher-quality and lower-quality, more vulnerable, issuers is, in our view, likely to remain pronounced in the near term. This will be underpinned by the fact that emerging market governments will not be equally successful in dealing with the fallout of the COVID-19 pandemic and its impact on their national economies and societies. It also means that, as there will be more opportunities to add, as well as destroy, value, they will need to be selective. EMD valuations have tightened on an absolute basis but still offer value on a relative basis, and default risks are more limited after the material de-rating in 2020. We prefer HY to IG in Credit and EMFX to LC Rates in LC, with a bias towards higher beta and higher yielders.
China: We hold a positive view on Chinese sovereign bonds, where real yields are quite attractive, and the economic recovery appears remarkable. Following this asset class’s inclusion in the index, it has been supported by strong flows from foreign investors.
