Summary: The Federal Reserve finally reacted to the escalating likelihood of a global recession with a sharp dovish turn last month, joining the ranks of the European and Chinese central banks. This is unhappy news for already-fragile EM and corporate bonds, especially in the high-yield space, but it augurs well for sovereigns.
The first quarter of 2019 saw a U-turn in central bank policy. With data pointing to a global slowdown, policymakers do not wish to take chances. That’s why we have seen the Federal Reserve stall its rate hike plans, the European Central Bank commit to whatever support measures are needed and the People’s Bank of China push stimulus in the form of fiscal policy.
We believe that this global policy panic will play in favour of global sovereigns. Credit spreads will also be supported, but investors should remember that dovish central bank policies may prolong the late-cycle period. They will not, however, be sufficient to entirely avoid the recession we believe is coming in Q4’19 or early 2020. This means that while credit valuations will be supported for longer, credit risk will remain very high; in this context, investors should stay cautious and avoid taking on unnecessary risk, especially in the high-yield and emerging market spaces.
Dovish Fed = strong sovereigns
The global policy panic sparked by the December sell-offs has seen the Fed turn away from quantitative tightening and its own rate hike schedule. As such, we will see more of what we saw before Powell: a continuous flow of resources aimed at incentivising investment, which in return does not pick up, leading inexorably towards recession.
A dovish Fed is good news for bond investors even amid muted economic growth. Treasuries will gain from the unconditional support even though if it is now clear that recession is coming. In the wake of the March Federal Open Market Committee meeting we have seen yields on the mid-to-long part of the curve falling faster than short ones, meaning that the spread between the five- and two-year Treasury yields has fallen to -6.6 basis points, which is the lowest we have seen in more than a decade. More importantly, the spread between 10-year Treasuries and the monthly T-bills went also negative, indicating an inversion in the mid-long part of the curve as well.
Besides being a sign of a recession, an inversion between 10-year and six-month yields also indicates that Treasuries and high-quality credits with maturities between seven and 10 years become particularly attractive as valuations will be supported by the Fed, which will soon need to replace mortgage-backed securities in its balance sheet with Treasuries matching the same maturities.
Things are going to be different in the credit space. As the longer part of the yield curve inverts even further and we enter recession, we will start to see investors selling off risky assets, and thus a quick worsening of both IG and HY credit spreads. While high-rated credits may in some cases represent a buying opportunity, we urge investors to remain cautious within the high-yield space. A recession might push default rates to levels unseen since the crisis.
European fixed income
We also favour sovereigns versus credits in Europe, where we believe credit spreads have tightened excessively since the beginning of the year, especially in the HY space. It is presently near-impossible to find investment grade corporates in EUR that offer a decent pick-up against their related benchmarks. This is why, as we approach recession, sovereigns will be favoured while corporates will suffer widening as recession approaches.
We believe that the 10-year German bund yield will continue trading below 0% as an economic slowdown deepens within the euro area. This will not, obviously, constitute a great opportunity for fixed income investors, who would pay more in commissions to trade the bund than either the net return or the limited increase in value could provide.
We prefer peripheral sovereigns, which still provide interesting yields amid political uncertainties and an economic slowdown. The biggest opportunity at the moment lies in Italy, which is paying a yield of approximately 2.5% for the 10-year BTP. Now that the country has entered recession and has been able to push its policy agenda within the framework of the European Union, it will have less incentives to leave the bloc, hence its anti-EU sentiment will slowly wane as the country tries to remain afloat. This should tighten the BTP-bund spread below 200 bps by the end of this year, a level previously seen before the 2018 elections. Also, the deal that Italy signed in March with China should benefit BTP valuations.
Indeed, we believe that while the international arena is against the steps taken by Italy to endorse the “Belt and Road” infrastructure project, the EU will not risk imposing punitive sanctions on a member country that is already in recession, while on the other hand, Chinese investors will have more incentives to be invested in the Italian bond market.
Spanish government bonds seem also positioned for a rally. The 10-year SGB presently offers a yield of 1.16%, but there remains a degree of uncertainty due to the April 28 elections. We believe that the elections will provide some momentary noise, but that the market’s focus will return to the country’s solid economy once they are over.
The Spanish economy is well-diversified, and the banking sector is emerging from a successful restructuring that makes it less susceptible to systematic risk.
Chinese sovereigns continue to perform
The biggest opportunity out there remains China. Beijing’s efforts to open its economy and provide suitable monetary and fiscal policies will see China’s stock rise in the international arena. In 2018, Chinese government bonds were among the best performing sovereigns. The yield on the 10-year CGB has fallen from close to 4% at the beginning of 2018 to 3.1% recently. This shows that these instruments have taken on a safe-haven role within emerging markets amid the uncertainty provoked by the China-US trade war.
This year, China is fighting with a different crisis: a slowing economy. While trade tensions seem to have come to a resolution, slowing growth in China could threaten both the country itself and the wider EM space. As such, the Peoples Bank of China will not allow this to happen; we have already seen it implement fiscal policies such as tax cuts that aim to support the economy.
PBoC support is important for CGBs, but we believe the opening of the Chinese financial market to foreign investors is even more important. A law passed in March will level the playing field between domestic and foreign investors, removing barriers that were previously a concern to international capital.
With CGBs set to be included in the Bloomberg Barclays Global Aggregate Index in April, we will start to see real money flowing towards these assets. There are already talks on the way to include these securities in the FTSE World Government Bond Index and the JP Morgan Government Bond Index as well. In our view, we will soon witness a bull steepener with the short part of the curve outperforming the longer part as foreign investors move to shorter maturities.
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