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Central banks worldwide are increasing their accommodative measures, in the form of quantitative easing and helicopter money, to resolve deep economic problems. To date, this has contributed to high stock markets and low interest rates both in Europe and in the United States. Even though an investor might have benefitted from the bullish market this year as the coronavirus pandemic was losing steam, there will be a reckoning.
The reckoning is going to stem from the US election and inflation, and bonds will be the first assets to suffer from it. Now more than ever, it is crucial to think about portfolio allocation and inflation hedges, to defend capital while we are witnessing to a debasement of fiat currencies.
Sovereigns – a pressure cooker about to explode
Because near-zero interest rates don't give any protection against rising inflation, sovereigns are the worst assets you can hold in your portfolio right now. Buying government bonds today means locking in such a low yield that, if inflation rises, the bond’s value will fall. It won't help to hold the bond until maturity, because inflation will eat up the small coupon that one is receiving together with the principal.
At the same time, government bond volatility worldwide is at its lowest point in history. This makes these securities even harder to trade – because in order to benefit from a one-basis-point shift, one needs to leverage their position massively.
We believe that US Treasuries today are the biggest mousetrap of all time. They do not provide any long-term upside, and the yield curve is doomed to steepen faster than expected due to inflation. Within the context of the US election, however, there might be space for short-term trading opportunities. We anticipate a bull-flattener US yield curve if Biden wins, and a bear-steepener if Trump wins.
We are quite solemn about inflation. There is so much focus on reviving it that at a certain point, it will rise. And when it is on the rise, it will be unstoppable because monetary policy will be the only tool to slow it down. Central banks cannot count on fiscal policy, because it is political.
What is happening now is that the US government is putting money directly in the pockets of families to avoid a blown-out crisis amid the coronavirus pandemic. Families that need money spend money as they receive it. Thus, inflationary pressure increases. If inflation is suddenly on the rise, what can the next US President do? He can’t take the money that has been given to families back, because this would make him extremely unpopular. So helicopter money will stay, inflation will continue to rise, and the Fed alone will be trying to stop it.
Even though there is a chance inflation will remain subdued in the last quarter of the year, we have to consider that volatility might rise amid a second wave of Covid-19, which may affect sovereigns’ performance. While the coronavirus pandemic has been beneficial to US Treasuries and the Bund, the yields of riskier sovereigns jumped significantly. The most remarkable example is Italy, which at the moment is offering the lowest yield it has ever paid since joining the euro. Before coronavirus, the 10-year BTPs were offering around 1% in yield. At the peak of the pandemic, they were offering close to 2.5%.
Italian sovereigns are perceived as a risky asset by the market, so whenever there are troubles, investors sell BTPs and buy the Bund. Now that Italian BTPs have tightened to pre-pandemic levels, we believe that there is more downside in holding these securities than upside. When trading, it is crucial to understand when to take profit and when to take a loss. Now that the market is high, it is time to sell in order to reposition for what's to come. We believe this is especially true for sovereigns from the European periphery: Spain, Italy, Portugal and Greece.
Credit deterioration means downgrades and defaults are on the way
Since the 2008 financial crisis we have seen central banks all around the globe trying to contain market volatility. Unconventional tools have been implemented to guarantee both liquidity and favourable economic conditions. None of these policies succeeded in treating a sick economy. With the advent of the coronavirus pandemic, central banks that were hoping to tighten the economy instead had to stimulate it even further.
Over the course of the last decade, more and more corporates have been taking advantage of the economic situation by gearing up their balance sheet. Financing is getting cheaper and cheaper, and investors are getting more and more attracted to risk. As credit deteriorates worldwide, this behaviour will have severe consequences in the corporate space. We believe that a second wave of coronavirus pandemic and the US election could be the triggers for a large number of corporate downgrades and defaults. This is the reason why we recommend investors to be cautious and cherry-pick risk as we enter the latest quarter of the year.
US election: predicting US corporate bond performance in the last quarter of the year
Trump wins We can expect a copy and paste of what we have seen in the past four years: deregulation, lower corporate taxes and a focus on domestic production. In this context, we favour financials, infrastructure, energy and domestic industrials and manufacturers. Junk bonds have a higher upside potential. However, even though we don't mind lower-rated bonds, we still prefer mid-term maturities up to seven years to limit inflation headwinds.
Biden wins The market will perceive a Biden win as a credit negative. We expect weakness in the sectors that have benefitted from deregulation and low corporate taxes under the Trump administration. In this scenario, we prefer higher-quality bonds to take advantage of short-term volatility that will induce investors to fly to safety. We believe that the market has not priced a Biden win yet – this is why volatility will be high. But this situation will not last for long. Investors looking for longer-term investments should explore opportunities in the green bond space.
Contested election Because this year will see a rise in postal ballots due to the coronavirus pandemic, there is a high probability of a contested election. In this scenario, safe-haven assets will be in the spotlight and will surge in value for as long as there is no clear winner. In this context, ten-year Treasuries and long-term, high-quality investment-grade bonds are the ones to benefit the most. Once there is a clear winner, we can expect the bond market to behave as we have indicated in one of the scenarios above.
EU corporate bonds – beware the second wave of coronavirus
There are compelling opportunities both in the investment-grade space as well as the high-yield space within European corporate bonds. As a matter of fact, corporate spreads have tightened since the coronavirus pandemic, but continue to be wider than pre-crisis. It is important, however, to locate bonds that will prove to be resilient amid the second wave of Covid-19. We find the lower investment-grade space and better rated high-yield corporates to be the most interesting. A combination of central bank stimulus and economic recovery will favour bonds of those sectors that have been harshly hit by the pandemic.
In a complex fixed income market, cherry-picking and caution will reward investors
Although we see numerous challenges in the fixed income world, we believe that investors can still be successful in trading bonds. We recommend investors to select risk carefully as there are clear signs of weakness in the market. In this environment, it is crucial to choose duration carefully as credit spreads might tighten further in the short term, but surprise negatively in the long run.
Quarterly Outlook
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