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Friday 29 March 2024

Markets ended 2020 in a buoyant mood, with emerging market spreads tightening in the final quarter as the US election result and positive vaccine news provided a boost to investor sentiment. While nobody has been blind to the global recession, focus has shifted to expectations of an economic recovery.

Most people were happy to see the back of 2020. It was an eventful and challenging year, but one with plenty to distil, look back on and learn from. The year ahead is likely to be less ‘unprecedented’ – a frequently used phrase over the past 12 months. The new year looks like it could offer good opportunities for investors. Here are seven themes that we think will impact emerging market fixed income in 2021.

Theme 1: Virus and vaccines – a multi-speed economic recovery

The draconian but necessary pandemic response of authorities everywhere sent the global economy into recession in March and April. As the extent of the COVID-19 infection rate varied markedly between countries, so too did the economic fallout and resultant recoveries.

The East Asian economies, especially China, were more resilient in 2020, especially relative to Europe and the US. While world output tumbled over the course of the year, China’s grew. This provided a boost to emerging economies, which contracted less than advanced economies. The projections for a 2021 recovery also favour emerging markets over the advanced economies, as the recent growth forecasts from the IMF indicate (see chart below).

Projections for 2021 assume any further waves of the pandemic are either avoided or reduced by the vaccine rollouts. Clearly, some uncertainty over the path of the virus remains, and caution will be needed in many countries when considering what levels of stimulus or supportive policies are needed to nurture the recovery. A sudden withdrawal of stimulus or a hasty return to policy normalisation could kill off a recovery.

Theme 2: Effervescent stimulus and low global interest rates

Highly accommodative monetary policy from the large developed economies pulled markets back from the brink in March 2020. Once some of the dust had settled, a cross-market recovery eventually fed into demand for emerging market bonds. From May 2020, low interest rates and improved investor sentiment led to a search for yield that pushed the spreads of emerging market bonds back towards the levels they started the year at.

A lot of 2021 positivity is grounded in the view that global interest rates will stay lower for longer. Also, that the accommodative polices of central banks will continue, in tandem with further fiscal stimulus. Such an environment creates a positive backdrop for emerging markets. But market sentiment would be tested in 2021 if there were signs that bubbling stimulus was fading.

Theme 3: High-yield emerging market bonds to lag less

Investment grade emerging market bond spreads tightened from their highs in March and April 2020, swiftly back towards where they were pre-pandemic. While high-yield emerging market bonds benefited from a recovery in May, their spreads remained wide of where they started the year (see chart below). Performance lagged the investment grade space due to uncertainty about any delayed impact the virus may have on frontier economies. It was difficult to accurately assess the implications for debt sustainability for much of the year.

So throughout 2020, high-yield emerging market bond spreads remained elevated. The result of the US election and positivity over vaccine success helped narrow the gap with an and end-of-year rally, but frontier names still lagged as the year came to a close. In 2021, we believe high-yield emerging market bonds are likely to lag less and perform better than they did in 2020. But country and credit selection is going to be crucial as most countries face increased debt loads.

Theme 4: Deep debt scars 

There was a global splurge in government borrowing in 2020 and emerging markets were not left out, although much of the borrowing took place domestically and in local currencies.

This differed from a textbook emerging market crisis, as governments were able to cut interest rates and borrow more cheaply. Many emerging markets, some even approaching the zero-bound in terms of rates, enlarged their central banks’ remits and embarked on quantitative easing-type policies to safeguard liquidity in their markets, or for outright financing for pandemic-related spending. Where frontier countries had higher inflation, or could not access all the needed finance at home, increased emergency lending was at hand. The IMF and other international financial institutions provided hard currency loans for countries on request. This financing source came without many of the usual list of policy conditions, as the focus became the rapid deployment of funds.

Towards the end of the year, it became possible to identify where the debt scars were most pronounced. Six sovereign nations saw a ratings downgrade in 2020, including several countries that had already faced severe solvency risks during 2019 (Argentina, Lebanon, and Zambia) and several countries whose economies were hit particularly hard by the pandemic (Ecuador, Belize and Suriname). The key question on investors’ minds is whether others might follow in 2021.

While debt risks have risen (see chart below), they do not indicate an imminent systemic emerging market debt crisis, in our opinion. The risks vary considerably by country. For example, both Brazil and Mexico had large budget deficits in 2020, but the debt pressures are very different. Brazil is expected to stabilise its public debt at around 103% of GDP while Mexico can do so at 65%.

The larger emerging markets have borrowed mainly in domestic markets, often with foreign flows, suggesting a currency crisis or the need to generate some inflation is more likely than an Argentina-style external debt default. But for the mostly frontier countries that have borrowed heavily externally, the foreign currency risks remain. For an investment portfolio, this is where country selection is key, as there is huge variance between countries. Some have lower risks, market access and can quickly shrug off liquidity concerns during a recovery, while solvency problems are likely to emerge for others.

Theme 5: A slightly softer US dollar

Emerging market bonds suffered from large outflows in March 2020, but financing flows recovered and ended the year in positive territory. However, the pace of local bond fund flows was slow initially and only began to pick up with any conviction as clearer forecasts for the US election result emerged. This trend was further boosted by the positive vaccine news. Better economic data in the third quarter and investor positioning helped even some of the hardest-hit emerging market currencies recover in the fourth quarter. Emerging markets currencies bore much of the adjustment brunt early in the crisis, but tended to recover over the course of the year (see chart below).

Despite the pandemic, 2020 saw record foreign inflows to China’s local bonds following its global bond index inclusion. We believe this trend is set to continue and is likely to create new investor demand that is diverted from developed markets, as opposed to redirecting flows from other emerging markets.

Our expectations are for a continued softening of the US dollar in 2021. We think this would give emerging market currencies a boost and be supportive of returns for emerging market local debt. However, any unexpected weakening in the global economy would see a moderation of investor interest.

Theme 6: Oil and OPEC agreements

Russia, the Gulf states and other emerging market oil exporters have experienced a lot of uncertainty and volatility in their economies as oil prices have swung from an early-year peak of close to US$69 per barrel to a low of around US$20 per barrel. The recovery in economic activity, plus sufficient unity among OPEC and OPEC+ members to honour planned production cuts, helped oil settle back close in on US$50 per barrel. Budget plans for 2020 had to be torn up and recast as pandemic spending needs rose while oil revenues slumped.

The oil price outlook remains uncertain for 2021. We believe the speed of the global recovery, tensions between the West and Iran, and success in maintaining OPEC+ harmony will all factor into it.

For oil exporters without large financial buffers, near-term reforms will be vital to restoring the sustainability of public finances. Many have never adjusted fully to an oil price below US$100 per barrel or made progress with diversification plans for their economies. This list includes Oman and Bahrain, Nigeria, Gabon and Angola.

For the Gulf countries with large financial asset bases, the choice has been to borrow rather than watch assets dwindle too fast. Here, reform and diversification is equally important, but not on such a pressing timetable. Since their inclusion, Gulf states have risen quickly among issuers in terms of size and now represent a large and growing portion of emerging market bond indices. Given current issuance plans, this trend looks set to continue in 2021.

Theme 7: Geopolitics hotspots unlikely to cool down

While a shift away from Trump-era US foreign policy is expected, the global political landscape has changed and we are not likely to return to policy that was familiar under the Obama presidency. However, a more expert-informed policy framework is expected, rather than knee-jerk reactions and late night Twitter posts. Nations such as Saudi Arabia, Turkey and Russia might find the going tougher, while Mexico and multi-lateralism could receive  a boost. While foreign policy changes are likely in 2021, some will take time to develop and will feature later into Biden’s term, in our view.

Geopolitics looks set to play a big part in emerging markets, with some headwinds affecting the asset class, while some crosswinds may require a regional or country specific approach. US-China relations look set to remain a core theme and tensions are unlikely to cool as China grows and threatens America’s global hegemony. Meanwhile, Middle-eastern politics will need monitoring, alongside elections, including in Peru, Chile and Ecuador.

Outlook

We are looking forward to what 2021 will bring, after a tough and unpredictable 2020. Given that three quarters of developed market bonds are trading at negative yields once adjusted for inflation, there is added impetus for investing in emerging market bonds.

While there is some argument that the emerging market investment grade bond segment is now starting to look less attractive on valuation grounds, we believe spreads in the high yield bond segment remain at attractive levels and some emerging market currencies remain undervalued.

Here’s an update of my favourite long term measure of bond market valuations.  I’ve been updating this chart on the blog over the years, and if you’d bought and sold US Treasury bonds when they diverged significantly from the range implied by the Fed’s long term rate expectations, you would have done OK.

So what does my favourite chart show?  I’ve shown the 10 year US Treasury bond yield, 10 years forward.  This is derived mathematically from the US Treasury yield curve, and is the implied 10 year yield starting in ten years’ time: 2030.  The beauty of using a forward rate is that it does away with shorter term noise; when we look at the period from 2030 to 2040, hopefully we don’t need to be talking about the strength or otherwise of the global Covid recovery, or about Trump and Biden political risk.  It’s a measure based on long term expectations of rates based on inflation trends, potential growth, central bank mandate commitments, globalisation, government borrowing and demographics.  At the moment, the 10y10y forward rate in the US is 2.09%, compared with the 10 year bond yield of 0.92% today.  Remember that this is a nominal rate and that broadly inflation targets around developed economies are 2%.  Effectively this means that the bond market is expecting real (inflation adjusted) yields in 2030 to be near zero. 

The other part of the chart is the median level of the Federal Reserve’s “dots”, and the range of the highest and lowest expectations of FOMC members.  Each quarter, the FOMC releases the “Dot Plot”, formally called its “Policy Path Chart”.  Each of the 16 FOMC members estimates where the Fed’s short term interest rate will be at the end of the next three years, and over the long term.  It’s that long term rate that I’m interested in, as it looks through the noise and short term economic uncertainties.  Last night, following the FOMC meeting, the Fed left its dot plot unchanged.  Rates for 2021 are expected to be left at 0% to 0.25%.  This is despite the market consensus that 2021 US GDP will come in at an above-trend 3.8%, and despite a rise in inflation expectations—but remember that the Fed adopted Average Inflation Targeting during 2020, which allows it to let inflation move above its old 2% target if it’s been below 2% historically.  The long term dot median was also unchanged at 2.5%, consistent with a real yield of something like +0.5%.  The long term real rate of interest is also known as R* (“R-star”).  The New York Fed publishes an estimate of R* based on the Laubach-Williams Model.  Its inputs are GDP, inflation and the Fed Funds rate.  At the start of the year, R* was estimated at over 1% on this model; it’s now below 0.5% post-Covid, consistent with a median long term “dot” of 2.5%.  You can see the model’s output here: https://www.newyorkfed.org/research/policy/rstar

The dislocation between trend growth and R* is dramatic.  Ageing bond managers like me used to look at models that said, based on the Efficient Markets Hypothesis, that nominal bond yields should be roughly the same as nominal GDP growth.  There shouldn’t, ex ante, be a different expected return in investing $100 in a US Treasury Bond than there should in putting $100 into the US economy (caveats around volatility excepted).  Trading bonds on that model would have led you to miss 20 years of bond market rallies…

Anyway, here’s the chart.

From March onwards, the 10y10y forward US Treasury yield collapsed below even the most pessimistic FOMC member’s long term dot.  Was it really likely that Covid would still be depressing interest rates between 2030 and 2040?  Possible but unlikely.  Selling bonds from March onwards looked attractive, and 10 year yields have nearly doubled since then from 0.5% to 0.92%.  Now though, we are back within the Fed’s range of outcomes.  It’s still at the lower end of range, and arguably bonds remain expensive.  The market’s forecast for the 10 year bond yield at the end of next year is 1.3% and for 2022 it’s 1.5%, with a roughly parallel shift higher at longer maturities.  Remember that bond markets have forecast higher bond yields every year for decades now, and have been wrong almost every time.  I can buy the idea that US Treasury bond yields go higher from here, but the high water mark for them might end up being much lower than bond bears are predicting.  You need to have some very good reasons to explain why a 40 year bull market in Treasuries is going to enter into sharp reverse.

Happy Christmas and a Happy New Year.

This year has seen the sharpest and largest economic downturn the modern global economy has ever seen. However, as I have commented several times this year, this recession is a rather strange one: for once, this time really is different (see chart below).

This recession has not been caused by any of the usual suspects: namely tight financial conditions, a real or market bubble bursting, a sharp rise in commodity prices or some combination of these. We have not seen the effect of this recession in many of the typical areas of weakness that follow such a downturn: I’m thinking of everything from the housing market and disposable incomes, to the huge rally in financial asset prices we have seen this year. Finally, this year has pushed investors to accept more than ever the bizarre situation of paying for the privilege of lending out their money — testing the zero bound in interest rates and leading to some very strange consequences indeed.

As we sit at this zero bound, I believe there are some important consequences for investors, ranging from the purpose of investing to the independence of central banks.

The theory of investing

The cornerstone of saving is security and return. In the following Panoramic we are going to focus on risk-free bond returns, and particularly on the strange consequences we see when this asset class has a negative return.

When buying a bond, you receive a set of cashflows in return for your investment. This is illustrated simply below.

This shows the income you receive and the final redemption payment. This income stream in the theoretical example generates a positive yield – the sum of the cash flows earned is positive. This is the fundamental basis of bond investing. However, recently this cashflow dynamic has been spun round. The actual example shows the cashflows you receive as a result of your investment in a negative-yielding bond, as we see in German bunds, for example. The cashflows earned are negative and the investor ends up with less money than originally invested.

Positive-yielding bonds offer a positive total return if held to maturity. Negative-yielding bonds provide a negative total return if held to maturity. Economic textbooks show savers receiving income, and building their wealth. Meanwhile, borrowers pay income for the privilege of borrowing. Yet, in a negative yield world, the saver receives the negative cashflow of the borrower, and the borrower receives income for borrowing. This is a very strange world indeed! In the past, this would have been very much a theoretical exercise, but now it is a real-world phenomenon, which investors are accepting – see the amount of negative-yielding debt illustrated below. [1]

How did we get to this point? The bull market of the last cycle has driven bond yields to new lows, while many central banks have cut rates to try to stimulate inflation in economies.  The question now is whether this downward trend can continue forever. I don’t think so: at some point, the consequences of having negative rates become too great for investors to accept. At this point we hit the “zero bound” – near zero, though not necessarily exactly at zero. The chart of 10-year rates below shows the trend over the last 30 years, with rates declining and halting at the zero bound. So why do rates stop at the “zero bound”?

Why there is a zero bound

Bond yields have difficulty going much below zero because if investors are faced with owning negative yielding debt in Japanese yen, for instance, they have an alternative. They can simply hold Japanese yen cash instead. Rather than exchanging 100 yen and receiving fewer yen at maturity if purchasing a bond, an individual could simply hold 100 yen in cash and not suffer the loss. Holding cash has its risks and potential costs in terms of security and storage. These costs effectively set where the zero bound falls, and why it is not exactly zero: it would be zero, were there no costs to holding cash instead of bonds. The presence of this alternative risk-free investment explains why central banks around the world have not enacted a significant negative rate policy: the existence of cash is the main barrier to negative rates.

The risk/reward of the zero bound – There Is No Yield (TINY)

Once we recognise there is a zero bound somewhere, what does that actually mean for bond investors?

When looking at the risk/reward of the zero bound, the first issue we face is that There Is No Yield (TINY). With yields at all-time lows, investors are not earning significant returns at all, while in some cases paying for the privilege of lending. Secondly, it is clear that yields can’t fall forever: the upside of holding duration is limited due to the existence of the zero bound. One way to explore this is to use zero coupon bonds to illustrate the risk and reward profile to which investors are exposed when buying bonds in the TINY world.

Currently, if you agree to buy a 30-year German bund at a negative yield, you essentially agree to make a loss if held to maturity. This is of course different from a positive interest rate environment, where if you hold the bond until maturity you will end up with a positive return. The profit or loss involved is illustrated in the chart below: if you buy a bond with a -2.3% yield, you lock in a halving of your money.

The upside to holding low- or negative-yielding bond securities is therefore very limited and explains the short duration view I express in my funds. When you hit the negative bound, or get near the negative bound, it becomes challenging to invest; upside is limited and losses can quickly accrue (even more so if you hold longer-term debt to maturity).

So while it is possible to get to negative interest rates in principle, it is rarer in practice, and there is a limit: the upside to investors is limited, but the downside could be quite large, and so at a certain point investors won’t accept this. This means it is hard to justify being long duration, from my perspective. As a risk-reward instrument, holding interest rate duration becomes unattractive when you get near the zero-bound. There are also other, wider consequences beyond the risk-reward of owning bonds as yields reach the zero bound.

Consequences of reaching the zero bound

One of the most obvious consequences of reaching the zero bound is that central banks can no longer stimulate the economy in the event of a deterioration in growth and demand. As rates cannot go very negative, the policy tool is effectively removed from their toolkit. This is illustrated by the actions of central banks in regions where rates were already negative or near zero, like Europe and Japan: the policy option has gone. We saw the effect on holders of interest rate duration over the past year: in countries where rates could still be cut (the US and the UK), falling interest rates provide some upside to bond investors; in countries with zero or near-zero rates (German and Japan), they did not provide much upside at all (see charts below).

Another effect of short-term zero or negative interest rates is the extent to which this undermines the banking system’s traditional role in bridging saver and lender. As former Bank of England Governor Mervyn King alluded to in a recent TV interview: “[Negative rates] can’t work with a successful banking sector unless the banks can pass on negative rates to their retail customers. Once that happens, I think you should expect to see a long line of customers seeking to take their cash out of the bank and keep it under the mattress, or at least in a new home safe. I don’t think that is a politically attractive prospect at all”. [2]

It is clear that having zero or negative rates is a threat to the ability of central banks to use monetary policy and to the banking system’s effective functioning.

Unable to cut rates, central banks then pursue other options, resulting mainly in driving rates lower along the yield curve via measures such as forward guidance (i.e. pre-committing policy to a low rate range) and quantitative easing. These actions lower rates along the whole yield curve, flattening it by pushing longer-term rates towards the zero bound too. This can be seen in the chart below of the market 50-year sterling overnight lending rate: it reached the zero bound.

Likewise, the psychology of investors not wanting to lock in a guaranteed loss leads them to extend the maturity of their investment, again pushing the whole curve towards the zero bound. Investors’ purchases of longer-dated bonds result in very flat yield curves as can be seen below. This effect is so powerful that in extremis whole bond curves can exhibit negative yields (see chart below).

As monetary policy reaches its limits, fiscal policy has to take a greater burden in reviving the economy. Consider the recent comments from Federal Reserve chairman Jerome Powell, and European Central Bank President Christine Lagarde. Both central bank chiefs have called on extended fiscal support to boost Covid-hit economies as we approach a tough winter. Powell said that “too little support would lead to a weak recovery, creating unnecessary hardship for households and businesses”, while stating that even if stimulus is above what is needed “it will not go to waste”. Meanwhile, Lagarde emphasised that it is “more important than ever for monetary policy and fiscal policy to keep working hand in hand”.[3]

Interest rates are a pricing mechanism that set a level at which savers and borrowers can interact, and provide an efficient recycling of savings. Between these two economic agents, we have a banking system that recycles that capital. These banks make money on the bid- offer spread between borrowing and lending, but are also heavily dependent on the central bank for help. When the central bank sets a high rate, it is guaranteeing savers and banks a high return for taking no risk – in effect offering a subsidy and a transfer of wealth from the state to the saver. In an environment of negative rates, the central bank is instead taxing the financial system, and savers will be reluctant to lend. In that case, the recycling of capital grinds to a halt.

How to remove the zero bound

The simplest way to remove the zero bound and restore the ability of central banks to cut rates would be to remove the option of holding cash. Electronic money is a solution as, if there were no cash, then your electronic money deposit could decay over time, producing negative rates with no alternative cash to hand. Politically, though, this would be highly unpopular for various, obvious reasons – and individuals may see this as a tax on capital. Other alternatives to money might also be sought, which would undermine this approach: gold, a foreign currency or a different version of electronic money such as Bitcoin are examples.

The second way would be to let the central bank lend money below zero to subsidise the banks. That is the ECB’s approach with its TLTRO (targeted longer-term refinancing operations) programme, designed to stimulate lending and act as a simple subsidy from the central bank to private sector banks. However, this is an intrinsically loss-making transaction by the central banks and ultimately has limited power, because it creates an arbitrage opportunity between negative rates and physical cash.

The third option is to print money. This is perhaps the simplest way to escape the zero bound, but unfortunately raises the difficult question: who do you give the printed money to? Central banks are in the business of lending money, not granting money.  As Federal Reserve Chair Jerome Powell said in his May keynote speech, “the Fed has lending powers, not spending powers”. [4]

The printing of money is a government decision

To escape the zero bound requires a number of key elements. It would require the support of governments through fiscal spending, the printing of money by the central bank and hopefully a pick-up in inflation. But this requires central banks and governments to work together. Fiscal spending is within the remit of government and, if the central bank is printing money, the decision on how that money is distributed is a political one. Central banks and governments have to work together.

No Independent Central (NICe) Banks

The ultimate way to do this, for fiscal and monetary policy to be aligned, would be to remove central bank independence. Arguably we have begun to see signs of this over the past year, with the significant government debt purchases of a number of central banks. Independent central banks were created in the first place to help control inflation and I would argue that, in politicising central banks, we would be allowing the inflation genie back out of the bottle. In order to escape the zero bound we need inflation, and by politicising central banks inflation and inflation expectations would rise.

It would be easier to remove the independence of some central banks than others, of course. The simple delineation here is federal central banks versus state central banks. It would be relatively straightforward to regain full control of the Bank of England, for example – in fact, it is already provided for under existing legislation: according to the Bank of England Act 1998, “the Treasury is given reserve powers to give orders to the Bank in the field of monetary policy, but the Act states that this is only if the Treasury is satisfied that they are required in the public interest and by ‘extreme economic circumstances’.” [5]

In the case of federal central banks it is more complicated. With federal central banks, monetary and fiscal policy are generally harder to carry out in tandem, as typified by the challenges faced by the European Central Bank.

The future of central banks

Central banks are an ever-evolving beast. Their need for independence was born in the high inflation conditions of the 1970s. This regime has worked exceptionally well in reducing inflation to the targets that have been set. If we now have a situation where inflation is permanently anchored around a two percent target then, by definition, central banks will quite likely be faced with the zero bound issue. The tapering of political influence on monetary policy has also helped reduce inflation, and this has been combined with the tailwind of falling inflation from globalisation and progress in technological productivity.

While central banks cherish their independence, they have been exceptionally vocal recently that fiscal measures (that are inherently political) are required. The gap between politics and central banking has been further eroded as central banks are now opining and focusing on what were previously political issues. For example they are now focusing more on income inequality and the global warming conversation — both historically hot political topics and not the remit of unelected central bankers. With these issues in mind, it may be practical for central banks to become less independent, and the political bias to generate inflation may be an appropriate change in economic direction.

Implications for investors

Given the authorities are going to do what they can to exit the zero bound, what are the implications for investors? It would be logical to assume that escaping the zero bound would require extensive monetary and fiscal policy. This would mean short rates being kept low for a number of years, while inflation needs to be re-established as a permanent feature. This points potentially to a very steep yield curve, with short rates pegged, a heavy supply of government debt, and inflation making real bond returns less attractive. It is likely that this high level of monetary and fiscal stimulus will be a strong boost for the global economy. What kind of traction will it provide in 2021 and beyond?

Outlook and concluding thoughts

The world is going through a t-shaped recession: a sharp fall down, with a recovery back towards previous levels. The question is how high up the “t” the crossbar gets. Given that the service sector has been the main victim of the lockdown recession and government action, the ability to reopen quickly may mean at the extreme that we even get close to a T-shaped recession. The lower the bounce, the better for interest rate risk and the worse for credit risk, and vice versa. This is why the economic outlook is so significant in bond investing. However, the risk-reward profile of taking interest rate duration is currently skewed: there is limited upside on profiting from further falls in interest rates if the zero bound persists. This has been demonstrated in the real world of bond investing this year.

There is a need to escape the zero bound for micro and macro policy reasons. This will require central banks to be more “NICe” as they work closely with governments. In such a scenario, fiscal and monetary policy will need to remain loose for some while, potentially aided by central banks printing money to provide the fuel to escape the zero bound. This type of policy generally leads to higher growth and inflation. This bodes well for the economy and for credit risk, but points to a rise in longer-term bond yields.


[1] When looking at total negative rates, one should bear in mind that rates are defined as the rate in a given currency. If we were to hedge global debt into a base currency of euros for example, the negative outstanding debt would be boosted; if it were turned into US dollars, it would be reduced substantially.

[2] Mervyn King, Bloomberg TV, 16/11/20.

[3] https://www.marketwatch.com/story/powell-says-u-s-economy-needs-more-fiscal-support-11601995205, https://uk.finance.yahoo.com/news/lagarde-pledges-forceful-ecb-stimulus-082057866.html

[4] Current Economic Issues: Remarks by Jerome H. Powell, Chair, Board of Governors of the Federal Reserve System at Peterson Institute for International Economics, Washington, D.C., May 13, 2020 https://www.federalreserve.gov/newsevents/speech/powell20200513a.htm

[5] https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/1998/the-boe-act.pdf

In an increasingly sustainability-conscious world, many investors are turning to environmental, social and governance (ESG) driven funds. As well as offering a useful framework to analyse financially-material risks, for investors who object to coal-mining and oil-refining, or to alcohol and gambling, it makes sense not to finance companies which engage in these activities through their investments. So far, so simple. What about financing governments?

With a volume of more than $56 trillion at the end of 2019, sovereign bonds represent 48% of the global bond market. However, despite its size and the exponential growth in investors’ desire for the integration of ESG factors, the sovereign debt market seems to be less developed than other asset classes.

In particular, there are four myths surrounding the application of ESG to government bonds that I would like to analyse:

  1. The asset class is risk-free, so the importance of ESG integration for these securities is limited;
  2. ESG factors do not drive the performance of sovereign bonds, which comes mainly from economic policy and economic growth;
  3. ESG engagement is not possible with sovereign issuers – given countries’ fiduciary duty to their citizens, investors in its debt have less influence than stockholders or corporate debt investors do on companies;
  4. Compared with corporates, it is more difficult to apply an ESG framework to sovereigns.

I might agree with the last point above, which arises most of the time from various ethical questions that appear in practice when integrating ESG. There are some inconsistencies that need to be refined if a solid and credible approach to ESG sovereign analysis is to be achieved. Many would object to investing in a company that produces nuclear weapons, and such an issuer would be excluded under most formal ESG screenings. But should an ESG-screened fund be able to invest in a country that buys nuclear weapons? Should US Treasuries be excluded from an ESG-integrated portfolio given that the death penalty is allowed in some states? And how should oil-exporting countries score from an ESG perspective? Difficult questions indeed, that highlight that the investment industry is still towards the beginning of its journey to contributing to a more sustainable economy – but that does not mean that there is no way to apply ESG analysis to sovereigns today, or for our industry to drive change in government behaviour.

Therefore let’s focus in depth on the first three arguments and go beyond the blunter, exclusions-based questions above.

Myth 1: Sovereign debt is risk free

To say that government bonds are risk free is daring. Yes, governments might have some tools to reduce their direct default risk and to pay off their nominal liabilities: more precisely, a government can increase taxes to raise revenues or can increase money supply (with the consequent increase in inflation and devaluation of its currency). Both these tools have consequences which ultimately mean investors end up with a sovereign debt real payoff differing from the nominal promise. For domestic-debt holders, when taxes or inflation rise they see the purchasing power of their returns diminished; for foreign-debt holders, the risk comes mainly from foreign-exchange movements and the worsening of growth that derives from pressure being put on household disposable incomes.

Besides, if we can take one thing from the Eurozone crisis of 2011 it is that what is considered safe can change fairly quickly from one day to the next. With global debt at record levels, it’s more crucial than ever to ensure that a country is run in a way it can prosper. Take for instance the example of Italy. Debt to GDP is predicted to increase to 160% this year (much higher than the Maastricht euro convergence criterion of 60%), while Italy will soon have more absolute debt than Germany, despite its economy being half the size. Still, Italian credit spreads have continued to tighten. Why? Because the creditworthiness of an issuer really depends on its funding costs more than anything else. For Italy, the cost of financing its public debt is largely a function of its relationship with Europe. It is clear then that political risk (the “G” pillar in ESG) can change the perception and market pricing of risk even for a developed nation.

This leads me nicely to—

Myth 2: ESG factors do not drive sovereign performance

As with most other asset classes, ESG factors may not be the main performance driver of sovereign bonds. This does not mean that they don’t matter when trying to achieve better risk-adjusted returns however: risks are intensified for sovereigns with fewer financial buffers.

Credit rating agencies have already acknowledged environmental issues and the growing effects of climate change as having increasingly negative credit implications for issuers without adequate adaptation and mitigation strategies. Social factors are relevant too, as social conditions and voter dissatisfaction can have political repercussions, including rising populism. And governance issues have always been considered to be one of the most material concerns affecting debt sustainability: think about institutional stability, the quality and independence of central bank membership and of finance ministers, the level of corruption and the rule of law. Looking at these factors more closely, it is interesting to see how even some countries in Europe do not score very highly on indicators measuring the strength of the “G” pillar (see below).

Myth 3: ESG engagement is not possible with sovereign issuers

When integrating ESG, active managers like to prove they can engage with issuers and that the successful integration of sustainability factors is not just a matter of excluding certain names. However, the problems one might expect in trying to engage with sovereigns on ESG factors are becoming less of an issue as ESG demand gains importance in the financial markets. Governments are becoming increasingly aware of the significant growth in ESG requirements from debt holders. In the same way they hold traditional roadshows and presentations for investors covering macroeconomic themes, they now address ESG issues in meetings. Brazil and Indonesia have recently met groups of ESG fund managers to address concerns on environmental protection regulations potentially leading to more deforestation.

Besides, ESG commitments are proving to be an efficient way for countries to access  finance. In recent years, demand for green bonds has outstripped supply as many thematic green funds struggle to find investments. Last October, we saw Egypt (with a B credit rating) become the first Arab country to issue a $750 million green bond. The bond was five times oversubscribed and, for the first time, Egypt succeeded in reducing its pricing margin to reach a negative new issue premium of 12.5 basis points (see the blog my colleague Greg published in October).

Indeed only a few days ago the World Bank published a guide to help public debt managers improve their engagement with investors on ESG topics. The guide outlines how sovereign debt investors use ESG information in their investment strategies, how debt managers are engaging with sovereigns and how engagement can be improved. It is plain to see that ESG is rapidly changing the financial industry and that governments are already aware of the many benefits they can derive from ESG engagement.

How do ESG scores correlate with credit ratings?

If ESG scores are measuring an issuer’s risk, can we simply look at the issuer’s credit rating? In part, yes, but that doesn’t give us the full picture. Generally there is a strong correlation between ESG scores and sovereign credit ratings, albeit with some outliers and dispersion (see chart below).

This shows that, while ESG scores can provide a useful starting point for bond investors as they bring a useful structure to the ESG comparison of sovereigns, we must also acknowledge that part of the ESG sovereign methodologies is capturing long-term competitiveness and sustainability factors (such as social progress, inequality, level of education, resource governance and standard of living). While such drivers are relevant for the creation of value in a country, they might not drive bond valuations with a shorter maturity profile. Therefore, it is paramount that fixed income investors consider the time horizon of an investment alongside the materiality of ESG factors. Identifying material ESG factors over appropriate time horizons is complicated, but crucial for bond investors in order to assess fully the risk and reward of a sovereign bond investment.

In a world in which zero or negative rates are the new paradigm in sovereign bond markets, the asset class is one which presents investors with an asymmetric downside risk. This makes it more important than ever to integrate ESG into sovereign risk analysis.

While many emerging market currencies have posted lackluster returns this year, the Chinese renminbi has been a clear outperformer, having appreciated by 5.9% against the US dollar in 2020.

There are a few important drivers that explain the currency’s appreciation this year. First of all, China has handled the COVID-19 virus better than most other countries and, as a result, has suffered to a lesser extent economically. While most countries will post negative GDP growth figures this year, China is predicted to grow by 2.0% in 2020 and another 8.1% in 2021 (Bloomberg survey of 67 economists, November 2020).

This more positive economic backdrop has also allowed the PBoC (People’s Bank of China) to enact more conservative monetary policy than most of its peers. While, at the onset of the pandemic, the PBoC cut the reverse repo and MLF rates and also reduced the reserve requirement ratio for banks, in more recent times it has normalized policy as economic growth has rebounded. As a result, after reaching a low point of 1.8% in April, five-year Chinese government bond yields have now risen to 3.2% while US Treasury yields remain at very low levels. As the PBoC aims slowly to reign in credit growth and tighten policy further in 2021, the US-China yield differential is likely to remain elevated, continuing to support the renminbi.

The COVID-19 pandemic has also provided a boost to China’s balance of payments. China’s goods exports have risen over the course of the year as demand for Chinese medical and electronic equipment has increased. These higher exports have contributed to China’s trade surplus reaching its highest level in five years.

China’s persistent services deficit has also improved considerably this year, as many of the services China typically imports from the rest of the world (such as tourism and travel) remain unavailable. This has caused the current account balance, which has been on a structural decline, to rebound recently from its lows.

Looking at China’s financial account, while net foreign direct investments (FDIs) have been broadly stable in recent years, the gradual liberalization of China’s bond markets and recent index inclusions (a topic I addressed previously) have contributed to record portfolio flows recently. Deutsche Bank estimates that there have been $116 billion in inflows to China’s bond markets this year, almost twice those of last year. Given the recent announcement by FTSE that it will include Chinese government bonds in the WGBI indices by October 2021, these flows are likely to persist in the near term, especially considering that foreign investors still make up only 3% of China’s $15 trillion bond market.

Taking a longer term view, while financial market liberalization will be extremely gradual in China and is likely to trigger bouts of volatility—for example with the recent increase in state-owned enterprise (SOE) defaults—the potential for further portfolio inflows remains enormous. Morgan Stanley estimates that, over the next decade (2021-2030), portfolio bond and equity flows into China will amount to at least $180 billion per year. These flows should therefore almost entirely offset the recurring $200 billion on average of “errors and omissions” that leave the country each year. On the whole, China’s balance of payments position therefore remains robust and supportive of the currency.

Of course, there are also risks to the view of further renminbi appreciation. One fairly obvious obstacle is that the currency has already appreciated by almost 5% (using the CFETS basket—China’s Foreign Exchange Trade System basket of currencies) since the lows in July, a relatively sharp move by historical standards. As a result, the CFETS RMB Index is now close to 96 once again, a level that had triggered the PBoC to intervene recently by allowing more outbound flows through the Qualified Domestic Institutional Investor (QDII) scheme, cutting the risk reserve ratio for FX forwards from 20% to 0%, and phasing out the countercyclical factor in the USD/CNY daily fixing. While these adjustments can be considered as gradual steps towards further market liberalization and in line with the PBoC’s pledge to intervene less in the future, they can also be interpreted as signals that the central bank remains committed to preventing the renminbi from appreciating too quickly.

Another risk to further renminbi strengthening would be a deterioration of the inflation outlook. The African swine flu reduced pork supply significantly in 2019, leading to high levels of food inflation which peaked in January 2020. Since then, food inflation has started to come down while service and producer prices remain depressed due to the pandemic. The combination of these factors have caused China’s CPI and core CPI indices to reach a ten-year low. While the relationship between inflation and the currency historically is tenuous, an episode of persistent deflation in China would probably be a hindrance to CNY strength.

Another major unknown for the renminbi remains how the Biden administration will work with China. Biden’s US election victory makes it possible for the US and China to collaborate once more, especially in areas such as the COVID-19 pandemic and climate change. On the other, the Biden administration may be tougher on other issues, such as human rights and technology. On trade, the president-elect will also not want to appear to be too soft on China, which he considers as a competitor. A roll back of previous measures and tariffs is therefore unlikely in the short term. Finally, one can also make the argument that Trump’s unilateral approach to dealing with China was not the most efficient, and that a coalition comprising the US and its historic allies could have greater sway in reshaping global trade rules over the next decade.

In summary, while the Chinese renminbi’s strength and resilience this year is in large part backed by fundamentals, further significant appreciation may be more difficult to achieve given recent strong performance and the PBoC’s more hawkish stance. In addition, uncertainties around inflation and Biden’s stance towards China could also weigh on the renminbi. As a consequence, for investors seeking exposure to Asia, currencies like the Singapore dollar, the Malaysian ringgit, the Thai baht or the Indonesian rupiah may represent a better alternative to the renminbi. These currencies will still benefit from Asia’s strong growth recovery in 2021, while potentially being less constrained in their upside.

Month: December 2020

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