first quarter of this year started with expectations of improving global growth
and easier financial conditions. It ended with a historic collapse of economic
conditions and materially tighter financial conditions in the US, as the
coronavirus pandemic spread and intensified.
markets reacted to the pandemic by building in a risk premium for the
deterioration in underlying global growth and solvency assumptions. As the
scope of the crisis became evident, starting in Italy then ripping through Europe
and the US, funding pressures in the US dollar market emerged, first in the US
Treasury market and then in European government bonds. US money markets followed,
and pressures ultimately arose across fixed income risk assets, from structured
to emerging market (EM) credit. Because US dollar assets are the largest
component of global markets, this pressure inevitably showed up in foreign
exchange markets where it became very difficult to borrow US dollars in the
forward market. The seizing up of the currency markets had a dramatic impact on
both developed market (DM) and EM currencies, along with all EM interest rates.
in particular, built in a risk premium based on funding stresses that have
become evident in US dollar markets. Risk aversion resulted in materially lower
interest rates in the US, wider credit spreads, the strengthening of funding
currencies, such as the euro and yen, and relatively stable EM interest rates. The
funding crisis that followed led to market liquidations with illiquid and
collapsing markets in structured credit and very erratic, violent price
movements, even in US Treasuries. In currency markets, it led to the
indiscriminate strengthening of the US dollar to multi-decade highs.
The primary DM policy response to the market
turmoil has been via monetary and fiscal policy. The EM policy response has been
primarily monetary, and to a less extent, fiscal.
The policy response by the US has been massive and
quick. The US Federal Reserve (Fed) has implemented over $1 trillion in quantitative
easing (QE) and put programs in place to buy almost every class of investment
grade security, which could expand the Fed’s balance sheet by nearly $4
trillion. In addition, we estimate that fiscal stimulus already totals around 10%
of GDP and could expand to 14% to 15%.
Similarly, in Europe, the European Central Bank (ECB)
has committed to expanding its balance sheet by over $1 trillion, while
significant fiscal action through loan guarantees has been announced. We expect
more direct stimulus. Given that the social safety net is more extensive in
Europe, there was less urgency compared to the US. The ECB, however, has been slow
putting its firepower to work and has not quelled market anxiety, in our view.
has significant fiscal and monetary policy room, has been notable in its anemic policy response. It has focused its
measures on businesses by providing subsidies and financing through increased
state and local government spending.
EM countries did not come into this crisis with much fiscal room. However, given
the Fed moves discussed above, they do have significant monetary room. EM
countries have reacted with a mix of measures, even those countries with little
fiscal room, such as Brazil. Brazil’s central bank has reduced interest rates
and the government is making cash distributions to lower-income wage earners,
along with other fiscal measures. Local governments have enacted measures to
provide credit to small and medium-sized enterprises. In India and Indonesia,
support is coming from the central banks in the form of lower interest rates or
increased market purchases of bonds and an increase in the fiscal deficit by a
few percentage points through direct cash transfers and subsidies.
opportunities can arise from market dislocation
believe market dislocations can create once-in-a-decade opportunities for
medium- to long-term investors. We also think a longer-term investment time
frame is important, as volatility will likely remain elevated. We would
classify opportunities as three types: those that will likely benefit from
central bank actions in specific countries, those that may benefit from central
bank actions globally, and those that will likely benefit from asset prices
having fallen to very low levels.
see opportunities in both DM and EM interest rate markets. In DM rates, we
believe there are significant opportunities in assets that central banks are
buying, but that are still dislocated relative to historical norms because of a
fundamental reassessment of growth and inflation, in addition to liquidations.
In the US, we believe those opportunities are in investment grade assets. However,
it is our belief that for most of these opportunities to be realized, inflation
expectations must increase. Plotting 5-year and 30-year levels of expected
inflation rates over those time frames, as illustrated in Figure 1, we see that
inflation expectations are very low compared to the Fed’s 2% target. We believe
Fed purchases of Treasury-Inflation Protected Securities (TIPs) will drive real
interest rates (nominal interest rates less inflation) lower to adjust these expectations.
Figure 1: Future inflation expectations over 5 and 30 years are low
in Europe, we believe ECB bond buying will cause the spreads on bonds from peripheral
European countries to narrow and possibly reach new lows, and that would aid
vulnerable countries, such as Italy, in terms of lowering its funding costs.
EM, we see two types of opportunities in interest rates. First, we see
opportunity in EM interest rates in countries whose central banks are likely to
continue reducing rates. We would expect most central banks to fall into that
category. While it is difficult to assign a magnitude to future rate cuts, we
believe the most monetary room is in Mexico, Russia and India, with less room
in Colombia, Brazil, South Africa, Indonesia, and Malaysia. We believe a subset
of rate opportunities exists in countries where yield curves have steepened
dramatically as a result of funding stresses in the US dollar market. We believe
such yield curve opportunities exist in India, Brazil, South Africa and
Indonesia where there is a desire by central banks to reduce long-term
borrowing costs and ease financial conditions that have tightened dramatically.
Foreign currencies (FX)
The opportunities in FX markets will likely come from DM central bank actions. With the repricing of growth and solvency assumptions, the US dollar and other DM currencies have risen sharply versus EM currencies. EM currencies have, on average, declined by 14% in the past year.1 We think the US dollar will decline once funding pressures are alleviated, reinforced by larger US budget deficits and lower interest rate differentials versus other currencies. Overall, central banks’ long-term injections will likely help global liquidity conditions and lead to the depreciation of the US dollar when the current period of risk aversion ends.
Figure 2: Recent dislocation in EM FX Real Effective Exchange Rate (REER) and US dollar REER
seen in Figure 2, the real effective exchange rates (REER) of a basket of EM currencies
are at the lowest levels since the early 2000s. Typically, we find such levels
of undervaluation only after crises, when EM FX is often out of favor. Also, the
US dollar real effective exchange rate is at elevated levels that have not been
seen for two decades (Figure 2). Current levels were not even reached during
the global financial crisis. We believe it is a bit early to pinpoint
currencies that will likely outperform going forward, as we need greater
clarity on oil prices.
that US-dollar-denominated assets dominate the credit landscape, we believe
most of the opportunities will likely be focused in the US credit markets.
Globally, we think the opportunity will be clearer in Europe where the ECB
continues to buy peripheral and investment grade bank debt. We remain cautious
on EM credit, as it will likely face additional headwinds related to the
depreciation of EM currencies, increased liabilities, and the commodity price
shock. As these shocks diminish over time, we believe significant value will be
presented by these markets. The catalyst for releasing that value will likely
depend on the other opportunities being realized.
At the end of the current market turmoil, many risk assets may end up with very cheap valuations, with most at decade or multi-decade lows. However, determining the sequence of which assets to buy will be key in portfolio construction, especially with the potential to generate greater excess returns for the longer term. The current selloff in global financial markets has two primary causes: a medium-term reassessment of growth and risk, and short-term funding pressures. We expect the drawdown in interest rate and currency markets due to funding pressures to reverse first and provide significant additional gains as interest rates fall to new lows in EMs. We are focused on taking advantage of normalizing inflation expectations and investment grade credit levels. We expect growth and risk concerns to dissipate over a period of between 18 to 24 months, with the US dollar declining as a result. We believe that EM non-investment grade credit, and possibly DM non-investment grade, will be late in recovering. Given that we believed EM assets offered attractive opportunities prior to the pandemic, we think the recent moves by the Fed have removed some longer-term headwinds for EM assets, and we remain constructive on the asset class over the next two years.
1. Source: Bloomberg L.P., April 3, 2019 to April 2, 2020
A credit spread is the difference between Treasury securities and
non-Treasury securities that are identical in all respects except for quality
risk and is subject to market volatility.
Interest rate risk
refers to the risk that bond prices generally fall as interest rates rise and
An issuer may be
unable to meet interest and/or principal payments, thereby causing its
instruments to decrease in value and lowering the issuer’s credit rating.
The risks of investing
in securities of foreign issuers, including emerging market issuers, can
include fluctuations in foreign currencies, political and economic instability,
and foreign taxation issues.
The performance of an
investment concentrated in issuers of a certain region or country is expected
to be closely tied to conditions within that region and to be more volatile
than more geographically diversified investments.
The dollar value of
foreign investments will be affected by changes in the exchange rates between
the dollar and the currencies in which those investments are traded.
referenced above are as of April 8, 2020. These comments should not be
construed as recommendations, but as an illustration of broader themes.
Forward-looking statements are not guarantees of future results. They involve
risks, uncertainties and assumptions; there can be no assurance that actual
results will not differ materially from expectations