A STORY OF TWO PARTS... VIEWS FROM THE FIXED INCOME DESK
Several weeks ago, we also pointed out the risk of the virus accelerating in Brazil, India, South Africa and Russia – all large, populous countries that contribute significantly to global GDP – all of which are now struggling with accelerating infection rates. We do not think the recent flare-ups in some US states should suddenly assume that we are due a severe secondary wave, but it does highlight the fact that we do have ongoing risks that have not gone away in the absence of a vaccine. Added to the confusion is an inability to price risk correctly in a market where massive central bank and government intervention have skewed valuations. The three risks remain the same: 1. A slower economic recovery. 2. A second wave of infection. 3. Increased company and sovereign credit issues/defaults.
Part one
There has been a different tone this week after the huge rally since the beginning of June. We have gone from forgetting about March, to the largest one day decline in equities since then. What has changed? Nothing really, but we were due some consolidation after such a big move, and this is probably it. A gloomy Fed and a spike in infections in the US was enough. The market had moved too far, too fast, especially with the significant spread compression of weaker rated credits more likely to default than go to BB’s.
The US Federal Reserve (Fed) meeting was acceptably dovish, but perhaps because that was already priced in, the markets were slightly disappointed. So continues the irrationality of market expectations. To be fair, Fed Chairman Jerome Powell poured a bit of cold water on expectations of a swift economic recovery, pointing to continued economic risk and the long road to recovery for employment. In any event, cash continues to flow into both equities and fixed income and, certainly from the latter’s perspective, there is too much money chasing too few bonds. We are not talking about a bear market rally anymore, but clearly there has been an increased focus on some of the risks that we still face. Stimulus is still the watchword, so that trumps anything else for now. Unfortunately, that isn’t going to save small, cash-flow restricted companies or jobs unless we see a swift resumption of consumer pre-Covid behaviour.
Interestingly, it was the recent new issue bonds that dropped (this is where the liquidity is) the most in those sectors that everyone loved last week – such as travel and airlines.
US Federal Reserve maintains its support
As expected, the Fed will continue to provide support, but maintained its message that more stimulus (fiscal) will be required. The Fed’s median projection shows rates being held close to zero through to 2022. Its long-term dot plot, which indicates how much each Fed official thinks it will cost to borrow money, stays at 2.5%. The Fed will continue to buy Treasuries and Mortgage Backed Securities at current base, so there was a positive surprise here. Finally, rates will remain on hold until the economy recovers - a nod to stronger forecasting over Yield Curve Control (YCC).
All things ‘Yield Curve Control’
We talked about this last week and we still think that it is highly unlikely that we will get an overt YCC until later. The Fed has been clear that interest rates are not going up for several years, and that should be enough to anchor front-end yields. The market continues to speculate, however, and that is one reason for the 10 year gapping in 20bps. There is still reluctance to do anything to drive the front end into negativity, so any control will likely be around the 5-year area. Clearly, if we do see YCC, the 10 year has further to fall. Interestingly, over the past 2 months, the 10 year has hardly moved, yet the S&P 500 index is up 20%. This begs the question of whether we can really use Treasuries as an indicator of macro concerns. There has been a massive ‘risk on’ period, yet no move in Treasuries*.
Part two: fixed income, gold, oil, Latin America and European banks
We have had some extreme moves in the last few days, with the S&P rebounding 1% on Friday, but down 4.8% over the week as a whole, mostly as a result of Thursday’s sell-off. Investors are getting increasingly nervous about valuations and economic conditions as the market has moved higher, and it is clear that large parts of the market are over-stretched at this point given the risks we still face. The fact the equity markets can fall 5% in one day illustrates the point that momentum and retail investors are driving things at the moment. The CBOE Volatility Index (VIX) VIX is back above 35 and 10 year US Treasuries are back at 70bps, with the dollar gaining after three weeks of declines*.
Room in the duration trade
Whilst spreads are still attractive in investment grade bonds, absolute yields are looking a bit stretched, albeit still higher than they were earlier this year. We are, however, in a more uncertain world. Europe is looking marginally better than the US, but the technicals are still stronger in US Fixed Income, especially given hedging costs for non-USD investors have shrunk significantly. There is still some room in the duration trade, given inflation is not expected to be an issue for many months, and there is room for spread compression from here. The huge amount of stimulus that has been thrown at the world economy should ultimately result in inflation at some point, but it would be a brave person to commit to a date given the false dawns we have had in the past. High Yield still has room to run in the lower rated credits, and in some sectors, but this is entirely dependent upon how quickly economies re-open, and how quickly the damage done is reversed. US BB High Yield was at around 2% Yield to Maturity (YTM), with a spread of 240bps back at the end of January. Today the YTM is 3.50%, with a spread of nearly 400bps*.
More volatility in gold?
In the short term, we may see some volatility in gold as Treasury yields fluctuate. If we see yields rise again, then the attractiveness of gold loses some of its lustre (given no yield) especially as inflation remains subdued. A weaker dollar has also not really made much of a difference in the short term. Indeed, we suspect that a lot of the stimulatory measures are already priced in.
What would continue to be supportive of gold is the Fed’s indication of zero interest rates, any continuation of equity market volatility, and resultant lower Treasury yields. Uncertainty is gold’s friend. If we do see sustained pressure on the dollar that will also be a longer term support, especially if we see a smooth re-opening, growth coming back, and higher expectations of inflation.
Oil conundrums
Oil has been on a tear since the beginning of May. The days of -$40 WTI seem like an age ago. The realities of a massive demand shock are slowly being felt despite the OPEC+ actions in extending production cuts for another month. The reality is that there is still a production glut. The forward curve is flat (December 2021 WTI futures are at $39.59) so whilst many shale producers are hedged this year, there is no hedging advantage for next year. Despite capital efficiencies continuing to be enhanced, most producers still break even at $40.
US crude inventories rose to a record high of 538m barrels, according to the US Energy Information Agency. Also there are signs of concern that re-opening may not be the quick panacea that oil is hoping for. Fuel stockpiles in Singapore are at their highest level in 4 years. Sinopec in China has cut its exports for June by 50% from May, perhaps signalling that other Asian economies are recovering at a slower pace than China.
Emerging Markets – Latin America
We have seen a huge rally in local currencies over the last several weeks. For example, much of the strength in the Brazilian equity market has come from the appreciation of the Real. There is a real disconnect here – the virus news keeps getting worse yet the currency is surging on dollar weakness. The expectation is that the Brazilian central bank will cut rates to a record low next week. It has room to do this given the rally in the Real. We think that Mexico will probably cut as well when it meets in a few weeks. This benefits the domestic equity markets, but reduces the FX carry and thus the attractiveness of the local currencies. A lot depends upon the Fed – more stimulus, dollar weakness – and also domestic policies. There is not a great deal of flexibility. If they do too much fiscal or monetary easing to combat the huge economic toll of the virus, it will ultimately affect the currency. If it weakens too much, then you have another problem with inflation at a time when the employment support packages, social security and furloughing are far more limited. Unemployment is likely to be far more permanent and the recovery far longer.
European Bank subdued
Banks have benefited from the rotation from value into growth stocks. Indeed, Banks are the second best performer in the Stoxx 600 after insurance since mid-May. Their performance this year has been subdued for many obvious reasons. It has been the same story in the bond market. Cocos - Contingent Convertibles - have performed in line with their subordinated nature, albeit coming back strongly in May and June.
Any upside may be limited given withdrawn dividends, loan loss impairments, weak margins and longer-term damage from the shutdown. At present, there is no risk of CoCo coupon payments being halted as this would trigger a collapse across the sector. This is a concern given the new rules post 2008/09. Banks are worried that if they keep lending then capital buffers may erode. S&P has said that a capital decline or breach would not necessarily trigger a downgrade, but clearly for banks to continue to be in a position to lend and thus help mitigate the pressure on businesses this needs to be addressed. Some banks have already issued new debt to boost capital levels and this trend will no doubt continue.
Conclusion
The market is flailing around seeking direction in the absence of vaccine news, economic data or yet another round of monetary and/or fiscal stimulus. The likelihood is that this is a temporary dip, given we have no new information and the Fed has continued to make all of the right noises. Our focus remains on employment as the key indicator of the recovery. It is going to be a long road and in the absence of any real ability to accurately price risk in the face of huge central bank intervention, we will see more volatility, exacerbated by ETF flows.
*Bloomberg, as at 12 June 2020
