April and May were marked by extremely strong rallies in markets across the globe, with risky assets seeing some form of the much-talked-about “V-shaped recovery”. Though equity markets led the charge, on the fixed income front, spread products have witnessed very sharp upticks over the past two months. Indeed, risky assets such as High Yield and Emerging Debt posted close to 8% returns, while even European Investment Grade posted a performance of over 3%. Core sovereign yields trended upwards in the early part of April but, towards the latter half of the month and in May, there was some stabilization, and peripheral sovereigns rallied sharply. Some of the market optimism can be attributed to the fact that, as the spread of COVID-19 decreased in Europe, many governments started to draft plans to accompany the gradual easing of lockdown measures that should begin to take place in May/June. Oil prices have also rallied significantly from their historically weakest levels, on the back of somewhat improved demand (with infrastructure projects announced by China) and unprecedented levels of supply cuts (namely by Saudi Arabia). However, the real force behind the recent rally is clearly the unprecedented support provided by central banks, not just in terms of unconventional measures and low interest rates, but also with the unlimited support provided, which the Fed highlighted yet again in Jerome Powell’s recent speech.
In spite of these positive developments, we remain wary about the absence of fundamental support. This leaves markets vulnerable to future downturns, though it is undeniable that the central bank backstop is a solid source of support. April and May saw several data prints that were dismal, including approximately 20 million unemployed in the US, recession flashing across Europe, retail sales plunging and Emerging Markets still suffering the effects of the shutdown. In spite of the deconfinement, key questions still remain on the efficiency and productivity of companies in the face of the new world of social distancing. Indeed, profit levels and revenue streams are unlikely to return to pre-Covid levels for most of the sectors until a cure/vaccine is found. Furthermore, several questions remain on the ability to jump-start the economy through consumption. One cannot ignore the fact that this crisis has highlighted not just a lack of liquidity for companies, but also a necessity for people to save for the perennial “rainy day”. In a world where a significant portion of the baby-boomers is approaching retirement age, one cannot help wondering if the global population will be more focused on saving rather than spending in the wake of the coronavirus effect. And this brings into question the oft-mentioned V-shaped recovery, which, from our perspective, appears to be a very optimistic scenario. The improved valuations and market conditions hence prompt us to be more selective and cautious, as we focus on picking the best opportunities through rigorous research and with a keen eye on risks rather than on embracing the market recovery wholeheartedly.
Neutral stance on US and European rates
As deconfinement begins in most European countries and in the US, there are signs of a return to normal for businesses and for the population at large. In this context, we could see improved (though still very weak) macro data. As a result, a small increase in US treasury yields is to be expected, though it will clearly be limited, in the context, to the announced heavy QE programme that will gradually be implemented. Our long position on US treasuries has been very beneficial since the beginning of the year and hence we aim to take profits after the rally and move tactically towards a more neutral stance.
On the other hand, other rates in the dollar bloc seem quite interesting, as we hold a slightly positive stance on Canadian and New Zealand rates. The Canadian sovereign curve appears to be relatively steeper, while New Zealand is benefiting from a dovish central bank that’s going to increase its QE programme in a bid to keep the cost of debt-financing low.
We are neutral on EU duration as we expect some consolidation after the dovish ECB outcome and further discussions on the proposed Next Generation EU recovery fund. However, we believe that valuations on core Euro sovereign rates remain relatively expensive and we aim to keep a slightly underweight position against non-core European sovereign rates. As such, we hold a positive bias on Spain, Portugal and Italy against German rates. Peripheral sovereigns outperformed core sovereigns over May and remain supported by the ECB’s asset purchase programmes, including the EUR 600bn increase in the Pandemic Emergency Purchase Programme. In addition, they are to be the main beneficiaries of the recently proposed Next Generation EU recovery fund, with a proposed size of EUR 750bn. Though the recovery fund is backed by France and Germany, the key questions are whether the fund will have enough firepower and how soon a consensus can be reached with the more sceptical member states (Austria, the Netherlands, Sweden and Denmark).
Neutral on EU and US linkers
Negative inflation cycles continue to drag on the asset class, and we expect further global inflation weakness in the months to come as a strong post-Covid-19 reflation scenario seems unlikely. Consequently, we are neutral on EU and on US linkers. In addition, we took profits on Australian linkers following their strong performance over May and June.
Neutral USD and underweight GBP
Our proprietary framework continues to point towards a negative view on the US dollar. The Fed’s rate cuts, QE programme and dovish stance also point towards a weaker dollar. The dollar, however, does appear to have re-gained its safe-haven status following the mid-March rally (amidst a dash for cash by investors seeking shelter from the fallout from the Covid virus), after it suffered considerably during the early portion of the sell-off. In this context, we prefer to have a neutral position on the US Dollar and continue to tactically manage the position.
The Pound Sterling is likely to remain under pressure as the UK remains one of the countries most affected by the Covid virus. Furthermore, the twin deficits continue to remain weak and the trade negotiations with the EU appear to be increasingly difficult. In terms of Brexit, not much effort seems to be going into extending the transition deadline, and talks appear to be at a dead end. 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.
In an environment where political risk is ripe (trade wars, protests in the US, Brexit), the Japanese Yen is an appealing safe-haven asset that is currently offering protection at relatively cheap levels. This justifies our tactically positive stance on the currency.
Favourable view on Investment Grade and neutral on High Yield
In the current context, investors have taken the opportunity to scoop up distressed valuations amongst IG and HY issuers, mostly through the reopening of primary markets. That window of opportunity allowed IG companies to issue more than EUR 100bn throughout April, making it the busiest month of issuance since 2013. As a consequence, risk premiums compressed in the European IG and EUR HY sectors. We maintain our favourable view on the European credit investment grade asset class, but 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 attractive levels. The ECB’s strong QE programme has led the central bank to own 20% of the eligible IG universe and, by year-end, it could own close to 40% of this universe. With such an important backstop, technicals are receiving strong support. Furthermore, dislocations are present in the investment universe in terms of the maturity spectrum, as the variations in spreads show that the short-term EUR IG credit segment has seen more relative spread-widening than the longer-term, though the shorter-term is deemed safer.
However, we are paying special attention to the risk of downgrades (and fallen angels), which, we feel, are quite high on IG markets. We believe that, not only has Eur IG credit suffered irrationally and indiscriminately as a result of the contagion of the virus, but that this is also due to the fact that investors have sold the higher quality and safer assets in order to shore up liquidity. In this context, it is important to exercise selectivity and focus on defensive sectors (telcos, retailers) while maintaining caution towards cyclical ones (energy, automobiles). Furthermore, we believe that the US IG segment is also exhibiting relatively attractive valuations. It is important to note that the Federal Reserve’s decision to buy corporate bonds (and hence IG) is a significant event and will undoubtedly support the asset class. This justifies our slightly overweight stance on US IG.
We are applying this selectivity across all the credit markets, while maintaining an overall neutral stance on European high yield, which does not directly benefit from the central bank purchase programme. Furthermore, oil-price declines are weighing more on the HY segment. We expect drift to be negative, with downgrades outpacing upgrades, as they do in times of recession, and default will rise significantly to around 10% in the US. In this context, and despite favourable valuations (yields above 7%), we prefer to hold a neutral view on the asset class.
Emerging Markets: Extended recovery in May amidst global monetary accommodation
In the medium term, we are retaining a constructive stance on EMD HC sovereigns and corporates and a more constructive stance on EM rates as we find pockets of value across EMD IG and HY sovereign and corporate segments. We are less constructive on EM currencies, as these are growth-sensitive assets that underperform in growth slowdowns that favour safe havens like US Treasuries and the US Dollar.
The main pillar of the view is based on a gradual global growth recovery in 3Q and 4Q after the 1H20 Covid-19 lockdowns. The depth of the activity decline is difficult to assess with any degree of certainty. Whether we are in the midst of a one- or a two-month lockdown, whether we are going to experience a second wave of lockdowns towards the end of the year on epidemic recurrence, and how well health systems and policymakers manage to deal with the spread of the pandemic and avoid permanent loss of productive capacity are all material unknowns.
While we acknowledge that further monetary and fiscal accommodation globally is likely and will attempt to mitigate the economic consequences of containment efforts, these actions will only soften the blow in the near term and are not likely to be sufficient to prevent technical recessions in either the DM or the EM.
We expect the Fed to continue extending its efforts to mitigate the deflationary impact of the containment strategy. We expect Fed policy rates to remain around zero and QE/liquidity support for the US Treasury, repo and money markets, ABS, MBS and the US credit markets to remain in place until the US economy returns to normal activity, potentially in 4Q20. We do not rule out the Fed extending further liquidity support to US HY credit and specific companies in the worst-impacted sectors (e.g. airlines). With their announced intention to do everything necessary to offset the pandemic’s impact next to a $2tn fiscal package passed by Congress, we would expect the Fed to manage to normalize global USD liquidity conditions as well as US Treasury and IG credit markets.
We also expect policymakers and central bankers across DM and EM to follow similar accommodative fiscal policies and, where possible, to revert to express QE and local bond buy-backs in order to mitigate the impact on the real economy and avert the excessive tightening of financial conditions.
Until global activity recovers, fiscal and monetary accommodations are unlikely to be inflationary, as the contraction of activity is unprecedented and deep. Lower oil/gas and industrial/agricultural commodity prices and a stronger US Dollar (which benefits from ‘flights to safety’ during recessionary periods) are likely to support the thesis of deflationary near-term dynamics.
China, in the process of exiting its 2-month lockdown, is a test case for the rest of the world with respect to how quickly activity rebounds and whether there is a second round of epidemic spread as the population terminates social-distancing strategies. We do not expect growth in China to recover materially above 3% in 2020 (although a reversal-to-trend growth figure of 4-5% in the medium term is likely) since the lower external demand will detract from any recovery of domestic demand in 2Q and 3Q.
The oil-price outlook is quite uncertain and suppressed by both a higher oil supply and a sharp fall in demand as the global economy falters during the pandemic episode. OPEC is likely to meet in June, as scheduled, but is not, at this point, confident of securing a new deal on oil-production cuts. We assume that oil will rebound from current depressed levels to an around $30-40 annual average.
We expect uncertainty and market volatility to remain elevated in the near term and until the pandemic risks start declining. We prefer to position as defensively as possible in the very near term and rotate from outperforming HY credits into underperforming IG credits.
In our medium-term base-case scenario, oil prices stabilize around $30-40, global growth declines to -1.5% in 2020, as most EM and DM enter technical recessions in 1H20, but a U-shape recovery occurs in 2H20, the EMD HY-to-IG spread tightens (as some of the sharp moves of oil exporters and vulnerable HY credits of early March are re-traced), as does the index EM spread (towards 350bps by year-end). In our base case, we do not expect Angola and Ecuador to enter ‘hard defaults’, as repayment schedules are relatively light, around $1.5-2bn each in 2020, and funding gaps can be sourced via as yet unannounced further fiscal tightening.
In EMD HC, we rotated from outperforming HY credits like Ivory Coast and Turkey into IG credits like India and Indonesia. We have also net-reduced exposure to Latam IG issuers like Chile, Colombia and Panama on concerns over pandemic containment. We scaled down exposure to the energy sector, with reductions concentrated in GCC.
Hard Currency
EMD HC recorded its worst month since October 2008 on a perfect storm of acceleration of the Covid-19 pandemic and OPEC's launch of an oil-price war (oil declined by 55%). EM central banks and governments followed by implementing a combination of rate cuts/local bond buyback programmes and counter-cyclical fiscal programmes. EM spreads widened by 253bps (to 626bps) while 10Y US Treasury yields declined by 48bps (to 0.67%), resulting in negative spread (-17%) and positive Treasury (3.8%) returns. IG (-8.1%) outperformed HY (-20.7%), with Lithuania (+1.2%) and Poland (0.4%) posting the highest, and Angola (-60.8%) and Ecuador (-59.3%) the lowest, returns.
EMD HC valuations have been restored and appear attractive relative to asset-class fundamentals on an absolute and on a relative basis. EMD HC now offers a yield of 7% and spread of 626bps, or the most attractive risk premiums since 2008. The HY-to-IG spread differential is, at 728bps, trading at its widest level ever. The medium-term case for EMD is supported by valuations, although the fundamental and technical/flow picture is complicated by near-term uncertainty with respect to the pandemic spread and impact on global growth, the timing of the economic re-start post-lockdowns, the EM downgrade and outflow risks. On a 1-year horizon, we expect EMD HC to return around 23%, on an assumption of 10Y US Treasury yields at 1.25% and EM spreads at 350bps.
We underperformed the index, with the largest detractors from performance the overweights (OW) in vulnerable oil-exporter credits like Angola, Ecuador, Pemex and Argentina. Underweights in IG credits (China, Philippines, Peru, Poland) also detracted from performance. In March, we initiated a rotation from outperforming HY credits (Ivory Coast, Turkey) into underperforming IG credits (India, Indonesia) while retaining exposure to distressed EM credits on expectations of higher recovery values. Our absolute (-46bps at 8.19yrs) and relative (-4bps at +1.06yrs) performances declined during the month.
We retain an overweight in HY versus IG. In HY, we reduced our exposure to Ivory Coast and Turkey, as these credits outperformed the correction in March.
In the Energy exporter space, we are net 8% and 0.71yr (spread duration) short vs the index, although energy exporters still contribute around 1/3rd of the overall beta DTS of the strategy. Our energy positioning is as follows: overweights in Azerbaijan and Kazakhstan, long-end Mexican Pemex and Brazilian Petrobras, small overweights in deeply distressed Angola, Ecuador and Iraq, neutral positions in Ghana and Nigeria, underweight in Gabon, full underweights in Russia, Oman and Saudi Arabia, and close to a full underweight (-12%) in the remaining GCC bloc, with exposure concentrated on the higher-rated Abu Dhabi and Qatar.
We retain exposure to Argentina, whose assets trade is distressed around the mid-30s and below expected recovery values of around 60-70 cents on the US Dollar. In the IG space, we hold positions in Indonesia and Romania but remain underexposed to the most expensive parts of the IG universe like China, Malaysia, the Philippines and Peru.
We partially covered the mid-20s underweight in Lebanon just before the country officially defaulted on its $1.2bn March 9th debt maturity. We expect recovery values of around 35, as Lebanon will require deep haircuts to restore debt sustainability from its current public-debt-to-GDP level of 170%. As we expect a prolonged debt-restructuring process that may create opportunities for better entry points, we are staying on the sidelines for the moment.
In Brazil, Mexico and Turkey, we hold overweights in attractively priced corporate bonds versus underweights in sovereign bonds, for a total corporate exposure of 9.2%.
We hold single-name CDS protection positions in Mexico against Pemex and a long protection against further asset-class volatility. To hedge against further market stress, we have also installed a tactical 1.2yr 10Y US Treasury duration position that we see as a hedge to further deterioration in risk sentiment and flights to safety.
Local Currency
EMD LC saw a sharp 14% correction in March, mainly from FX (-12%) and rates (-3.3%), while carry added 0.9%. Throughout the month, cases of Covid-19 increased exponentially worldwide and the WHO declared a pandemic. While equity markets lost 20%, the fall in oil prices reached 55%, amplified by the ongoing price war between Russia and Saudi. US Treasuries closed 60bps lower but – affected by serious liquidity disruptions – were selling off up to 60bps intra-month. High-beta FX led the sell-off, with the MXN (-19%) and the RUB and BRL (both -18%), underperforming, followed by the COP, the ZAR and the IDR. Asia outperformed the PHP (flat), the THB (-5%) and, generally, low beta, including CEE.
In the LC rates space, we saw further differentiation, with South Africa and Colombia underperforming on mounting fiscal concerns (+175bps and +130bps), and Turkey (+270bps) on external financing concerns. Other high-yielders retraced half the sell-off after a sharp mid-month rally (Russia +60bps, Brazil +28bps). Low-yielders on average closed wider, except Poland and the Czech Republic (-57bps and -13bps).
We outperformed the benchmark by 8bps on a net basis. Starting the month, we added to high-beta FX short to hedge our residual OW position, which was not proving easy to sell (Ukraine, Dominican Republic) and took profits after the Fed and the ECB announced unlimited QE. Mid-month, we added to duration in US Treasuries and high-yielders (Brazil, South Africa, Russia), later taking some profits. We remain cautious in the medium term, as the lockdown measures take their toll on growth and fiscal balances.
At month-end, our USD long position stood at 16% (+10bps), with the beta unchanged at 0.96. The absolute duration is now 7yrs (+1yr) and relative duration 1.8yrs (+1.2yrs).
