Fixed Income
Highlights 2021 Model Bond Portfolio Broad Allocations: Translating our 2021 global fixed income Key Views into recommended positioning within our model bond portfolio results in the following conclusions: target a relatively aggressive level of overall portfolio risk, while maintaining a moderately below-benchmark duration exposure alongside overweight allocations to lower-quality global corporate credit, and inflation-linked debt, versus nominal government bonds. Specific Allocation Changes: We are increasing credit spread risk in the US by upgrading our recommended overall US high-yield allocation to overweight, focused on B- and Caa-rated credit tiers, while downgrading US investment grade corporates to neutral. We are also reducing the size of our underweights in euro area corporates and shifting the overall allocation to emerging market USD-denominated credit to overweight. Feature Happy New Year! Just before our holiday break last month, we published our 2021 “Key Views” report, outlining the thematic implications of the BCA 2021 Outlook for global bond markets.1 In this follow-up report, we translate those themes into specific investment recommendations and changes to the allocations in the Global Fixed Income Strategy (GFIS) model bond portfolio. The main takeaways are that the expected global backdrop of improving economic growth momentum, a reduction in coronavirus uncertainty as vaccines are distributed, highly accommodative monetary policy and a weakening US dollar will all provide an additional reflationary lift to global financial markets after a strong H2/2020. That means moderately higher global government bond yields (led by US Treasuries) along with outperformance of growth-related spread product like corporate bonds – specifically in the riskier credit segments like US high-yield and emerging markets (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months A Review Of The 2020 Model Bond Portfolio Performance Before we look ahead to discuss the details of the changes to our model bond portfolio for 2021, we need to take a final look back at the performance of the portfolio in 2020. Chart 12020 Performance: A Positive Year After A Volatile Start Last year, the model bond portfolio delivered a total return (hedged into US dollars) of 5.9%, which outperformed its custom benchmark index by +20bps (Chart 1).2 That moderately solid return was not delivered without some volatility over the course of the year, particularly during the global market tumult last February and March. Over the full year, the government bond portion of the portfolio underperformed the custom benchmark index by -70bps while the spread product segment outperformed by +90bps. The government bond underperformance occurred entirely in the first quarter of the year, as we began 2020 with a recommended below-benchmark global duration stance and an underweight overall allocation to government bonds versus spread product. For a portfolio that is intended to reflect our strategic investment recommendations, the COVID-19 market volatility in Q1/2020 forced us to change our allocations more frequently and aggressively than usual. In early March, we moved to an overweight recommendation on government bonds and underweight on spread product (particular corporate debt) while also shifting the portfolio duration to above-benchmark. That was a large flip from a pro-risk portfolio construction to a defensive one, but which helped claw back some of the severe underperformance in the month of February as government bonds yields plunged and corporate credit spreads surged higher. After the dramatic easing of monetary policy by the major global central banks in March, most notably the US Federal Reserve’s decision to begin buying corporate bonds, we reverted back to a pro-risk stance by upgrading US investment grade credit and Ba-rated high-yield to overweight – positions that were maintained for the rest of 2021. Those US corporate bond exposures alone accounted for essentially all of the spread product outperformance of our model bond portfolio in 2020 (Table 2). Table 2GFIS Model Bond Portfolio Full Year 2020 Overall Return Attribution In terms of specific country exposures (Chart 2), our underweight stance on US Treasuries (both in allocation and duration exposure) early in 2020 severely hurt the government bond portion of the portfolio (-76bps of underperformance versus the benchmark). This dwarfed the 2020 outperformance from other countries like Italy (+11bps), Japan (+17bps), and the UK (+5bps). Importantly, our move to allocate out of nominal government bonds to inflation-linked debt in the US, Italy and Canada back in June was a positive contributor on the year, boosting the overall portfolio outperformance by a combined +25bps. Chart 2GFIS Model Bond Portfolio Full Year 2020 Government Bond Performance Attribution Within spread product (Chart 3), the biggest gains outside of US investment grade came from UK investment grade (+18bps), euro area investment grade (+12bps) and US CMBS (+11bps). The biggest drags on performance came from underweights in euro area high-yield (-23bps) and US B-rated high-yield (-17bps), as we maintained a relatively cautious stance on those sectors even during the sharp rally in the latter half of 2020 given the lingering risks from COVID-19 and US election year uncertainty. In the end, 2020 proved to be an outstanding year for taking any kind of credit risk, as the majority of spread product sectors in our model bond portfolio universe strongly outperformed government debt. Chart 3GFIS Model Bond Portfolio Full Year 2020 Spread Product Performance Attribution By Sector In the end, 2020 proved to be an outstanding year for taking any kind of credit risk, as the majority of spread product sectors in our model bond portfolio universe strongly outperformed government debt (Chart 4). Given our overweight stance toward credit, the year ended on a strong note, with the portfolio delivering +16bps of outperformance in Q4/2020 – the details of which can be found in the Appendix on pages 19-23. Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In 2020 Top-Down Bond Market Implications Of Our Key Views As a reminder, the main fixed income investment themes from our 2021 Key Views report were the following: Global growth will accelerate over the course of 2021 as COVID-19 vaccines are distributed and economic confidence improves in response. Longer-term global nominal bond yields should see some upward pressure as growth picks up, with US Treasury yields rising the most. Global real bond yields will stay deeply negative with on-hold central banks actively seeking an inflation overshoot. The US dollar will remain soft in 2021, providing an additional reflationary impulse to the global economy. Lower-quality global credit should outperform against a backdrop that will prove positive for risk assets: easy money policies, improving growth momentum and a reduction in virus-related uncertainty. We now present the specific fixed income investment recommendations that derive from those themes, described along the following lines: overall portfolio risk, overall duration exposure, country allocations within government bonds, yield curve allocations within countries, and corporate credit allocations by country and credit rating. Overall Portfolio Duration Exposure: MODERATELY BELOW BENCHMARK Our Global Duration Indicator, comprised of leading economic growth variables, is already signaling that the direction of global bond yields will be higher in 2021 (Chart 5). Successful distribution of COVID-19 vaccines should eventually add additional upward momentum to global growth as confidence improves later in the year. Even if the vaccine rollout does not go as smoothly as expected, that would put pressure for fiscal stimulus policy responses – especially in the US - that can help sustain economic recoveries. Chart 5Global Bond Yields Will Drift Higher In 2021 Chart 6Stay Below-Benchmark On Overall Duration Exposure However, with major central banks like the Fed and ECB likely to keep policy rates unchanged in 2021, so as not to impede a recovery in inflation, any upward lift to bond yields will be moderate and driven overwhelmingly by rising longer-term inflation expectations and not a repricing of future monetary policy tightening. That means developed market yield curves should bearishly steepen, in general, as front-end yields remain anchored. We shifted to a below-benchmark overall portfolio duration stance back at the end of last October, equal to just over 0.5 years of duration versus the custom benchmark index (Chart 6). We are comfortable maintaining that position, in that size, while maintaining a bearish steepening bias to yield curve exposure across all countries in the model portfolio. Government Bond Country Allocation: OVERWEIGHT LOW YIELD BETA MARKETS, OVERWEIGHT PERIPHERAL EUROPE, UNDERWEIGHT THE US In more normal times, we would let our expectations of monetary policy changes guide our recommended government bond country allocations. Yet in 2021, we see almost no chance for any meaningful change in the monetary policy bias of any developed market central bank. Thus, we continue to rely on a “yield beta” framework for making fixed income country allocation decisions in our model bond portfolio. In 2021, we see almost no chance for any meaningful change in the monetary policy bias of any developed market central bank. We expect the largest increase in developed market bond yields in 2021 to occur in the US, thus we recommend favoring countries that have a lower sensitivity to changes in US Treasury yields (i.e. the “yield beta”). The obvious candidates are government bonds in Japan and core Europe, where inflation expectations are likely to see less upward pressure than in the US – especially if the US dollar weakens further (Chart 7). Thus, we begin 2021 by maintaining our existing overweight positions in Germany and France. Chart 7Favor Government Bond Markets Less Correlated To UST Yields In 2021 The UK has been transitioning from a high-beta to low-beta bond market in recent years and we do not see that trend turning in 2021. The Bank of England (BoE) will maintain a dovish policy bias this year as the UK economy begins adjusting to the post-Brexit world and a stronger pound will dampen inflation pressures. We also begin 2021 by staying overweight UK gilts in our model portfolio. We anticipate that the Italy-Germany government bond spread will converge to the lower Spain-Germany spread in 2021. Chart 8Stay Overweight Italian Government Bonds Australia and Canada are two countries where a high yield beta to US Treasuries would make them ideal underweight candidates in a global bond portfolio this year. However, the Reserve Bank of Australia (RBA) and Bank of Canada (BoC) have instituted aggressive quantitative easing (QE) programs that are designed to dampen increases in government bond yields. As a result of these opposing forces on Australian and Canadian bond yields, we begin 2021 with a neutral allocation to both countries. However, we may shift either or both to an underweight stance if we sense any wavering of the commitment of the RBA or BoC to their QE programs amid improving economic growth. We also expect further declines in the risk premia for Italian government bond yields in 2021. The combination of aggressive ECB government bond purchases, which includes greater buying of BTPs than in years past, and signs of a somewhat more supportive backdrop of fiscal unity within the European Union (the €750bn Recovery Fund) reduce both the sovereign credit risk and “redenomination risk” of a potential euro breakup. We anticipate that the Italy-Germany government bond spread will converge to the lower Spain-Germany spread in 2021 – an outcome that last occurred in 2016 (Chart 8). We are not only maintaining our long-held overweight stance on Italy in our model portfolio, we are increasing the size of the allocation to begin 2021. Inflation-Linked Bond Allocations: MAINTAIN EXPOSURE IN THE US, ITALY AND CANADA; ADD A NEW ALLOCATION TO FRANCE Chart 9Stay Overweight Global Inflation-Linked Bonds Inflation-linked bonds had a strong relative performance versus nominal government debt across the developed markets during the second half of 2020, with breakevens widening even in countries with low realized inflation like France and Australia. Dovish central banks, the reflationary impacts of rising commodity prices (also fueled by US dollar weakness), and the V-shaped recovery in global economic growth from the 2020 COVID-19 recession have all played a role in helping lift breakevens from the depressed levels seen last spring. None of those factors is expected to change during at least the first half of 2021, thus allocations to inflation-linked bonds are still justified in several countries. We are adding a new position in French inflation-linked bonds versus nominal French bonds with breakevens below our model-implied fair value. Our fair value models for 10-year inflation breakevens show that valuations are no longer unequivocally cheap in most countries, but only in Australia do breakevens look much too high relative to underlying fundamental drivers (Chart 9). US TIPS breakevens are approaching levels that would appear “expensive”, defined as at least one standard deviation above fair value, but we still see additional upside as the model implied fair value is also rising. We currently have recommended allocations to inflation-linked bonds in the US, Italy and Canada in our model portfolio, and we are maintaining those positions as we begin 2021. We are adding a new position in French inflation-linked bonds versus nominal French bonds with breakevens below our model-implied fair value. Spread Product Allocation: OVERWEIGHT GLOBAL CORPORATES VERSUS GOVERNMENT BONDS, FOCUSED ON US HIGH-YIELD AND EM Our expectation of a combination of improving global economic growth and persistent reflationary monetary policies is a very positive backdrop for global spread product, most notably corporate bonds. However, valuations across the global corporate debt spectrum are not universally cheap after the strong H2/2020 performance. Thus, we are maintaining only a moderate overall overweight stance on spread product versus government bonds in our model bond portfolio, equal to 5% of the portfolio (Chart 10). At the same time, we recommend taking more relative spread risk within that moderate overweight allocation. This is the way we are balancing the competing forces of a pro-risk backdrop and increasingly stretched valuations in many sectors. The biggest change we are making to the credit side of our model bond portfolio is downgrading US investment grade corporate exposure to neutral while upgrading US high-yield to overweight. As we discussed in our 2021 Key Views report, spread valuation measures are more stretched for higher-rated US investment grade corporate debt compared to junk bonds. Chart 10A Moderate Recommended Overweight To Global Spread Product In 2021 Combined with a monetary liquidity backdrop that supports the performance of riskier assets like high-yield (Chart 11), we anticipate that US high-yield will be a relatively strong performer within the US credit markets in 2021. Chart 11Upgrade Lower Rated US High-Yield To Overweight When looking at the relationship between spread valuation (using our preferred metric of 12-month breakeven spreads) and risk (using a standard measure like duration-times-spread), the lower rated credit tiers of US high-yield stand out as having the most attractive risk/valuation tradeoff (Chart 12). Thus, we are focusing our shift to an overweight stance on US high-yield in our model bond portfolio by increasing the allocations to the B-rated and Caa-rated tiers. Chart 12Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) Outside the US, we are also adding additional spread product exposure by increasing the weightings to euro area high-yield and emerging market USD-denominated sovereign debt. However, we are still maintaining a relatively higher allocation to US high-yield over euro area equivalents, and emerging market USD-denominated corporate debt over sovereigns. The biggest change we are making to the credit side of our model bond portfolio is downgrading US investment grade corporate exposure to neutral while upgrading US high-yield to overweight. Finally, we are entering 2021 with the same relative tilt within US mortgage-backed securities (MBS) we maintained during the latter half of 2020, with an overweight stance on agency commercial MBS and an underweight on agency residential MBS. Overall Portfolio Risk: AGGRESSIVE The net impact of all the changes made to our portfolio allocations is to boost the estimated tracking error – the relative portfolio volatility versus that of the benchmark – from 31bps to 73bps (Chart 13). This is a significant increase in the usage of our portfolio “risk budget”, but the tracking error is still below our self-imposed limit of 100bps. Chart 13Taking A More Aggressive Posture On Overall Portfolio Risk Chart 14Boosting Portfolio Yield Through Selective Overweights After maintaining a cautious stance on overall portfolio risk levels in the latter half of 2020, given the persistent uncertainties over the spread of COVID-19 and the US presidential election, we now deem it appropriate to be more aggressive within our model bond portfolio allocations. The pro-risk positioning changes will also boost the overall yield of the model bond portfolio. The greater allocations to riskier spread product sectors leave the portfolio with a yield that begins 2021 modestly higher than that of the benchmark index (Chart 14). Portfolio Scenario Analysis For The Next Six Months After making the shifts to our model bond portfolio allocations, which can all be seen in the tables on pages 24-25, we now turn to scenario analysis to determine the return expectations for the portfolio for the first half of 2021. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To US Treasuries On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs: Base Case The current surge of global COVID-19 cases gives way to increased distribution of vaccines. The result is a steady improvement in global growth. Some additional fiscal stimulus is delivered in the US and the larger countries of Europe. Central banks keep their foot on the monetary accelerator with realized inflation moving only modestly higher. The US Treasury curve bear steepens as US inflation expectations continue drifting higher. The VIX index reaches 23, the US dollar depreciates by -5%, oil prices climb +10% and the fed funds rate remains at 0%. Optimistic Scenario The global distribution of COVID-19 vaccines goes smoothly and rapidly, while the current surge in COVID-19 cases fades in the early weeks of 2021. Global growth quickly accelerates on the back of soaring consumer & business confidence. Global fiscal stimulus surprises to upside, while central banks remain super-dovish even as inflation perks up. The US Treasury curve bear-steepens substantially as US inflation expectations steadily increase. The VIX index falls to 18, the US dollar depreciates by -10% in a pro-risk/pro-growth move, oil prices climb +20% and the fed funds rate remains at 0%. Pessimistic Scenario The vaccine rollout is slower than expected, with COVID-19 restrictions remaining in place for longer. Policymakers deliver inadequate new fiscal and monetary stimulus measures to support underwhelming growth. The US Treasury curve bull-flattens as US inflation breakevens plunge. The VIX index soars to 35, the US dollar appreciates by +5%, oil prices plunge -20% and the fed funds rate remains at 0%. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A. The US Treasury yield assumptions are shown in Table 3B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 15 and Chart 16, respectively. Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis Chart 15Risk Factor Assumptions For The Scenario Analysis Chart 16US Treasury Yield Assumptions For The Scenario Analysis The model bond portfolio is expected to deliver an excess return over its performance benchmark during the next six months of +50bps in the base case and +78bps in the optimistic scenario, but is projected to underperform by -37bps in the pessimistic scenario. These are larger expected relative returns than witnessed during the latter half of 2020, consistent with the larger tracking error we are taking entering 2021. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2021 Key Views: Vaccination, Reflation, Rotation," dated December 17, 2020, available at gfis.bcarsearch.com. 2 Our model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt and USD-denominated emerging market debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. Appendix Appendix Chart 1Q4/2020 GFIS Model Bond Portfolio Performance Appendix Table 1GFIS Model Bond Portfolio Q4/2020 Overall Return Attribution Appendix Chart 2GFIS Model Bond Portfolio Q4/2020 Government Bond Performance Attribution Appendix Chart 3GFIS Model Bond Portfolio Q4/2020 Spread Product Performance Attribution By Sector Appendix Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio In Q4/2020 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Chart 12020 Returns After a tumultuous start to the year, corporate bonds rallied in 2020 H2, managing to eke out small annual gains versus Treasuries. Specifically, investment grade corporates outperformed duration-equivalent Treasuries by 4 basis points in 2020 and high-yield outperformed by 185 bps (Chart 1). Treasuries, for their part, bested cash by 7% on the year but returns have been trending down since August. As we look forward to 2021, the economic cycle is in what we call a sweet spot for spread product returns. Economic growth is above trend, but inflation is low and monetary conditions are highly accommodative. This macro back-drop will lead to positive spread product returns versus Treasuries and a moderate bear-steepening of the Treasury curve in 2021. However, stretched valuations for investment grade corporates mean that investors must be selective within spread product. We think the Ba credit tier offers the best risk-adjusted opportunity in the corporate bond space, and also recommend favoring tax-exempt municipal bonds over equivalent-quality investment grade corporates. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-matched Treasury index by 79 basis points in December and by 4 bps in 2020. The investment grade corporate index eked out a small gain relative to the duration-matched Treasury index in 2020. Corporates underperformed Treasuries by 18% from the beginning of the year until March 23, the day that the Fed stopped the bleeding in credit markets by unveiling its suite of emergency lending facilities. With the Fed’s backstops in place, the corporate index went on to outperform Treasuries by 22% between March 23 and the end of the year (Appendix A). As we noted in our 2021 Key Views Special Report, the corporate bond index option-adjusted spread is not quite back to its pre-COVID low.1 However, valuation is close to all-time expensive after adjusting for changes in the index’s average credit rating and duration. The 12-month breakeven spread for the Bloomberg Barclays Corporate Index (adjusted to keep the average credit rating constant) has only been tighter 4% of the time since 1995 (Chart 2). The same figure for the Baa-rated credit tier is 5%. As noted, the macro environment of above-trend growth and accommodative Fed policy is very positive for spread product returns. However, better value exists outside of the investment grade corporate space. In particular, we advise investors to look at Ba-rated high-yield corporates and tax-exempt municipal bonds. High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 190 basis points in December and by 185 basis points in 2020. Ba-rated junk bonds outperformed duration-matched Treasuries by 431 bps in 2020, while B-rated and Caa-rated bonds lagged by 13 bps and 238 bps, respectively. Since the March 23 peak in spreads, Ba-rated bonds outperformed Treasuries by 33%, B-rated bonds outperformed by 30% and Caa-rated bonds outperformed by 36% (Appendix A). We view Ba-rated junk bonds as the sweet spot within the corporate credit space. The sector is relatively insulated from default risk and yet still offers a sizeable spread pick-up over investment grade corporates (Chart 3). We noted in our 2021 Key Views Special Report that the additional spread earned from moving down in quality below Ba is in line with historical averages.2 Assuming a 25% recovery rate on defaulted debt and a minimum required risk premium of 150 bps, we calculate that the junk index is priced for a default rate of 2.8% for the next 12 months (panel 3). This represents a steep drop from the 8.4% default rate observed during the most recent 12-month period. However, only seven defaults occurred in November, down from a peak of 22 in July. Job cut announcements, an excellent indicator of the default rate, are also falling rapidly (bottom panel). Overall, we see room for spread compression across all junk credit tiers in 2021 but believe that Ba-rated bonds offer the best opportunity in risk-adjusted terms. Table 3ACorporate Sector Relative Valuation And Recommended Allocation*Table 3BCorporate Sector Risk Vs. Reward* MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 22 basis points in December but underperformed by 17 bps in 2020. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 10 bps on the month to reach 61 bps (Chart 4). This is higher than the 58 bps offered by Aa-rated corporate bonds, the 49 bps offered by Agency CMBS and the 24 bps offered by Aaa-rated consumer ABS. Despite the relatively attractive OAS, we continue to view the elevated primary mortgage spread as a material risk for MBS investors. The elevated spread suggests that mortgage rates need not rise alongside Treasury yields in the near-term, meaning that mortgage refinancings can continue at their current rapid pace (panel 3). Our view is that expected prepayment losses embedded in MBS spreads (aka the option cost) are too low relative to this pace of refinancing. Last year’s spike in the mortgage delinquency rate was driven by households that were granted forbearance by the federal government’s CARES act (panel 4). The risk for MBS holders is that these households will not be able to resume their regular mortgage payments when the forbearance period ends this spring. While the situation bears close monitoring, our sense is that excess savings built up during the past nine months will be sufficient to prevent a surge of bankruptcies when the forbearance period ends. The recent stimulus package provides households with even more assistance. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 62 basis points in December but underperformed by 161 bps in 2020. Sovereign debt outperformed duration-equivalent Treasuries by 176 bps in December but underperformed by 98 bps in 2020. Foreign Agencies outperformed the Treasury benchmark by 7 bps in December but underperformed by 640 bps in 2020. Local Authority debt outperformed Treasuries by 146 bps in December but underperformed by 86 bps in 2020. Domestic Agency bonds outperformed by 14 bps in December but underperformed by 9 bps in 2020. Supranationals outperformed by 2 bps in December and by 3 bps in 2020. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, 2020’s dollar weakness was mostly relative to other Developed Market currencies (Chart 5). Value has improved somewhat for EM Sovereigns during the past few weeks, but the index continues to offer less spread than the Baa-rated US Credit index (panel 4). At the country level, Turkey, Colombia, Mexico, Russia, South Africa and Indonesia are the only countries that offer a spread pick-up relative to duration and quality-matched US corporates. Of those, only Mexico looks attractive on a risk/reward basis. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 56 basis points in December but underperformed by 286 bps in 2020 (before adjusting for the tax advantage). We upgraded municipal bonds to “maximum overweight” in our recent 2021 Key Views Special Report.3 Attractive valuations are the main reason for this move. First, spreads between Aaa-rated municipal bonds and equivalent-maturity Treasuries are elevated compared to history across the entire yield curve (Chart 6). Second, municipal bonds look even more attractive relative to duration and quality-matched credit. The Bloomberg Barclays Revenue Bond index offers a greater yield than the quality-matched Credit index across the entire maturity spectrum (before adjusting for the tax advantage). The same is true for the Bloomberg Barclays General Obligation index beyond the 12-year maturity point (panel 3). While the failure to include state & local government aid in the recent relief bill is a big blow to municipal budgets that are already stretched, we think municipal bond spreads offer more-than-adequate compensation for default/downgrade risk. State & local governments are already engaging in austerity measures that will help protect bondholders (bottom panel) and State Rainy Day Fund balances were at all-time highs heading into the COVID downturn. Both of these things should help stave off a wave of municipal downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-steepened in December. The 2/10 Treasury slope steepened 13 bps to 81 bps. The 5/30 Treasury slope steepened 7 bps to 129 bps. Our expectation is that continued economic recovery will cause investors to price-in eventual monetary tightening at the long-end of the Treasury curve. With the Fed maintaining a firm grip on the front end, this will lead to Treasury curve bear steepening. A timely vaccine roll-out and the recently passed fiscal relief bill will serve to speed this process along. We recommend positioning for a steeper curve by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. Valuation is a concern with our recommended steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar levels. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 141 basis points in December and by 117 bps in 2020. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 22 bps and 18 bps on the month. They currently sit at 2.01% and 2.07%, respectively. Core CPI rose 0.22% in November, pushing the year-over-year rate from 1.63% to 1.65%. Meanwhile, 12-month trimmed mean CPI fell from 2.22% to 2.09%, narrowing the gap between trimmed mean and core (Chart 8). We anticipate further narrowing in 2021 Q1 and therefore expect core CPI to print relatively hot. For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven inflation rate looks somewhat elevated on our Adaptive Expectations Model (panel 2).4 Inflation pressures may moderate once the core and trimmed mean inflation measures converge, and this could give us an opportunity to tactically reduce TIPS exposure in the first half of this year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, we expect short-maturity real yields to come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in December and by 98 bps in 2020. Aaa-rated ABS outperformed the Treasury benchmark by 12 bps in December and by 81 bps in 2020. Non-Aaa ABS outperformed by 33 bps in December and by 207 bps in 2020 (Chart 9). On paper, the Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 is quite negative for ABS. However, as we explained in a recent report, we don’t anticipate a material impact on spreads.5 For one thing, Aaa ABS spreads are already well below the borrowing cost offered by TALF. But more importantly, consumer credit quality is strong. As we first explained last June, the stimulus received from the CARES act led to a significant increase in disposable income and a jump in the savings rate (panel 4).6 Faced with an income boost and few spending opportunities, many households paid down consumer debt. Given the recently passed additional fiscal support and the substantial savings that have already accrued, we see household balance sheets as being in a good place. As such, we advise moving down-in-quality to pick up extra spread in non-Aaa ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 113 basis points in December but underperformed by 57 bps in 2020. Aaa Non-Agency CMBS outperformed Treasuries by 58 bps in December and by 56 bps in 2020. Non-Aaa Non-Agency CMBS outperformed Treasuries by 277 bps in December but underperformed by 360 bps in 2020 (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus will not be negatively impacted.7 Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 50 basis points in December and by 105 bps in 2020. The average index spread tightened 7 bps in December to reach 49 bps (bottom panel). At its September meeting, the Fed decided to slow its pace of Agency CMBS purchases. It is no longer looking to increase its Agency CMBS holdings, but rather, will only purchase what is “needed to sustain smooth market functioning”. This is nonetheless a backstop of the market, and it does not change our overweight recommendation. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of December 31ST, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of December 31ST, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 85 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 85 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of December 31ST, 2020) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 4 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation
The reflation trade remained the dominant theme for markets this December. The dollar suffered the largest negative abnormal returns of all the major asset classes while EM equities and gold offered the strongest risk-adjusted performance. Surprisingly,…
One of BCA Research’s Global Fixed Income Strategy service’s key views is to underweight the US in global bond portfolios, and favor countries where yields have a lower sensitivity to rising US yields. We expect the benchmark 10-year Treasury yield to rise…
This is our last report of this year. We will resume publications in January. The EM strategy team wishes you a happy holiday season and a prosperous new year. Chart Of The weekFiscal Thrust Is A Major Negative In 2021 Emerging market equities, currencies and credit markets are facing crosscurrents. On the positive side, their business cycle will continue to improve, albeit from very low levels, and there is too much money chasing fewer securities globally. On the other hand, several factors argue for a shakeout in EM financial markets: (1) peak investor sentiment and positioning, (2) peak stimulus and continued regulatory tightening in China and (3) the negative fiscal thrust in the US as well as in EM ex-China, Korea and Taiwan. Our Chart of the Week illustrates that the aggregate fiscal thrust in EM ex-China, Korea and Taiwan will be -2.7% of GDP in 2021. The charts on the following pages illustrate these positives and negatives. With such factors in mind, EM risk assets should price in those negatives and work out excesses before resuming their uptrend. Hence, our best hunch is that a potential shakeout is likely to occur before a breakout. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com EM ex-China: Fiscal Thrust And New Covid Cases In many emerging economies, the good news about the vaccines could be offset by a negative fiscal thrust in 2021. Brazil, Peru, Poland and Hungary stand out as those economies facing the most negative fiscal thrust in 2021. Brazil is in an especially precarious position and is facing a dilemma: financial markets might sell off in the wake of fiscal stimulus or the economy will relapse again if fiscal policy is not eased substantially. Chart 1 Chart 2EM ex-China: Fiscal Thrust And New Covid Cases Chart 3EM ex-China: Fiscal Thrust And New Covid Cases Will EM Share Prices Break Out? EM equity prices have risen back to their highs of the last decade. Will they break out and enter a secular bull market? In our outlook report for 2021, for the first time in the past 10 years we suggested that odds of a breakout next year are more than 50%. Nevertheless, it could be preceded by a shakeout. The following pages contain many indicators and charts that highlight both upside and downside risks. Watching emerging Asian credit markets is essential: if the excess return on high-yield corporate bonds breaks out above investment grade bonds, odds of a breakout will rise. Chart 4Will EM Share Prices Break Out? Chart 5Will EM Share Prices Break Out? Chart 6Will EM Share Prices Break Out? Outside The US, Global Equities Have Not Broken Out Yet Only US stocks have had a broad-based breakout – both large and small caps as well as the equal-weighted index. Global ex-US equity indexes have not yet broken out above their previous highs. Chart 7Outside The US, Global Equities Have Not Broken Out Yet Chart 8Outside The US, Global Equities Have Not Broken Out Yet Chart 9Outside The US, Global Equities Have Not Broken Out Yet Chart 10Outside The US, Global Equities Have Not Broken Out Yet Too Much Money Chasing Fewer Securities One major reason to expect breakouts in global ex-US share prices is too much money chasing fewer securities. The current round of QEs is producing ballooning broad money supply worldwide. Such a powerful boost to broad money supply is a major departure for QE programs from those of the last decade. We discussed those differences in the following special report: Dissecting The Impact Of QE Programs On Asset Prices And Inflation. Chart 11Too Much Money Chasing Fewer Securities Chart 12Too Much Money Chasing Fewer Securities Chart 13Too Much Money Chasing Fewer Securities Chart 14Too Much Money Chasing Fewer Securities EM/China EPS Recovery To Continue In H1 2021 As previous stimulus packages continue to work their way through the Chinese economy, its business cycle will remain robust in H1 2021. Reviving business and consumer confidence will reinforce it. EM corporate profits will continue recovering in H1 2021. Chart 15EM/China EPS Recovery To Continue In H1 2021 Chart 16EM/China EPS Recovery To Continue In H1 2021 Chart 17EM/China EPS Recovery To Continue In H1 2021 Chart 18EM/China EPS Recovery To Continue In H1 2021 Global Business Cycle And Investor Expectations Global trade and manufacturing have staged a strong comeback but investor/analyst expectations are already very elevated. Chart 19Global Business Cycle And Investor Expectations Chart 20Global Business Cycle And Investor Expectations Chart 21Global Business Cycle And Investor Expectations Chart 22Global Business Cycle And Investor Expectations Growth In EM ex-China, Korea And Taiwan In EM ex-China, Korea and Taiwan, the economic activity will continue to improve, albeit from very low levels. Chart 23Growth In EM ex-China, Korea And Taiwan Chart 24Growth In EM ex-China, Korea And Taiwan Chart 25Growth In EM ex-China, Korea And Taiwan Chart 26Growth In EM ex-China, Korea And Taiwan Investor Sentiment On Stocks The latest Bank of America Merrill Lynch survey noted that investor overweights in EM stocks and commodities are the highest since November 2010 and February 2011, respectively. Overall investor "risk on" optimism is the highest since early 2011. Our charts corroborate extremely bullish investor sentiment. Chart 27Investor Sentiment on Stocks Chart 28Investor Sentiment on Stocks Chart 29Investor Sentiment on Stocks Red Flag For Chinese Equities Rising corporate bond yields in China’s onshore bond market are not an impediment to rising Chinese share prices as long as forward EPS net revisions are also rising. Recently, not only have onshore corporate bond yields risen but also forward EPS net revisions have rolled over. Such a combination does not bode well for Chinese equities. Chart 30Red Flag For Chinese Equities China’s Monetary Conditions Have Tightened In China, monetary conditions have tightened as real (inflation-adjusted) interest rates have risen considerably and the RMB has appreciated. Such tightening has historically heralded a shakeout in the domestic A-share market and industrial metals prices. Chart 31China's Monetary Conditions Have Tightened Chart 32China's Monetary Conditions Have Tightened Message From Chinese Equities Chinese cyclical equity sectors and small cap stocks have paused or have had a small setback despite strong economic numbers. This could be a roadmap for DM and EM share prices in the coming months. Chart 33Message From Chinese Equities Chart 34Message From Chinese Equities Message From Chinese Equities China’s A-share index and relative performance of Chinese cyclical stocks versus defensive ones point to a halt in the EM and commodities rallies. Chart 35Message From Chinese Equities Chart 36Message From Chinese Equities China: Peak Stimulus The PBoC has been withdrawing liquidity from the banking system — the seasonally-adjusted excess reserves ratio has been trending lower. This points to a peak in the credit impulse. Reduced central and local government bonds issuance entails a crest in the fiscal stimulus. Chart 37China: Peak Stimulus Chart 38China: Peak Stimulus Chart 39China: Peak Stimulus Chart 40China: Peak Stimulus China Stimulus And EM Stocks And Commodities Cycles in the adjusted Total Social Financing (TSF) lead fluctuations in EM equity and industrial metals prices. Can EM and commodities break out despite the peak stimulus in China? They have not been able to do so in the past 10 years. Stay tuned. Chart 41China Stimulus and EM Stocks And Commodities Chart 42China Stimulus and EM Stocks And Commodities The US Dollar Is Very Oversold And Is Due For A Rebound Following the 2016 US elections, the US dollar rallied strongly for several weeks before selling off violently. It seems that the broad trade-weighted dollar is now following a reverse pattern. The US dollar in 2016 is shown inverted in this chart. The greenback was selling off before the 2020 US elections and has since continued to weaken. If this reverse pattern is to play out, the US dollar will near its bottom soon and then stage a playable rebound. Chart 43The US Dollar Is Very Oversold and Is Due For A Rebound Chart 44The US Dollar Is Very Oversold and Is Due For A Rebound Several Indicators Herald A US Dollar Rebound The relative outperformance of the US equal-weighted equity index against its global peers and the recent relapse in a cyclical European currency (the Swedish krona) versus a defensive currency (the Swiss franc) point to a potential rebound in the US dollar. Chart 45Several Indicators Herald A US Dollar Rebound Chart 46Several Indicators Herald A US Dollar Rebound Chart 47Several Indicators Herald A US Dollar Rebound Commodities Prices Have Surged Recently Many commodities prices have recently spiked after the notable rally from their March/April lows. Is the latest spike the final climax phase of the cyclical rally? If yes, China-related plays might have approached a major peak. Chart 48Commodities Prices Have Surged Recently Chart 49Commodities Prices Have Surged Recently The Latest Rebound In Oil Prices Is Unsustainable The US and European mobility index points to lower gasoline consumption. Critically, the rise in US oil inventories (shown inverted) points to a drop in crude prices. Chart 50The Latest Rebound In Oil Prices Is Unsustainable Chart 51The Latest Rebound In Oil Prices Is Unsustainable Chart 52The Latest Rebound In Oil Prices Is Unsustainable The Long-Term Oil Outlook Global oil demand will rise next year, as the deployment of the coronavirus vaccines revives mobility and travel. However, greater demand will be offset by higher crude production in 2021. The long-term oil outlook is dismal as the OPEC+ arrangement of suppressing crude output will likely prove unsustainable. In turn, oil consumption will be suppressed by green policies. Notably, long-term (three- and five-year) oil price forwards have failed to advance. Chart 53The Long-Term Oil Outlook Chinese Oil Imports Have Slowed Chart 54The Long-Term Oil Outlook Oil Production Will Rise For Major Producers Chart 55The Long-Term Oil Outlook Long-Term Oil Prices Remain Depressed Chart 56The Long-Term Oil Outlook EM Fixed-Income Markets EM sovereign and corporate credit spreads (shown inverted on the chart) move in tandem with commodities prices and EM exchange rates. We continue to recommend receiving 10-year swap rates in Mexico, Colombia, Russia, Malaysia, India and China. In the long run, EM currencies are attractive versus the US dollar. Investors should consider buying cash bonds on potential EM currency weakness. Chart 57EM Fixed-Income Markets Chart 58EM Fixed-Income Markets Chart 59EM Fixed-Income Markets Chart 60EM Fixed-Income Markets EM Currencies Are Cheap A Peak In Copper And Iron Ore Prices Copper and iron ore prices are vulnerable going into 2021 due to various factors elaborated in our two recent in-depth special reports. Chart 61A Peak In Copper And Iron Ore Prices Chart 62A Peak In Copper And Iron Ore Prices Chart 63A Peak In Copper And Iron Ore Prices Five High-Conviction Strategies / Trades Long global value / short Chinese value stocks; Stay neutral on EM versus DM equities; Continue receiving select EM 10-year swap rates (please refer page 21); Stay short a basket of high-beta EM currencies versus an equal-weighted basket of the euro, CHF and JPY; Stay long EM consumer staples / short EM bank stocks. Chart 64Five High-Conviction Strategies/Trades Chart 65Five High-Conviction Strategies/Trades Chart 66Five High-Conviction Strategies/Trades Chart 67Five High-Conviction Strategies/Trades Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Feature Feature ChartEconomies Have Already Snapped Back In this final report of a tumultuous 2020, we present our key views for 2021 in the form of ten questions and answers during a recent conversation with a client. 1. Let’s begin with a blunt question. How can your views ever anticipate a shock such as this year’s once-in-a-century pandemic? Nobody can predict when, where, or how a shock will come. But what we can, and should, always do is gauge the fragility of the market to an incoming shock, whatever that unknown shock might be. Before the pandemic struck, both our 2020 key views and our first report of this year, Markets Are Fractally Fragile, pointed out that a fragile market was vulnerable to “the tiniest of straws that could break its back.” Right now, markets are close to a similar point of fragility. 2. What is the specific source of market fragility right now? The fragility is that tech stock valuations have become hyper-dependent on low bond yields in a so-called ‘rational bubble’. Specifically, the (earnings) yield premium on tech stocks versus the 10-year bond yield is at its 2.5 percent lower threshold that has signalled four previous fragilities in February 2018, October 2018, April 2019, and January 2020 (Chart I-2). Chart I-2Tech Stock Valuations Are Fragile These previous fragilities resulted in an exhaustion, or worse, a correction, in tech stocks, and by extension in the overall market. The upshot is that a meaningful rise in bond yields could once again undermine the stock market. 3. But I thought that higher bond yields were good for stocks, if the higher bond yields imply that growth is accelerating? Not necessarily. Yes, a stock price is proportional to growth, but it is also inversely proportional to the discount rate, which is the required return that investors demand to hold it. If the discount rate increases by more than growth, then the stock price will fall, not rise. The discount rate equals the bond yield plus the equity risk premium. At ultra-low yields, the two components move together. This is because when the bond yield declines towards its lower bound, the bond price carries less upside versus downside and thereby more risk. Meaning that in relative terms, equities require a smaller risk premium. When bond yields increase, the opposite is true – both the bond yield and the equity risk premium rise together (Chart I-3). Chart I-3AUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time Chart I-3BUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time The result is that growth would have to increase very sharply to counter the large rise in the bond yield plus equity risk premium. 4. But 2021-22 are likely to be years of very strong growth just like the post-recession years 2009-10, right? Wrong. You see, after a slump the strongest growth occurs in the sharp snapback of lost output, and most of this sharp snapback has already happened. In 2008-09, the US and German economies shrank for four quarters. It then took five quarters of strong growth to recover two-thirds of this lost output. But in 2020, everything has happened at quintuple-speed. It has taken just one quarter to recover two-thirds of the lost output, and by the end of this year US GDP will be almost back to its pre-pandemic level (Feature Chart and Chart I-4). Chart I-4Economies Have Already Snapped Back This is because we quickly realised that even in a full-scale pandemic, 90 percent of economic activity can continue with face masks and social distancing. The activities that are most disrupted – retail, hospitality, and transport – account for just 10 percent of output. Meanwhile, China, which on some measures is the world’s largest economy, is already ‘back to normal’ because its effective track-and-trace system has circumvented the need for face masks and social distancing. The upshot is that, as far as global economic output is concerned, most of the powerful snapback has already happened. 5. But if economic output has largely recovered, why does it not feel like it has? For three reasons. First, the most disrupted activities comprise so-called ‘social consumption’ such as going to bars and restaurants, having friends round for dinner, and going on holiday. In other words, all the fun things in life. Although these activities account for just 10 percent of economic output, they likely account for a much bigger proportion of our happiness. Second, we are producing and consuming the 90 percent of undisrupted output differently. For example, working from home, doing business meetings virtually, and doing our shopping on-line. Crucially, much of this ‘new-normal’ is here to stay even when the pandemic ends. Third, although the disrupted activities account for just 10 percent of output, they account for a very significant 25 percent of all jobs. Meaning that the jobs market has not snapped back to the same extent as output. Indeed, permanent unemployment continues to rise (Chart I-5). Chart I-5Permanent Unemployment Continues To Rise Alas, the jobs market will take a long time to fully recover even when the pandemic ends. This is because the new-normal way of producing and consuming will permanently scar traditionally high-employment sectors such as retail and hospitality. Constituting a major economic fragility in the new-normal (Table I-1). Table I-1Retail And Hospitality Employ 25 Percent Of All Workers 6. All of which means inflation stays below the 2 percent target, right? Right. But your question should be framed differently. You see, inflation is a non-linear system with two states: price stability and price instability. You can shift an economy between these two states, but you cannot hit an arbitrary target like 2 percent, 3 percent, or 5 percent. So, your question should be, will developed economies stay in the state of price stability? And the answer is yes, because it is the much better state to be in, and it took decades of blood, sweat and tears to achieve. Nevertheless, any government can flip its economy into the state of price instability if it so desires. Just look at Turkey. A warning sign is that the central bank loses its independence, enabling it to monetise government debt. That’s the warning sign to look out for. 7. Talking of fragility in a new-normal, hasn’t the double whammy of Brexit and the pandemic weakened the EU? No, quite the contrary. As Jean Monnet, a founding father of the EU, said: “Europe will be forged in crises.” And he was right. Each of the last three crises has strengthened the EU’s architecture. The euro debt crisis added the missing ‘lender of last resort to sovereigns’ weapon into the ECB armoury – a weapon whose mere presence means it has never had to be used. Brexit removed the most troublesome member from the EU fold, as well as demonstrating how costly it is to exit. And the pandemic has allowed the EU to smash two major taboos: explicit fiscal transfers across countries, and the large-scale issuance of common EU bonds. All of which means that the yield spreads on euro area ‘periphery’ bonds over Germany and France will continue to tighten, and ultimately disappear altogether (Chart I-6). Chart I-6The Yield Spread On Euro Periphery Bonds Will Vanish 8. What about the prospects for the UK outside the EU? Like all divorces, Brexit is a gain of self-determination for a loss of wealth. Hence, since the Brexit vote in 2016, the UK economy has flipped from outperformer to underperformer (Chart I-7). Chart I-7The UK Economy Has Flipped From Outperformer To Underperformer The UK economy will continue to underperform until it forges a fresh purpose and role as a newfound singleton on the world stage. 9. Turning to investments, will the 2020 losers become the 2021 winners, and vice-versa? No, that’s an over-simplification. For example, for bonds to lose their 2020 winnings, yields would have to back up a lot. But as we’ve already discussed, that would burst the ‘rational bubble’ in tech stocks, undermine the stock market, and put renewed downward pressure on bond yields. In which case, banks will struggle to sustain any outperformance (Chart I-8). Meaning that ‘value’ will struggle to sustain any outperformance. Hence, a much smarter strategy is to switch between winners and losers within ‘growth’ and within ‘value’. Specifically, overweight healthcare versus tech, and overweight utilities versus banks. Chart I-8Bank Relative Performance Tracks The Bond Yield Of course, sector allocations always carry implications for regional and country equity allocation. The main implications are to overweight Europe versus Emerging Markets (Chart I-9), and to overweight Developed Markets versus Emerging Markets. Chart I-9Europe Vs. EM = Healthcare Vs. Tech 10. Finally, what about your long-term recommendations? This brings us full circle to the first question. While we could not predict the pandemic, all our four mega-themes for the 2020s proved to be successful, and in some cases very successful. A hypersensitivity to higher interest rates. Overweight equities versus bonds. Europe conquers its disintegration forces. Overweight European currencies. Non-China exposed investments outperform. Underweight materials and resources. The rise of blockchain and alternative energy. Overweight alternative energy, underweight oil and gas, and underweight financials. Given their long-term nature, these structural recommendations are as appropriate today as they were a year ago. And with that, it is time to sign off on a tumultuous 2020 and usher in 2021, a year which we define as Fragility In A New-Normal. We wish you and your families a safe and healthy holiday season, and a less tumultuous 2021. Fractal Trading System* This week’s recommended trade is to go long US utilities (XLU) versus US materials (XLB). Set the profit target and symmetrical stop-loss at 5.7 percent. In other trades, short European retail (EXH8) versus the market (STOXX) achieved its 4.2 percent profit target at which it was closed. The rolling 12-month win ratio now stands at 61 percent. Chart I-10 When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Global growth will accelerate over the course of 2021 as COVID-19 vaccines are distributed and economic confidence improves in response. Longer-term global bond yields see some upward pressure as growth picks up, but global real yields will stay negative with on-hold central banks actively seeking an inflation overshoot. Maintain below-benchmark overall global duration exposure, and position for steeper government bond yield curves and wider inflation breakevens. The rise in global bond yields we anticipate will be relatively moderate, with US Treasury yields rising the most. Underweight the US in global bond portfolios, and favor countries where yields have a lower sensitivity to rising US yields (core Europe, Japan, UK). Also overweight Peripheral European debt given supportive monetary and fiscal policies that are helping to reduce credit risk (Italy, Spain, Portugal). The US dollar will remain soft in 2021, providing an additional reflationary impulse to the global economy. Overweight global inflation-linked bonds versus nominal government debt. Lower-quality global credit should outperform against a backdrop that will prove positive for risk assets: easy money policies, improving growth momentum and a reduction in virus-related uncertainty. Upgrade US high-yield to overweight through higher allocations to lower rated credit tiers, while downgrading US investment grade, where valuations are far less compelling, to neutral. Favor US corporates versus euro area equivalents, of all credit quality, based off less attractive euro area spread valuations. Within US$-denominated emerging market debt, favor corporates over sovereigns. Feature Dear Client, This report, detailing our global fixed income investment outlook for next year, will be our last for 2020. Please join me for a webcast this coming Friday, December 18 at 10:00 AM EST (3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT) where I will discuss the outlook followed by a Q&A session. Best wishes for a very safe, healthy and prosperous 2021. We’ve all earned that after a difficult 2020 that none of us will soon forget. Rob Robis, Chief Global Fixed Income Strategist BCA Research’s Outlook 2021 report, “A Brave New World”, outlining the main investment themes for next year based on the collective wisdom of our strategists, was sent to all clients in late November.1 In this report, we discuss the broad implications of those themes for the direction of global fixed income markets in 2021. In a follow-up report to be published in the first week of the New Year, we will translate those themes into specific recommended allocations and weightings within our model bond portfolio framework. A Summary Of The 2021 BCA Outlook The tone of the BCA 2021 Outlook was generally positive, with conclusions that are supportive for the outperformance of risk assets relative to safe havens like government bonds (Chart 1). Chart 1How To Play Recovery & Reflation In 2021 Global growth will strengthen over the course of next year, after an initial soft patch related to the late-2020 COVID-19 economic restrictions in Europe and the US. Economic confidence will improve as the COVID-19 vaccines become more widely distributed, at a time of ongoing substantial monetary and fiscal stimulus in most important countries. A major release of pent-up demand is likely, fueled by the surge in private sector savings in the US and Europe after households and businesses cut back on spending because of the pandemic. The lingering impact of China’s substantial fiscal and credit stimulus in 2020 will still be felt throughout the world for most of 2021, even with Chinese authorities likely to begin curtailing the expansion of credit around mid-year. The tremendous amount of global spare capacity created by the virus and associated economic restrictions will keep inflation subdued in most countries. Thus, both monetary and fiscal policymakers will be under no pressure to pre-emptively tighten policy. The pace of monetary/fiscal stimulus will inevitably slow on a rate-of-change basis after the massive ramp up of government spending, income support, loan guarantees and central bank asset purchases. However, policymakers are expected to pull any and all of those levers once again in the event of a severe pullback in economic growth or a major bout of financial market turbulence. After a wild 2020 in a US election year, geopolitical uncertainty is expected to recede a bit next year. Although US-China tensions will remain elevated even under the incoming Biden administration, European politics are expected to be a tailwind for financial markets. A UK-EU Brexit deal is expected to be reached given economic realities, increased fiscal cooperation within the EU will support fiscally weaker countries like Italy, and the threat of the US imposing tariffs on Europe will disappear after Donald Trump leaves office. Our Four Main Key Views For Global Fixed Income Markets In 2021 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2020 BCA Outlook: Key View #1: Maintain below-benchmark overall global duration exposure, and position for steeper government bond yield curves and wider inflation breakevens. Chart 2COVID-19 Lockdowns Will Not Last Forever COVID-19 was the elephant in the room for financial markets in 2020, influencing sentiment whenever cases flared up or subsided. Yet the impact diminished steadily since the first wave of the virus stretched beyond China in the spring. The broad span of global risk assets – equities, corporate credit, industrial commodities – has performed very well during the current, and much larger, surge in cases occurring in the US and Europe. One big reason for this is that investors now understand that lockdowns, and the associated drag on economic growth, do not last forever. In addition, investors know that policymakers in most countries will react to any sharp downturn in economic confidence with more fiscal and monetary stimulus to help offset the negative growth impact of the lockdowns. In Europe, many European governments enacted harsh national lockdowns in a bid to “flatten the curve” during the latest surge. This has helped successfully reduce the growth rate of new cases and hospitalizations (Chart 2). This will eventually lead to an easing of restrictions, and a recovery in economic activity, in early 2021. While US case numbers are also surging, the response by governments has been much less widespread, and severe, compared to Europe. There is little political appetite (even with a new president) for another wave of harsh restrictions along the lines of what took place last spring. Some slowing of economic activity is inevitable because of increased regional restrictions in large states like California and New York, as is already evident in some late-2020 data. However, any downturn should not be expected to last long with the growth rate of US COVID-19 hospitalizations having already peaked. The big game-changer, of course, is the introduction of COVID-19 vaccines which have already begun to be distributed in the UK and US. While there are uncertainties related to the operational logistics of a worldwide vaccine rollout, including whether enough people will voluntarily choose to be vaccinated to achieve herd immunity on a global scale, the very high announced efficacy levels of the various vaccines mean that an end of the pandemic is now achievable. Investors should see through the current surge in COVID-19 cases, and any short-term hiccup in economic growth, and focus on the bigger picture of the introduction of the vaccine and the positive implications for global economic confidence in 2021. Growth has already been holding up well in the US and China in the final months of 2020, with both manufacturing and services PMIs remaining solidly above the 50 line indicating expanding activity. As the euro area lockdowns begun to ease up, growth there will catch up, which already appears to be underway with the sharp uptick in the December PMI data (Chart 3). Those three regions account for one-half of worldwide GDP, so that is already a solid footing for global growth entering 2021. A sustained improvement in the pace of global economic activity is important, as it is becoming increasingly harder for governments to sustain the extreme levels of policy stimulus delivered in 2020. In China, policymakers are starting to rotate their focus away from aggressive stimulus and fighting deflation back to the cautious risk management approach to credit expansion that was in place prior to COVID-19. BCA Research’s China strategists expect the latest Chinese credit cycle to peak by mid-2021, with the credit impulse set to decline in the second half of the year (Chart 4). Combined with the tightening of monetary conditions through a strengthening yuan and higher local interest rates, some slowing of Chinese growth is inevitable. Although given the lags between stimulus and growth, the impact is more likely to be felt toward year-end and into 2022 – good news for much of the global economy that still relies heavily on exporting to China as an engine of growth. Chart 3A Growth Recovery Without Inflation Chart 4China Stimulus Will Peak Out By Mid-2021 Overall global fiscal policy is on track to be less supportive in 2021. The latest estimates from the IMF show that the “fiscal thrust”, or the change in the cyclically-adjusted primary budget balance relative to potential GDP, in most developed economies will turn negative next year (Charts 5A and 5B). Such a swing is inevitable given the sheer magnitudes of the fiscal stimulus measures first introduced to combat the economic damage from COVID-19 that will not be repeated in 2021. By the same token, less fiscal stimulus will be necessary if overall global growth improves, especially if vaccines can be successfully distributed to much of the world. Chart 5ANegative Fiscal Thrust In 2021 … Chart 5B… But Governments Will Spend More If Needed What does all this mean for global government bond yields? We believe that it signals a continuation of the trends seen towards the end of 2020 – a slow grind higher in longer-term yields, led by better growth and rising inflation expectations, but without any need to discount a move to tighter monetary policy because of a sustained overshoot of realized inflation. The current economic projections of the Fed, ECB, Bank of England (BoE), Bank of Canada (BoC) and Reserve Bank of Australia (RBA) all show that policymakers there expect unemployment rates to remain above pre-pandemic levels to at least 2023 (Chart 6). At the same time, central banks are also projecting inflation to be below their target levels/ranges over that same period. In response, the forward guidance from these central banks has been very dovish, with policy interest rates expected to remain at current levels at or near 0% for at least the next two to three years. Interest rate markets have taken the hint, with a very low expected path for rates over the next few years discounted in overnight index swap curves. Chart 6Central Banks Projecting A Slow Return To Full Employment Chart 7Markets Expect Years Of Negative Real Policy Rates The implication of this is that central banks are projecting a sustained, multi-year period where policy rates will remain below forecasted inflation (Chart 7). Or put more simply, central banks are consistently signaling that negative real interest rates will persist for a long time. This means that one of the most oft-discussed “oddities” of global bond markets in 2020 - the persistence of negative real long term bond yields in most major economies, most notably in the US Treasury market, even as inflation expectations increase – is unlikely to disappear in 2021. Those negative real yields reflect, to a large part, the expectation that real global policy rates will stay persistently negative (Chart 8). At some point in 2021, markets could challenge this dovish guidance from central banks that could temporarily push up both future interest rate expectations and longer-term real yields, especially in the US. However, it is more likely that central banks will not validate that move higher in yields for fears of pre-emptively short-circuiting an economic recovery. Such a hawkish shift could be more plausibly delivered in 2022 at the earliest, with the Fed the most likely candidate to change its guidance. Summing up all of the above points with regards to our recommendations on overall management of government bond portfolios, we arrive at the following conclusions (Chart 9): Chart 8Rising Inflation Breakevens With Stable Negative Real Yields Chart 9Moderately Higher Global Bond Yields In 2021 Duration exposure should be set below-benchmark. Our forward-looking Duration Indicator, comprised of leading economic indicators and economic expectations data, is strongly signaling that global yields should head higher in 2021. Position for a bearish steepening of yield curves. This will be driven more by rising longer-term inflation expectations, as the short-ends of yield curves will remain anchored by dovish on-hold central banks. Key View #2: Underweight the US in global bond portfolios, and favor countries where yields have a lower sensitivity to rising US yields Moving beyond the overall global duration view, there are significant country allocation decisions that derive from our outlook for 2021. First and foremost, we recommend underweighting US Treasuries in global bond portfolios, as we anticipate the biggest increase in developed market bond yields next year to occur in the US. We expect the benchmark 10-year Treasury yield to rise to the 1.25% to 1.5% range sometime in 2021. This move will come mostly through higher inflation expectations. The 10-year TIPS breakeven inflation rate is expected to reach the 2.3-2.5% range that we have long considered to be consistent with the market pricing in the Fed sustainably achieving its 2% inflation goal. Any additional Treasury yield increases beyond our 2021 forecast range would require the Fed to shift to a more hawkish stance signaling future rate hikes. With the Fed now operating with an Average Inflation Target framework, allowing for temporary overshoots of inflation after periods when inflation was below the Fed’s 2% target, the hurdle for such a shift in Fed guidance is much higher than in previous years. The Fed has also changed the nature of its forward guidance compared to years past, signaling that any future monetary tightening will only occur once actual inflation has sustainably returned to the 2% target. That means that the Fed will no longer pre-emptively choose to hike rates on merely a forecast of higher inflation – it will first need to see a sustained period of higher inflation materialize before considering any tightening. Thus, any move beyond our expected 1.25% to 1.5% range on US Treasuries would require a hawkish signal by the Fed that it intends to begin removing monetary accommodation through rate hikes. Under the Average Inflation Target framework, that will not happen in 2021 but could happen the following year if inflation stays at or above 2% over the course of next year. Turning to other countries, we recommend favoring bond markets with a lower historical “yield beta” to US Treasuries. In other words, we prefer overweighting counties where government bond yields are typically less correlated to changes in Treasury yields. We show those historical yield betas, using 10-year yields, in Chart 10. Importantly, the betas are calculated only for periods when Treasury yields are moving higher. We call this “upside beta”, which is a useful tool to identify which bond markets are more sensitive to selloffs in the US Treasury market. Chart 10Favor Lower Beta Government Bond Markets In 2021 The highest “upside beta” countries among the major developed markets are Australia, Canada and New Zealand, while the lowest “upside beta” countries are Germany, France and Japan. The UK is in the middle of those two groupings, although the trend over the past few years suggests that it is transitioning from a high-beta to low-beta country. Note that for all countries shown, the upside yield betas are below one, indicating that no market should be expected to see a bigger rise in yields than the US. Strictly based on our forecast of higher Treasury yields and calculated yield betas, we would recommend more overweight allocations to markets in the lower-beta group and more underweight allocations to the higher-beta group. We are comfortable recommending overweights to the lower-beta group of Germany, France, Japan and the UK. Although among the higher-beta group, we are reluctant to recommend underweighting all three countries because of the policy choices of their central banks. The RBA, BoC and Reserve Bank of New Zealand (RBNZ) have all enacted aggressively large quantitative easing (QE) programs in 2020 as a way to provide additional monetary stimulus after cutting policy rates to near-0%. The BoC stands out as being extremely aggressive on QE with its balance sheet expanding more than three-fold on a year-over-year basis (Chart 11). Chart 11More Divergence In The Pace Of Global QE None of these three central banks has discussed slowing the pace of purchases anytime soon. In the case of the RBA and RBNZ, they have gone as far as signaling the role of QE in dampening their bond yields to help stem the appreciation of their currencies. They may have limited success in driving down yields further, however. Measures of bond valuation like the term premium, which typically move lower when QE accelerates, have bottomed out across the developed markets even as central banks have absorbed a greater share of the stock of government debt in 2020 (Chart 12). Yet even if QE can no longer drive yields lower, it can limit how much yields can increase when under cyclical upward pressure. For this reason, we do not expect government bond yields in Australia, Canada or New Zealand to behave in line their historical higher yield beta that would make them clear underweight candidates in a period of rising US Treasury yields, as we expect. Net-net, we recommend that investors focus underweights solely on US Treasuries within global government bond portfolios. This suggests that yield spreads between Treasuries and other bond markets should continue to widen, as has been the case over the final few months of 2020 (Chart 13). We recommend neutral allocations to Australia, Canada and New Zealand, while overweighting core Europe, Japan and the UK. Chart 12More QE Is Less Impactful In Pushing Down Bond Yields Chart 13US Treasuries Will Continue To Underperform In 2021 We also are maintaining our overweight recommendation on Italian and Spanish government debt, which was one of our most successful calls of 2020. We view those markets more as a credit spread story versus core Europe, rather than a directional yield instrument like US Treasuries or German Bunds. On that basis, the spread of Italian and Spanish yields versus German yields has room to compress even further, as both are strongly supported by ECB bond purchases. Also, the introduction of the European Union’s €750bn Recovery Fund is a strong signal of greater fiscal co-operation within Europe – another important factor that has helped reduce the risk premium (credit spread) on Italy and Spain. When looking at the yields currently on offer in the developed world, Italy and Spain offer very attractive yields in a global low-yield environment (Table 1). Stay overweight. Table 1Developed Market Bond Yields, Both Unhedged & Hedged Into USD Key View #3: Overweight global inflation-linked bonds versus nominal government debt We have discussed the importance of rising inflation expectations as a core driver of the rise in global bond yields that we expect in 2021. This has been in the context of improving global growth, reduced spare economic capacity and central banks staying very dovish, all of which are necessary ingredients to boost depressed inflation expectations. A weaker US dollar will also play a significant role in that boost to inflation expectations and bond yields that we expect next year. The decline in the greenback seen in the latter half of 2020 has been driven by the typical factors (Chart 14): Chart 14More Negatives Than Positives For The USD The Fed’s aggressive rate cuts, dating back to 2019, have reduced much of the relative interest rate attractiveness of the US dollar Accelerating global growth after the sharp worldwide plunge in growth in Q2/2020 benefitted non-US economies more, eliciting a standard decline in the “anti-growth” US dollar Uncertainty and risk aversion declined after the initial COVID-19 shock at the start of 2020, easing the safe haven demand for dollars. Looking ahead, rate differentials continue to point to additional downward pressure on the US dollar, even with the moderate rise in longer-term US Treasury yields that we expect next year. Risk aversion and uncertainty should also decline in a dollar-bearish fashion with the US presidential election behind us and the COVID-19 vaccine ahead of us. Improving global growth should also be supportive of more dollar weakness, especially as Europe recovers from the current lockdown-driven slowdown. A weaker US dollar is a key variable to trigger faster global inflation through the link between the currency and global traded goods prices. On a rate-of-change basis, a weakening US dollar has a strong negative correlation to the growth rate of world export prices and commodity prices (Chart 15). Thus, more USD weakness in 2021 will lift realized global inflation through commodities and traded goods prices, especially against a backdrop of faster global growth. Chart 15Global Reflation Through A Weaker USD Chart 16Stay Overweight Global Inflation-Linked Bonds In 2021 BCA Research’s commodity strategists expect oil prices to move higher next year on the back of an improving demand/supply balance, with the benchmark Brent price of oil averaging $63/bbl over the course of 2021. A weaker USD could provide additional upside to that forecast, giving a further lift to realized inflation rates around the world. To position for this boost to inflation via a weaker dollar and rising commodity prices, we recommend that fixed-income investors continue holding a core allocation to inflation-linked bonds versus nominal government debt. We have maintained that recommendation since last spring after the collapse of global breakeven inflation rates that left breakevens very undervalued according to our fair value models (Chart 16).2 The valuation case is far less compelling now after the steady climb in breakevens over the latter half of 2020, with only French and Japan breakevens below fair value. However, given our expected backdrop of improving global growth and highly accommodative global monetary policy, breakevens are likely to continue to climb to more expensive levels. Our preferred allocations are to US and French inflation-linked bonds, while we would be cautious on Australian inflation-linked bonds which appear extremely overvalued on our models. Key View #4: Within an overweight allocation to global corporate debt, overweight US high-yield versus US investment grade and favor all US corporates versus euro area equivalents. Global corporate bond markets have enjoyed a spectacular rally over the final three quarters of 2020 after the huge pandemic related selloff of last February and March. The benchmark index yields for investment grade corporates in the US, euro area and UK have all fallen back below pre-COVID levels, while index yields for high-yield in the same three regions are back at the pre-COVID lows (Chart 17). The story is similar on a credit spread basis. The benchmark index option-adjusted spread (OAS) for investment grade corporates is only 11bps away from the pre-COVID low in the US and 4bps from the pre-COVID low in the euro area, with the UK spread now slightly below the pre-pandemic low (Chart 18). High-yield spreads still have some more room to compress with US, euro area and UK junk index spreads 67bps, 68bps and 110bps above the pre-pandemic low, respectively. Chart 17Corporate Bond Yields Falling To New Lows Chart 18Corporate Bond Spreads Approaching Pre-COVID Lows Supportive monetary policy has played a huge role in the global credit rally. Central banks have used their balance sheets aggressively to help ease financial conditions, including the direct buying of corporate bonds by the Fed, ECB and BoE. Looking ahead to 2021, it is clear that credit markets are still benefitting from loose monetary policy while also enjoying a tailwind from better global growth. The global high-yield default rate is rolling over and the US default rate has clearly peaked (Chart 19). There is now less of a need for direct buying of corporates by central banks with credit markets seeing major investor inflows with a robust pace of corporate bond issuance. Corporate bond markets can now walk on their own with the support of central bank crutches. This means that investors should pivot away from the more cautious “buy what the central banks are buying” approach that we had advocated for much of 2020 and be more selectively aggressive. First and foremost, that means increasing allocations to US high-yield corporate debt, both out of US investment grade and euro area corporates. Default-adjusted spreads in the US, which measure the high-yield index OAS net of realized default losses, will look far more attractive as the US default rate peaks (Chart 20). If the US default rate moves back below 5% over the next year from the current 8% rate, the US default-adjusted spread will climb back into positive territory. This will compare more favorably to the default-adjusted spread for euro area high-yield, which has been higher because the euro area default rate did not suffer a major spike this year despite the sharp downturn in euro area growth back in the spring. Chart 19Easy Money Policies Supporting Global Credit Chart 20High-Yield Looks More Attractive With Fewer Defaults In 2021 US high-yield also looks most attractive using our preferred metric of pure spread valuation, the 12-month breakeven spread. This measures the amount of spread widening that must occur over a one year period for corporate debt to have the same return as a duration-matched position in government bonds. We compare this “spread cushion” to its own history in a percentile ranking to determine if spreads look relatively attractive. Within US corporate debt, the 12-month breakeven spread for investment grade credit is down to the 5th percentile, suggesting virtually no room for additional spread tightening (Chart 21). For US high-yield credit, the 12-month breakeven spread is still relatively elevated at the 60th percentile level, suggesting more room for spread compression. Within euro area corporates, the 12-month breakeven percentile rankings for investment grade and high-yield are at the 27th and 28th percentile, respectively, suggesting a more limited scope for spread compression compared to US high-yield (Chart 22). Chart 21Move Down In Quality Within US Corporates Chart 22No Compelling Value In Euro Area Corporates When comparing the 12-month breakeven spreads of all corporate debt in the US, euro area and UK, broken down by credit tier, to a more pure measure of spread risk - duration times spread – the attractiveness of lower-rated US junk bonds is most compelling (Chart 23). In particular, US B-rated and Caa-rated junk spreads offer very high 12-month breakeven spreads relative to spread risk. Chart 23Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) Adding it all up, it is clear that lower-rated US high-yield debt offers an attractive value proposition for 2021. This is especially true given the positive global growth and monetary policy backdrop. The annual growth rate of the combined balance sheets of the Fed, ECB, BoE and Bank of Japan has been an excellent leading indicator of the excess return of US high-yield US Treasuries (Chart 24). The surge in balance sheet growth of 2020 is pointing to strong US high-yield bond performance versus Treasuries, and an outperformance of lower-rated US high-yield, in 2021. Chart 24Upgrade US High-Yield To Overweight Chart 25Within EM USD Credit, Favor Corporates Over Sovereigns This leads us to shift to an overweight stance on US high-yield, while downgrading US investment grade to neutral, as our key global spread product recommendation for 2020. Within other corporate credit markets, we recommend only a neutral allocation to euro area corporate credit, given the relatively less attractive valuations. Finally, within the emerging market US dollar denominated universe, we continue to recommend an overweight stance on corporates versus sovereigns, as the former will benefit more in 2021 from the lagged effect of Chinese credit stimulus and central bank balance sheet expansion in 2020 (Chart 25). Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research The Bank Credit Analyst, "Outlook 2021: A Brave New World", dated November 30, 2020, available at bca.bcaresearch.com. 2 Our breakeven inflation models use the growth rate of oil prices in local currency terms and a long-term moving average of realized inflation as the inputs. Recommendations Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
BCA Research’s US Bond Strategy service concludes that investment-grade corporates will outperform Treasuries in 2021, but the potential for further spread compression is limited. Junk spreads have more room to tighten, and the Ba credit tier looks…