The first half of this year has been dominated by the spreading coronavirus pandemic and the policy response to it. The latter has been overwhelming; both monetary and fiscal policy are fully engaged in developed countries while monetary policy is leading the charge in emerging markets.
This immense policy response has been well-documented, and its impact on markets has removed almost all of the funding and balance sheet-related risk premia that were built into valuations in March. In addition, a significant amount of the economic risk premia have also been removed. The impact of policy is best seen in the development of the path of inflation expectations in the US. Over the course of the second quarter, 5-year real yields in the US fell by 60 basis points to -83 basis points, while nominal yields fell by 10 basis points, leading to an increase in inflation expectations of 50 basis points.1 It remains our belief that real yields will need to rally further and inflation expectations will need to increase for risk assets to continue performing.
Other assets that have benefited most have been, as expected, the ones the central banks have focused on. Risk and liquidity premia have largely been removed from assets such as US investment grade, the European periphery and emerging market rates. Other assets—emerging market high yield comes to mind—have seen a significant reduction in liquidity premia, but a smaller reduction in economic risk. The change in liquidity and funding dynamics has been best reflected in the US dollar. Its rapid ascent was quickly halted and reversed in the second quarter, with the broad US dollar index (BBDXY) ending the quarter nearly 2% lower.2
Future evolution of two P’s (Pandemic and Policy)
The evolution of the pandemic and the ensuing policy response will likely continue to drive macro conditions. In most countries (certainly developed markets), health will largely determine the opening or re-closing of their economies, which will also impact macro variables. However, some emerging markets will likely have no choice as they cannot afford to close down again, meaning the human toll will likely rise. Even under such an unfortunate scenario, the outcome for growth may not be that different in the short term, as external factors may weigh on emerging market economies. However, the longer-term effect of additional fiscal spending could impact growth rates for years.
While relatively unpredictable, the current path of the pandemic does not show significant signs of abating globally. We believe the economic outlook will likely continue to be muddled by better data in regions where the virus is under control and worse data from new restrictions in regions like the US. Current global economic data seem to indicate that our base case of an economic contraction of over 6% in the US, nearly 10% in Europe and 5% globally is the most likely outcome. The risks of a more bearish or materially better outcome have diminished significantly, in our opinion. The very high economic volatility seen in Q2 will likely diminish by Q4, however, it likely will not return to normal before Q2 of next year, when the consensus indicates that we should have a vaccine. Despite the expected reduction in uncertainty, underlying economic activity in the US and globally is highly unlikely to return to trend before 2022.
Under the current conditions of low inflation, a high output gap and high borrowing requirements, we see little limitation to policy responses. Both monetary and fiscal policy will likely remain fully engaged and cushion the downside, more for markets, but also economically. The US Federal Reserve (Fed) will likely do the heaviest lifting, as dollar funding, by virtue of being the reserve currency, will likely have the largest impact globally. Emerging market central banks will likely continue to ease policy rates, adding to the significant number of rate cuts that have already been delivered. Emerging market central banks have delivered, on average, around 150 basis points in total rate cuts since the beginning of March.3 While we are at the lower bound in some emerging markets, there is room for additional cuts in many others, such as Mexico, India, and Indonesia.
Expectations for the other P’s (Pricing and Portfolios)
The V-shaped recovery in asset prices has certainly removed a significant amount of the excess risk premia that were priced into markets at the end of the first quarter. We continue to classify investment opportunities into three categories: those that will likely benefit from central bank actions in specific countries, those that will likely benefit from central bank actions globally, and those that will likely benefit from asset prices having fallen to very low levels. The opportunity set in the last category is currently the least attractive, in our view, while we believe the first two categories continue to offer attractive long-term investment potential.
We continue to see attractive opportunities for alpha and capital gains in both emerging market and developed market rates. For assets that central banks are trying to buy, some of the market dislocation has been corrected, however, given the very uncertain economic outlook, they still remain attractive, in our view. It continues to be our belief that, for those opportunities in the investment grade space to be realized, real rates in the US must continue to fall. While 5-year real rates have fallen to -0.83%, as noted above, they should continue to fall as the economic recovery gains momentum. If the Fed moves to enhanced forward guidance, whether using a form of yield curve control or not, the primary beneficiary should be materially lower real rates.
Similarly, in Europe, after a slow start, the European Central Bank’s (ECB) bond buying is starting to overwhelm market risk aversion. We believe this will continue as there is little restriction on the ECB to continue with this policy, since inflation is likely to disappoint on the downside.
The greatest seismic shift has occurred in emerging markets. As emerging market central banks have lowered rates to record lows, risk premia have shifted from currency risk to term premia.4 The rally in front-end rates is having significant ancillary effects on emerging market longer-term rates markets. Having benefitted from the first order effects of policy, we are now focused on the second order effects from the same policy changes. Given the expansion of fiscal policy and the excess deficits that would need to be funded, the natural market reaction is to increase term premia. Throughout the past 20 years, emerging market term premia have often been quite low, as the risk premia were built into front-end rates as currency risk premia. This was generally appropriate given the highly elastic current account deficits. Recently, however, the external accounts of several countries have shown significant improvement for both good (structural changes) and bad (cyclical domestic demand collapse in this sudden stop) reasons. This has reduced the need for currency risk premia, which have declined, while increasing the need for term premia so that deficits could be funded on both an unhedged and hedged basis by external investors, domestic banks, and other domestic financial intermediaries. Figure 1 shows overnight rates in several countries (Mexico, Colombia, Russia, South Africa, India and Indonesia, excluding Brazil, where the yield curve is very steep) subtracted from 10-year government bond yields. The increase in term premia is unmistakable.
Figure 1: Emerging market local government bond term premia
The increase in term premia can be viewed another way—are hedged emerging market rates competitive with other assets? We looked at 5-year emerging market local government bonds in different countries, segmenting them into low yielding countries, those with steep yield curves and those in transition where rates are still being eased, and compared them to 5-year BBB rated US dollar denominated corporate bonds. We looked at the carry and roll in emerging markets on an unhedged and hedged basis and found them to be competitive for the first time in years.
Figure 2 shows the carry and roll on an unhedged basis (expected monthly carry plus roll).5 As the graph indicates, the recent plunge in front-end rates in emerging market countries has had a minimal impact on the expected carry and roll because of the increase in term premia.
Figure 2: Emerging market local rates carry and roll in local currency terms
Despite the rate cuts enacted by the emerging market central banks, we believe the opportunity set in emerging market rates is remarkably attractive and one we remain focused on in our portfolios.
The opportunities in currency markets will likely come from actions by the Fed and other developed market central banks. Fed actions halted the rise in the US dollar in April. Since then, the dollar has declined, leaving it unchanged from the start of the market dislocation that began in February and barely up on the year. We continue to believe that the Fed’s long-term injection of liquidity combined with a zero interest rate policy may lead to the depreciation of the US dollar when the current period of risk aversion ends.
The path of the US dollar will likely be impacted by the Fed’s exit strategy. If, as expected, it moves to enhanced forward guidance utilizing yield curve control, we believe real interest rates in the US will decline to record low levels.6 As Figure 3 shows, the divergence of the US dollar from the level of real interest rates is reaching historically wide levels. Materially lower real interest rates should remove the interest rate support for an extended period of time.
Figure 3: US dollar versus US 5-year real yields
For credit assets to perform well—outside of those that are systemically important for central banks—we would need to see a resurgence in economic activity and a reduction in economic volatility. The recent rally in prices is related to the removal of liquidity concerns and recently improving economic data. While economic volatility has been reduced, as have bearish and optimistic tail risk probabilities, the base economic case argues for caution. We continue to favor long-dated emerging market investment grade bonds and European financials that are critical for the functioning of monetary transmission in the European Union.
At the end of the second quarter, markets recovered from the selloff in the first quarter. However, the pandemic has not shown signs of abating and economic volatility, while declining, is unlikely to return to normal metrics before Q2 of 2021. In such an environment, we believe an investment process that evaluates both fundamentals and valuations is critical to sequencing investments to generate higher excess returns from the current market turmoil.
The seismic shift in global central bank policy has created significant opportunities in emerging market and developed market rates, which we believe will be the first to be realized. We are also focused on taking advantage of the Fed’s extraordinary policy moves and the expected impact on the dollar. We have been reducing our emphasis on the high yield credit markets as we believe they will be late in recovering. The fiscal and monetary policy actions in developed market countries have removed some of the longer-term headwinds to emerging market assets and we remain very constructive on the asset class.
1 Source: Bloomberg L.P., data from April 1, 2020 to June 30, 2020.
2 Source: Bloomberg L.P., data from April 1, 2020 to June 30, 2020.
3 Source: Bloomberg L.P., data from March 1, 2020 to July 6, 2020.
4 A term premium is the additional yield earned for holding longer-maturity bonds.
5 Carry and roll is a bond’s combined expected total return based on its current interest rate and its potential for capital appreciation should it season toward maturity to a lower interest rate (within a steep yield curve environment).
6 Yield curve control is a monetary policy tool in which a central bank advises on its potential to, or actually conducts, open market transactions to manage interest rate levels on government bonds.
Carry and roll are a bond’s combined expected total return based on its current interest rate and its potential for capital appreciation should it season toward maturity to a lower interest rate (within a steep yield curve environment).
Term premia is the additional yield earned for holding longer-dated bonds.
Currency risk is the risk that changes in the relative value of certain currencies will reduce the value of investments denominated in a foreign currency.
A credit spread is the difference between Treasury securities and non-Treasury securities that are identical in all respects except for quality rating.
Investing involves risk and is subject to market volatility.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.
An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified investments.
The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.
The opinions referenced above are as of July 20, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations
Before investing, investors should carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the fund(s), investors should ask a financial professional for a prospectus/summary prospectus or visit invesco.com.
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