investment viewpoints
Alphorum: transition states in fixed income
Welcome to Alphorum, our quarterly collation of alpha-seeking views from the LOIM global fixed-income team. In this launch issue, we focus on two prevalent themes: the outlook for US growth and inflation, and how credit investors can accelerate in the race to net zero.
US exceptionalism
The diverging growth trajectories of the United States and Europe is becoming clear. In the US, amid a resurgent economy and massive fiscal stimulus plans, the Federal Reserve is taking a patient approach with monetary policy by accommodating inflationary signals and increased public-debt issuance. In contrast, the European Central Bank is more concerned about inflation and public debt as the bloc’s economy struggles to recover from the pandemic.
Fiscal support, Fed dovishness and economic reopening has spurred inflation risk to stage a comeback in the US. We expect rates volatility, which rose above the historical average in Q2, to remain elevated as investors continue to assess how the rollout of US fiscal stimulus will impact inflation.
Markets currently expect the Fed to raise the benchmark interest rate in 2022 but the accuracy of this timing is uncertain given the slack in the labour market and the Fed’s emphasis on accommodating growth. We do see upwards pressure on interest rates but perceive managing the risk of rates volatility as a more immediate concern than judging when the next increase will occur.
Net zero: the race is on
The focus on decarbonisation in the policy, social and corporate spheres is making 2021 a pivotal for year for the transition to a net-zero economy. Efforts to achieve the goals of the Paris Agreement will impact every sector in the global economy and hugely influence sources of risk and opportunity in fixed-income markets.
In our view, it is essential to identify companies whose emissions trajectories are aligning towards a net-zero future – particularly current heavy emitters in critical sectors, such as steel or cement, whose transformation will accelerate the green transition. We call these businesses ‘ice cubes’ and they are instrumental to our net-zero fixed-income approach.
Market perspectives
We also provide our views of the risks and opportunities in major fixed-income markets worldwide, from sovereign bonds to high-yield credit, and perspectives on integrating sustainability. Read our overview of each market below, or download the full issue of Alphorum.
Government and inflation-linked bonds
The Federal Reserve has consciously avoided opposing nominal rises in interest rates viewing inflationary pressures – such as rising oil and commodity prices, and specific supply-side shocks like the shortage of semiconductor chips to the auto industry – as transitory. This approach arguably accelerated the sell-off in February but more recently nominal yields are stabilising somewhat, suggesting that the Fed’s approach might be working, at least for now. The USD 3 trillion American Rescue Plan means net issuance of Treasuries has been larger than expected, which partly explains the sharp rise in US nominal yields in the US in Q1.
In contrast, the European Central Bank (ECB) has explicitly stated that any significant rise in nominal yields would be seen as a tightening of financial conditions, with the bank’s pandemic emergency purchase programme being used to push back against this if necessary. However, despite the ECB’s concerns, a modest rise in real yields is not being accompanied by other signs of tightening. Technicals are therefore extremely supportive for European sovereign bond markets, as supply will become negative once redemptions from sovereigns and the quantitative easing programme are taken into account.
Bond markets are significantly less expensive than at the end of 2020, mostly due to breakevens remaining at a multi-year peak and uncertainty about the extent to which the Fed is willing to let inflation overshoot, which commands a higher risk premium. We expect the Fed to remain committed to its policy path, which should anchor the front end of the yield curve, but if inflationary forces prove stubborn, the market could price in higher risk premiums at the long end.
Read the full issue of Alphorum.
Corporate credit
Despite a third wave of COVID-19 triggering new lockdown measures across Europe, the region’s Purchasing Manager’s Indices for March surprised on the upside. Both the services and manufacturing sectors signalled expansion, with the final composite coming in at 53.2 against an expected figure of 49.1, reversing the downwards trend of recent months1. However, US figures are noticeably stronger, with the composite climbing from 59.7 in March to 62.2 in April, underlining the accelerated recovery there2.
The ratings drift is normalising. The peak of defaults appears to be is behind us, although Europe’s more supportive attitude to troubled companies can delay the inevitable and means that the full impact of the pandemic will materialise more slowly across the bloc. Sustainability considerations are also impacting fundamentals, with S&P revising its assessment of risk for the oil and gas industry upwards and the Bank England announcing the greening of its corporate bond buying programme from the end of the year.
The ongoing search for yield is compelling investors to move further down the capital structure, with the new-issue market providing the best way of achieving an attractive combination of size and yield. We currently see more opportunities in the high-yield space, as well as and through hybrid issues, which offer a more attractive reward profile. Although they are lower in the capital structure, hybrids have lower credit ratings than senior debt but comparable default risk, in our view, making the greater spreads on offer attractive. Above all, we focus on companies with strong fundamentals and business models that are most likely to thrive in a more sustainable future.
Read the full issue of Alphorum.
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Emerging market debt
Headwinds to emerging market (EM) growth have risen but many countries are well-equipped to withstand some volatility. The starting point for EM policy rates is extremely low, inflation seems to be contained, and continued normalisation in global trade and strong commodity prices will also help.
With the balance sheets of EM countries depleted by the pandemic, debt-to-GDP ratios will take time to heal, but healthy current-account balances and resilient FX reserves reduce the risk of capital flight. Of course, the broad EM universe contains both robust economies like China and weaker ones like Brazil, where structural reforms are needed and recovery will take longer. Turkey now sits in the latter category, however, but its idiosyncratic crisis is unlikely to impact other EM countries.
Supportive monetary policy in developed markets continues to create a hunt for yield which inevitably benefits EM debt. EM central banks have deployed significant post-COVID stimulus, but the increase in bond supply has largely been matched by healthy demand from investors. However, rising US borrowing costs are causing some anxiety: flows in EM bond funds posted a negative week in March after 20 weeks of uninterrupted growth.
Even after the strong rally of the past few months, EM hard currency bonds still present opportunities for carry in the current near-zero rates environment. With China at the vanguard of the global recovery, Chinese sovereign bonds look attractive, particularly as their low historical correlation with developed- market rates make them a useful diversification strategy.
Read the full issue of Alphorum.
Sustainability
We believe the transitioning towards a CLIC™ economy is underway. In alignment with this shift, public policy, technological advancement, corporate and social awareness, and increasingly structured standards and certification are contributing to a growing sustainable fixed- income market.
Taking utilities as an example, we seek issuers with defined carbon-reduction strategies who aim to avoid stranded assets. Enel S.p.A (Enel)1, an Italian electricity and gas multinational with 2020 revenues of about USD 90 billion in 20202, is a case in point. Over the last decade, it has invested in transforming itself from a predominantly coal-fired business to one based primarily on renewables. Today, it relies on coal for only 7% of its generating capacity.
Enel is what we describe as an ‘ice cube’: a decarbonising business seeking a low temperature pathway. By 2030 the company aims to reduce CO2 emissions by 80% and have a renewable-energy generating capacity of 145 gigawatts. Ultimately, it is committed to the Paris Agreement by targeting a temperature trajectory of 1.5°C.
It was among the first utilities companies to issue both green bonds, whose proceeds must be used for environmental projects, and sustainability-linked bonds, which are tied to sustainability metrics embedded in company’s strategy. Recently identified by S&P as an ‘energy transition leader’, the company is also a model corporate citizen with ESG ratings of AAA from MSCI and A from CDP3,4.
Read the full issue of Alphorum.
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