Fixed income 2021
Unfix your thinking.
2020 ended on a positive note with the economic and political news flow extremely positive since the US elections in early November. Economic surprises remained positive, and the start of the vaccine rollout and the “blue sweep” in the US are two positive catalysts for 2021. However, as we entered a new year, some problems have carried over into 2021. Investors still face the same questions. With higher debt levels due to Covid emergency help, lower policy rates in most countries compared to a year ago, and the pandemic not yet defeated, investors are looking for bonds with decent return potential but manageable risk. Early January’s rise in US real yields even raised the question about the risks of a second taper tantrum.
Before we go into these questions, we should draw your attention to Figure 1, which depicts the problematic situations fixed income investors face today. The yield of the global aggregate index, for example, reached a new record low in 2020. Real yields – nominal yields minus inflation expectations – even dropped below zero for most maturities. While yields in developed market government bonds are close to zero, only emerging markets debt and corporate high yield do offer yields significantly above zero. This has shifted investors’ attention towards the latter two asset classes. A call we agree with.
On top of these long-term considerations, we just finished a year where government bonds have shown particularly good performance, due to the severity of the Covid crisis and central bank fierce interventions in the bond markets, taking yields to new all-time lows (see Figure 1). For example, US Treasuries finished the year with an 8% performance on a total return basis, mainly due to falling yields and the US Federal Reserve buying around 2.2 trillion US dollars of US Treasury securities, both factors unlikely to be repeated this year at the same magnitude. Even European negative-yielding debt such as German Bunds returned around 5% last year. These assets can still, in our view, present good tactical opportunities, but structural forces makes them less appealing in the longer term.
Given the performance of last year and yields still close to historical lows, investors’ concerns of a snap back in prices have risen. Therefore, it is important to consider valuation aspects, as attractive asset-price-valuation metrics reduce the “timing risk”. Our long-term return potential estimates (see Figure 2) are this kind of anchor for investors, offering a valuation-based future-return estimate. According to this analysis, corporate credit and emerging market hard-currency debt do offer attractive long-term return potentials in the fixed income space. However, even within the credit space we need to differentiate, as only high-yield credit still offers an attractive return from a strategic perspective. With default risks still looming due to the current lockdowns, we see the time for high yield and EM corporates coming soon when the vaccination roll out is in full swing, reducing the risk of another Covid-wave. A confirmation of President Joe Biden’s expected large fiscal push in Q1 should also bode well for risky US assets and in particular high-yield credit where spreads have also almost recovered from the Covid shock.
Long-term return potentials in emerging market local debt are burdened by higher inflation in emerging markets compared to developed markets, weighing on their currencies’ purchasing power. This is why timing plays a bigger role for local-debt investors. We highlighted in a recent publication1, that we expect a tactical opportunity in emerging market local currency towards the end of 2020. Recent events have even brought forwards this window of tactical opportunity.
Firstly, the US elections. Even though President Biden’s victory does not necessarily improve the US-China trade/tech conflict, it clearly reduces the tail risk of a further escalation. Secondly, the blue sweep in US politics and the associated higher chance of a more forceful US fiscal policy not only supports US GDP but global GDP as well. Thirdly, central bank policy remains accommodative. The recent spike in US real yields – nominal yields rose faster than inflation expectations – can be seen as a test to this hypothesis and serve as a reminder of the taper tantrum in 20132. However, it is important to stress that major central banks like the Fed and ECB have recently confirmed to keep monetary policy accommodative until significant economic improvement is achieved. We doubt that the economic improvements in 2021 will be enough for them. This is important, as it should limit the upside for real yields in developed and emerging markets even in a benign economic scenario and should keep debt sustainability risks in check as we will see later. Finally, our conviction of a global synchronized economic recovery in 2021 has further strengthened with the approval of a Covid vaccine in major economies. This should give the US dollar a weaker tilt in 2021, which usually bodes well for EM assets in general.
A key take away of our 2020 Investors’ Survey3 revealed investors’ concern that sovereign default risks – in particular in emerging markets – are on the rise due to unprecedented fiscal stimulus packages leading to an even higher debt mountain. We argued at that time4, that risks are higher for countries with a high dependence on tourism (e.g. Caribbean countries), and much more moderate in countries with significant weights in EM bond benchmarks. Which is why we also expect a low risk of contagion effects within the EM universe.
Moreover, we highlighted that focusing purely on debt levels would be a one-sided perspective. Long-term studies show that debt-service ratios are even more useful in predicting sovereign defaults5. However, the debt-service ratios have increased more slowly than hefty 2020 stimulus packages suggest. Available non-performing loan (NPL) and provision data6 by banks in emerging markets also suggest that corporate default risks remain manageable. The upward trend in NPL- has been moderate so far ratios (see Figure 3). A further rise in NPLs is likely, but we do not see evidence that banking sector vulnerabilities will become a real burden for governments.
High debt levels cannot be ignored, and many emerging markets – in particular Latin American economies – will have to adopt more prudent fiscal policies over the next two years. How much time emerging market governments will get to bring their house in order again depends, as so often, on major central banks, in particular the Fed. Hasty policy normalization by the Fed would clearly front-load the need for many governments in emerging markets to stabilize or reduce debt ratios. But, if there has been one take away from ECB, Fed, and PBoC policy meetings, it is that monetary policy is likely to remain extremely accommodative for a long period of time. We see a very low probability of a first policy rate hike by the Fed in the next two years. We expect earlier policy normalization by the PBoC, but for emerging markets, policy decisions by the Fed remain much more important and we believe that Chairman Jay Powell will be extra-cautious in signaling his intentions in order to avoid sharp repricing in the US bond market. Therefore, we still believe that global sovereign default risks in major emerging markets remain moderate, while the outlook for vaccines gives an even more positive tilt to this assessment.
The rally in emerging market assets has raised investors’ concern that too much “hot capital” may have entered emerging markets. Indeed, capital inflows into EM have picked up substantially. However, inflows at best have recovered from heavy outflows in the first half of 2020. Moreover, flows into emerging markets have been shallow at best into Latin America and the EMEA region recently, arguing against excessive inflows here. Asian inflows have been more sizable, with the third quarter posting the highest inflows since 2011. However, even the stronger Asian inflows seem rather moderate compared to the period of 2009 - 2014 (see Figure 4). Investors’ positioning data for emerging market local debt also supports this view, with most countries seeing a foreign participation share well below pre-Covid levels.
Nevertheless, there are good reasons why portfolio flows to Asia have been stronger recently and should remain solid. Most importantly, the more robust growth outlooks amid moderate inflation pressure. Asia, and North-Asia in particular weathered the pandemic crisis much better than most other countries worldwide, with China, Taiwan, and Vietnam delivering positive economic growth in 2020.
Secondly, trade war risks – a key concern for investors in the region – have fallen since negotiations about a “phase 1 deal” started in late 2019. We still believe that tech tensions are likely to remain with us under the Biden administration. However, a scenario of a trade war escalation ending in a new equilibrium of higher tariffs has become significantly less likely under President Biden, as he probably has a better understanding of the economic damage such an escalation would have for the US economy.
Thirdly, China’s opening up improves the economic outlook for the entire region. The Regional Comprehensive and Economic Partnership (RCEP) among 15 Asia-Pacific economies and the planned investment treaty between the EU and China (CAI) are only two recent examples of China’s opening up. But we believe these agreements will benefit the region in general as the heterogeneity of economies within the RCEP argues for stronger regional integration. China’s opening up is not just built on giving foreigners access to economic sectors including finance (full opening in 2020) and infrastructure but the equity and bond markets too. While the share of Chinese equities in global benchmarks has been rising for years, the opening of the local Chinese bond market is a relatively new feature. The inclusion of Chinese government bonds into the GBI-EM and the Bloomberg Barclays Global Aggregate Bond index have attracted significant bond inflows into China. However, investors are still underweight Chinese government bonds. Taking into account the Chinese real and nominal yield, which is one of the highest in emerging markets, we expect further inflows into the Chinese market. Flows into China should help other emerging markets, in particular Asian ones as well. Currency returns, for example, remain correlated and appreciation pressure in the yuan tends to lead to Asian FX appreciation pressure and spread compression as well.
The recent rise in US real yields has resulted in investors worrying about a second taper tantrum, where an abrupt shift in policy guidance leads to sharp swings in bond yields. We agree that the timing of policy normalization matters. Slowing balance sheet expansion in a weak economic environment is likely to trigger more market turbulence than in a stable economic environment. However, we believe the Fed learned from the 2013 taper tantrum and will prepare the market slowly for any policy shift. In our opinion, such a cautious approach would lead to a gradual rise in US nominal and possibly real yields.
However, it is a myth that rising yields in developed markets lead to negative total returns in emerging market assets. If rising nominal and real yields are driven by improving growth expectations, then emerging market assets can also appreciate. Over the past 20 years, we have seen several periods in which rising US yields were accompanied by solid total returns in emerging market bonds. Sell-offs in emerging market bonds usually take place in an environment of abruptly rising US yields and deteriorating economic conditions, which is clearly not our outlook for 2021.
Similarly, our expectation for a gradual pick-up in bond yields should not be a negative factor for corporate debt or a spiraling default rate. Although companies have issued a record amount of debt in 2020, taking opportunity of low yields throughout the summer, indebtedness should stay manageable. Companies will benefit from increasing business growth from Q2 onwards as we expect activity to pick up towards the summer months. This will happen in tandem with a gradual rise in US yields, well managed by the Fed as previously stated. This should lead to rising profitability and investors’ confidence that companies will be able to repay or service debt in an environment of still favorable credit conditions. Credit spreads in developed and emerging markets should in turn tighten. That such an outlook is constructive for emerging markets and high yield can be seen in Figure 5, as both fixed income segments delivered attractive total returns in an environment of solid growth, despite rising real yields.
The fixed income universe is broad and despite the large amount of low and negative yielding bonds out there, even in this current environment, there are still areas where there is income on offer for investors. By broadening their horizon and looking at new areas to allocate to, investors can still extract returns from fixed income.