From Squeeze to Totaalvoetbal
April 12, 2019

View from the Bond Market, by Chris Iggo, Chief Investment Officer Fixed Income, AXA Investment Managers

The big squeeze

Big wide world

Positive sentiment

It is risky though

High risk, high return

China diversifies

Good macro story

Totaalvoetbal

Fixed income markets are enjoying a good run with the Federal Reserve again, suggesting this week that rates are on hold for the foreseeable future. Brexit has been delayed and the economic data continues to look more like "Goldilocks" than the "big bad wolf". Yet my conversations with investors still point to a cautiousness and lack of confidence in getting sustainable returns in most asset classes. For fixed income, the view is that yields are too low. Yet credit is providing very strong returns and, as I always argue, pure core government bonds are there to provide a hedge if risk turns sour. Stay bullish bonds for now.

The big squeeze – The squeeze in credit markets continues. April has seen spreads narrow by around 7 basis points in investment grade markets and 26-27 bps in high-yield. Peripheral sovereign spreads in Europe are also lower. Year-to-date the tightening of credit spreads has been impressive with investors happy to buy credit for the additional yield in an environment characterized by unchanged interest rates and modest economic growth. The technical set-up of the markets helps too – there has not been a huge amount of issuance in investment grade and high-yield markets. In the UK the delay to Brexit has had little discernible impact on the market with spreads moving in line with the US and the Euro Area. The UK has seen very strong demand for credit this year driven to a large extent by increased demand from pension funds in buy and maintain strategies. This is sustaining returns even as valuations get more expensive.

Big wide world - Emerging market fixed income has done well so far in 2019 after having a negative return year in 2018. The JP Morgan Emerging Markets Global Diversified index had delivered a total return of 7.22 percent as of April 10. Within the total, high-yield emerging market issuers in aggregate had a total return of 8.5 percent with Africa being the strongest region (10.3 percent). The Egypt, Cote d'Ivoire, Ghana, Kenya, and Senegal sub-indices all delivered double digit returns. A pot of bonds from African issuers still provides a yield in US dollars of 7.1 percent, higher than it was a year ago, but significantly down on the end-November level of over 8.5 percent. The overall index provides a yield to maturity of 5.98 percent, with the market having rallied from a yield high of 7.1 percent last year. Comparing yields available on emerging market debt to high-yield markets in the US and Europe, and to investment grade developed markets there remains a significant attraction for investors to bet on emerging market bonds. In the high-yield space, emerging markets provide a 147 basis points advantage relative to the US market and over 100 bps advantage compared to euro high-yield when hedged into the euro. At the investment grade level, emerging markets yield 4.33 percent compared to 3.69 percent in the US and 0.8 percent in Europe (EM yield hedged into euro is around 1.3 percent)

Positive sentiment – I have been positive on emerging market debt for some time. The Fed's pivot towards the end of last year and the subsequent decline in US treasury yields has highlighted the yield attractiveness of the asset class. The failure of the dollar to strengthen by a further significant amount has also taken pressure of emerging market currencies. Many currencies have managed to appreciate against the US dollar so far this year, boosting the dollar value of investing in local emerging market debt. Still, hard currency has provided the better returns with the average spread of hard currency sovereign emerging market debt being still close to 350 bps above US treasuries. This provides a fairly significant buffer to protect returns relative to a US treasury exposure. Investors are attracted by the higher yields. This week the Saudi Arabian Oil Company (Aramco) raised $12 billion in the international bond market across several tranches including a $3 billion bond due to mature in April 2029. The coupon was 3.5 percent and the spread was 105 bps above the comparable US treasury bond. The bond did not come particularly cheap compared to US corporates but provides a useful diversifying asset for global credit investors who might have some concerns about leverage or slower growth in the US. Sentiment towards the issuer won't have been harmed by the fact that oil prices are at a six-month high with recent momentum in the oil market suggesting higher prices to come. The fact that it is also seen to have a very strong implicit sovereign guarantee (the Saudi Arabia sovereign has the same A+ rating) was also an attraction.

It is risky though – However, emerging markets debt is a risky asset class. Two of last years' big stories are back in the news. Turkey is again reeling from economic and political concerns while investors are worried about Argentina because of difficult economic times ahead of elections later this year. Both have underperformed the JP Morgan index in 2019. The benchmark Argentina 2028 USD bond saw its yield to maturity rise above 10 percent last week while both the peso and the Turkish lira have weakened against the US dollar. Both countries reflect classic emerging market macro-economic issues. Significant economic imbalances – typically inflation or external deficits – require harsh policy adjustments which in turn can lead to political volatility and pressure to change policy direction. Turkey took steps to rein in credit growth last year which saw its current account deficit disappear. But since then, public dissatisfaction with austerity has had a political impact culminating in protest votes against President Erdogan last month. This impacts significantly on foreign investor confidence and pressure on the exchange rate. Overnight interest rates were raised to staggeringly high levels in recent weeks to combat the weakness of the Turkish lira and prevent further erosion of the country's foreign exchange reserves. In fact, one only has to look at the levels of monetary policy rates in those two countries to tell you that all is not well. In Argentina the 7-day rate is at 66.755 percent and in Turkey the 1-week repo rate is at 24 percent.

High risk, high return – Investing in the debt of these issues is not for the faint hearted. The Argentina and Turkish sub-indices of the JP Morgan index have had a return volatility of 8.74 percent and 23.8 percent over the last ten years, compared to a volatility of 6.43 percent for the index as a whole. Indeed, Turkey and Argentina have each been responsible for about 7.5 percent of the overall level of volatility in the index over that period – which is more than their respective weights in the market value of the index. Still if you had only invested in Argentina and Turkey (50 percent in each market, re-balanced monthly) over the last ten years, you would have beaten the overall index by over 50 percent (a bit less than this once transaction costs had been deducted). That works out to an annualized return of around 13 percent. Of course, this higher return comes with higher risk in terms of the volatility of returns but also the real risk of capital impairment if macroeconomic conditions get so bad that debts cannot be repaid. After all, Argentina has something of a history of defaulting.

Together the two names account for only 6-7 percent of the index these days. If one had excluded these two from an otherwise benchmark approach to emerging market debt over the last decade, the results would have been a total return around 80 bps per year lower than the EMBI total index with an annualized volatility of 5.8 percent compared to 6.4 percent. The risk adjusted return would have been similar but there would have been less stress worrying about very volatile political and economic events.

China diversifies – The reduced share of these two names in the overall index and the low correlation of their idiosyncratic returns to the rest of the emerging market universe suggests that, for now, the overall asset class can continue to perform even with volatility around Turkey and Argentina. Recent global data has been a bit firmer (which the IMF seems to have missed in its most recent downbeat assessment to the growth outlook) and this is supportive for emerging markets. China remains an important factor to watch, although I tend to think of it as important in its own right, and somewhat apart from traditional "emerging markets". If China can sustain growth in the 6-7 percent range, then that is positive for the global economy and both commodity and manufactured goods suppliers. Chinese bonds have been a stable performer over the last year and have generated 4.3 percent of total return so far in 2019. It remains to be seen how quickly foreign involvement in the Chinese market grows now that the process of including Chinese names in more global indices has begun. In the dollar denominated world of the JP Morgan indices, China has traditionally had a lower volatility than the index as a whole and displays a strong level of diversification relative to the higher beta names like Turkey and Argentina. Here's a thought, Chinese bonds as a safe-haven alternative to US Treasuries and Bunds in the years to come?

Good macro story – Consensus economic forecasts are for steady growth in the emerging markets this year and next. Inflation has generally trended lower in recent years and monetary policies are generally supportive with the aggregate level of policy rates lower than the average nominal GDP growth rate. Latin America remains the most challenged region in terms of growth with Argentina still in recession for part of this year and overall growth for the region expected to be below 2.0 percent. The Asia-Pacific region remains relatively robust with growth between 4.5 percent and 5.0 percent, although this is dependent on how successful the Chinese policy measures to boost growth are. The Middle East and Africa are the regions expected to have the best growth rate delta with 2019 forecasts largely being above the outcomes for the last couple of years. This ties in with the bond performance so far this year and the appetite for new issues from countries in these regions. There are many things that could derail the performance of emerging markets – a shift higher in US rates, a higher dollar, weaker global growth, contagion from Turkey to other economies, or some geo-political shock. Absent these, then the higher yielding emerging market fixed income asset class should continue to do well.

Totaalvoetbal – The Champions' League games were not decisive, but Liverpool and Barcelona probably have the advantage going into the second legs next week. The Juventus – Ajax tie is fascinating with the Italians again having to rely on Cristiano Ronaldo against an exciting and youthful Ajax team. You would not rule out the team from the Netherlands stealing a win in Turin. Tottenham are certainly capable of holding off City but for United the challenge is huge. Barcelona were not particularly good on Wednesday but United didn't have an attempt on target either. The Reds will need to up their game and my fear is that they just don't have the depth of quality. I expect Liverpool will be able to hold on to their 2-0 advantage over Porto although the Estadio do Dragao will be an intimidating place next Wednesday. In six out of the last ten seasons, the final has involved at least one of the eight teams still left in the competition. It really is the elite and getting to this stage is a significant achievement. Ajax and Porto are the "outsiders" and they have done especially well. As a kid I remember being very fond of Ajax (I even had an Ajax jersey) largely because of Cruyff, Neeskens and Rep and the "total football" style of play. If United can't cook up a 1999 moment in the Camp Nou then I would not be unhappy to see the trophy paraded through the streets of Amsterdam next month.

Have a great weekend,

Chris

 





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View from the Bond Market, by Chris Iggo, Chief Investment Officer Fixed Income, AXA Investment Managers

The big squeeze

Big wide world

Positive sentiment

It is risky though

High risk, high return

China diversifies

Good macro story

Totaalvoetbal

Fixed income markets are enjoying a good run with the Federal Reserve again, suggesting this week that rates are on hold for the foreseeable future. Brexit has been delayed and the economic data continues to look more like "Goldilocks" than the "big bad wolf". Yet my conversations with investors still point to a cautiousness and lack of confidence in getting sustainable returns in most asset classes. For fixed income, the view is that yields are too low. Yet credit is providing very strong returns and, as I always argue, pure core government bonds are there to provide a hedge if risk turns sour. Stay bullish bonds for now.

The big squeeze – The squeeze in credit markets continues. April has seen spreads narrow by around 7 basis points in investment grade markets and 26-27 bps in high-yield. Peripheral sovereign spreads in Europe are also lower. Year-to-date the tightening of credit spreads has been impressive with investors happy to buy credit for the additional yield in an environment characterized by unchanged interest rates and modest economic growth. The technical set-up of the markets helps too – there has not been a huge amount of issuance in investment grade and high-yield markets. In the UK the delay to Brexit has had little discernible impact on the market with spreads moving in line with the US and the Euro Area. The UK has seen very strong demand for credit this year driven to a large extent by increased demand from pension funds in buy and maintain strategies. This is sustaining returns even as valuations get more expensive.

Big wide world - Emerging market fixed income has done well so far in 2019 after having a negative return year in 2018. The JP Morgan Emerging Markets Global Diversified index had delivered a total return of 7.22 percent as of April 10. Within the total, high-yield emerging market issuers in aggregate had a total return of 8.5 percent with Africa being the strongest region (10.3 percent). The Egypt, Cote d'Ivoire, Ghana, Kenya, and Senegal sub-indices all delivered double digit returns. A pot of bonds from African issuers still provides a yield in US dollars of 7.1 percent, higher than it was a year ago, but significantly down on the end-November level of over 8.5 percent. The overall index provides a yield to maturity of 5.98 percent, with the market having rallied from a yield high of 7.1 percent last year. Comparing yields available on emerging market debt to high-yield markets in the US and Europe, and to investment grade developed markets there remains a significant attraction for investors to bet on emerging market bonds. In the high-yield space, emerging markets provide a 147 basis points advantage relative to the US market and over 100 bps advantage compared to euro high-yield when hedged into the euro. At the investment grade level, emerging markets yield 4.33 percent compared to 3.69 percent in the US and 0.8 percent in Europe (EM yield hedged into euro is around 1.3 percent)

Positive sentiment – I have been positive on emerging market debt for some time. The Fed's pivot towards the end of last year and the subsequent decline in US treasury yields has highlighted the yield attractiveness of the asset class. The failure of the dollar to strengthen by a further significant amount has also taken pressure of emerging market currencies. Many currencies have managed to appreciate against the US dollar so far this year, boosting the dollar value of investing in local emerging market debt. Still, hard currency has provided the better returns with the average spread of hard currency sovereign emerging market debt being still close to 350 bps above US treasuries. This provides a fairly significant buffer to protect returns relative to a US treasury exposure. Investors are attracted by the higher yields. This week the Saudi Arabian Oil Company (Aramco) raised $12 billion in the international bond market across several tranches including a $3 billion bond due to mature in April 2029. The coupon was 3.5 percent and the spread was 105 bps above the comparable US treasury bond. The bond did not come particularly cheap compared to US corporates but provides a useful diversifying asset for global credit investors who might have some concerns about leverage or slower growth in the US. Sentiment towards the issuer won't have been harmed by the fact that oil prices are at a six-month high with recent momentum in the oil market suggesting higher prices to come. The fact that it is also seen to have a very strong implicit sovereign guarantee (the Saudi Arabia sovereign has the same A+ rating) was also an attraction.

It is risky though – However, emerging markets debt is a risky asset class. Two of last years' big stories are back in the news. Turkey is again reeling from economic and political concerns while investors are worried about Argentina because of difficult economic times ahead of elections later this year. Both have underperformed the JP Morgan index in 2019. The benchmark Argentina 2028 USD bond saw its yield to maturity rise above 10 percent last week while both the peso and the Turkish lira have weakened against the US dollar. Both countries reflect classic emerging market macro-economic issues. Significant economic imbalances – typically inflation or external deficits – require harsh policy adjustments which in turn can lead to political volatility and pressure to change policy direction. Turkey took steps to rein in credit growth last year which saw its current account deficit disappear. But since then, public dissatisfaction with austerity has had a political impact culminating in protest votes against President Erdogan last month. This impacts significantly on foreign investor confidence and pressure on the exchange rate. Overnight interest rates were raised to staggeringly high levels in recent weeks to combat the weakness of the Turkish lira and prevent further erosion of the country's foreign exchange reserves. In fact, one only has to look at the levels of monetary policy rates in those two countries to tell you that all is not well. In Argentina the 7-day rate is at 66.755 percent and in Turkey the 1-week repo rate is at 24 percent.

High risk, high return – Investing in the debt of these issues is not for the faint hearted. The Argentina and Turkish sub-indices of the JP Morgan index have had a return volatility of 8.74 percent and 23.8 percent over the last ten years, compared to a volatility of 6.43 percent for the index as a whole. Indeed, Turkey and Argentina have each been responsible for about 7.5 percent of the overall level of volatility in the index over that period – which is more than their respective weights in the market value of the index. Still if you had only invested in Argentina and Turkey (50 percent in each market, re-balanced monthly) over the last ten years, you would have beaten the overall index by over 50 percent (a bit less than this once transaction costs had been deducted). That works out to an annualized return of around 13 percent. Of course, this higher return comes with higher risk in terms of the volatility of returns but also the real risk of capital impairment if macroeconomic conditions get so bad that debts cannot be repaid. After all, Argentina has something of a history of defaulting.

Together the two names account for only 6-7 percent of the index these days. If one had excluded these two from an otherwise benchmark approach to emerging market debt over the last decade, the results would have been a total return around 80 bps per year lower than the EMBI total index with an annualized volatility of 5.8 percent compared to 6.4 percent. The risk adjusted return would have been similar but there would have been less stress worrying about very volatile political and economic events.

China diversifies – The reduced share of these two names in the overall index and the low correlation of their idiosyncratic returns to the rest of the emerging market universe suggests that, for now, the overall asset class can continue to perform even with volatility around Turkey and Argentina. Recent global data has been a bit firmer (which the IMF seems to have missed in its most recent downbeat assessment to the growth outlook) and this is supportive for emerging markets. China remains an important factor to watch, although I tend to think of it as important in its own right, and somewhat apart from traditional "emerging markets". If China can sustain growth in the 6-7 percent range, then that is positive for the global economy and both commodity and manufactured goods suppliers. Chinese bonds have been a stable performer over the last year and have generated 4.3 percent of total return so far in 2019. It remains to be seen how quickly foreign involvement in the Chinese market grows now that the process of including Chinese names in more global indices has begun. In the dollar denominated world of the JP Morgan indices, China has traditionally had a lower volatility than the index as a whole and displays a strong level of diversification relative to the higher beta names like Turkey and Argentina. Here's a thought, Chinese bonds as a safe-haven alternative to US Treasuries and Bunds in the years to come?

Good macro story – Consensus economic forecasts are for steady growth in the emerging markets this year and next. Inflation has generally trended lower in recent years and monetary policies are generally supportive with the aggregate level of policy rates lower than the average nominal GDP growth rate. Latin America remains the most challenged region in terms of growth with Argentina still in recession for part of this year and overall growth for the region expected to be below 2.0 percent. The Asia-Pacific region remains relatively robust with growth between 4.5 percent and 5.0 percent, although this is dependent on how successful the Chinese policy measures to boost growth are. The Middle East and Africa are the regions expected to have the best growth rate delta with 2019 forecasts largely being above the outcomes for the last couple of years. This ties in with the bond performance so far this year and the appetite for new issues from countries in these regions. There are many things that could derail the performance of emerging markets – a shift higher in US rates, a higher dollar, weaker global growth, contagion from Turkey to other economies, or some geo-political shock. Absent these, then the higher yielding emerging market fixed income asset class should continue to do well.

Totaalvoetbal – The Champions' League games were not decisive, but Liverpool and Barcelona probably have the advantage going into the second legs next week. The Juventus – Ajax tie is fascinating with the Italians again having to rely on Cristiano Ronaldo against an exciting and youthful Ajax team. You would not rule out the team from the Netherlands stealing a win in Turin. Tottenham are certainly capable of holding off City but for United the challenge is huge. Barcelona were not particularly good on Wednesday but United didn't have an attempt on target either. The Reds will need to up their game and my fear is that they just don't have the depth of quality. I expect Liverpool will be able to hold on to their 2-0 advantage over Porto although the Estadio do Dragao will be an intimidating place next Wednesday. In six out of the last ten seasons, the final has involved at least one of the eight teams still left in the competition. It really is the elite and getting to this stage is a significant achievement. Ajax and Porto are the "outsiders" and they have done especially well. As a kid I remember being very fond of Ajax (I even had an Ajax jersey) largely because of Cruyff, Neeskens and Rep and the "total football" style of play. If United can't cook up a 1999 moment in the Camp Nou then I would not be unhappy to see the trophy paraded through the streets of Amsterdam next month.

Have a great weekend,

Chris

 



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