Sector report by Harrison Knowles, 27 November 2020
Given the current global macroeconomic situation, investment opportunities to go long in the main government/sovereign debt markets seem to be few and far between. The largest, namely, U.S, U.K and Japanese markets currently hold historically low yields and hold lots of potential for a gradual increase in the near future. For those who do not necessarily follow bond markets or perhaps need a reminder, the yield and price of a bond hold an inverse relationship. Essentially implying prices for bond investments are substantially high and are likely to decline over the near future. Given the context of this fund and the fact that we are only considering long positions, other debt markets must be tapped into to find a suitable ETF to invest in.
In this report I look to analyse the effects of the corona virus pandemic on the large economies and their respective bond markets, before trying to devise a suitable investment in the EMD (Emerging Market Debt) market in order to obtain some higher yields and proposals in which are likely to produce a net gain in the coming months.
In the fallout of Covid-19, there are a plethora of other macro events that can swing our judgement on an investment proposal. An ongoing US-China trade war, US presidential election, United Kingdom’s Brexit saga and emerging market trends have continued to play a role in the global economy. In this section I would like to emphasise on current global trends in policies, whilst analysing specific geographies. However, it seems natural to begin by developing an understanding of the global pandemic.
Coronavirus across the globe
In the current economic climate, both monetary policy and fiscal policy have been subject to drastic change around the globe. With the onset of the Covid-19 pandemic, I feel as though lots of the characteristics of today’s market are very similar to the early stages of a long-term debt cycle.
Back in the final week of February, markets jolted into panic, in realising the dangers that the pandemic posed to economies. Central banks across the globe were quick to react, implementing measures and slashing rates at a pace not seen since the 2007-2009 financial crisis. With looming fears of GDP shrinkage, and a credit crunch, slashing rates created lots of discussion points given that the rates were already very low. This in-turn encouraged different techniques alongside fiscal policies in order to ease the hardship that was expected to hit the labour market and consumer demand. The issue was and still is that slashing rates, encouraging borrowing, essentially putting money in the consumers hands, doesn’t solve the problems. Since, when people become ill, productivity across workplaces and schools suffer, and demand for goods & services takes a dive. Volume of response conducted by central banks in different regions varied a lot as we will soon discover. Across the globe however, trends continued to form beyond the initial onset of the pandemic when it comes to rates and policies.
Our first concern is Asia. The origin of the pandemic forms much of this report as we will consider the advantages Asian countries have gained, and their influence on the section on FX risk. Naturally, the main influence on rates in Asia this term has been Covid-19. Though I want to stress the importance of the following: the UK has a population 20 times smaller than China, yet it has seen five times as many cases of COVID-19 and almost ten times as many deaths. All of which raises the question: how has China managed to wrest control of its pandemic?
In China, unprecedented measures to limit virus transmission in and around the Hubei province restricted the mass spread. As seen in Figure 1.1. the originating country alongside Japan’s number of cases soon became few and far between relative to other geographies.
Measures of spread limitation led by a centralised epidemic response system meant both China and Japan were relatively well-placed to tackle the disease. Whilst the society were also quick to realise the potential outcomes given a population that had experienced the SARS-Cov and its associated high mortality rate. It seems most appropriate to withhold comparisons until the conclusion of this section, though the effectiveness of China and Japan’s response is notably down to response time.
Now focusing on the respective economies, initially with Japan and the BoJ, an interesting factor in its response to the onset of Covid-19 came in the form of its already implemented ¥6tn-a-year ($55bn) exchange traded funds (ETF) purchasing programme. Pre-pandemic, on any given day, if the TOPIX (Tokyo Stock Price Index) fell by 0.5% or more, the BoJ would purchase TOPIX-tracking ETFs in the afternoon. This meant that speculating on short positions became ever riskier, and even in spite of concerning news such as a global pandemic, hedge funds stayed away from large bearish positions that would have amplified selloffs otherwise. Whilst a second support for the market came in the form of company share buybacks, which is thought to have had a large effect not due to the sheer scale, but otherwise the exceptionally low-volume trading environment into which were pitched.
The People’s Bank of China were also quick to provide monetary policy support to safeguard financial market stability. Key measures include liquidity injections into the banking system via open market operations, expansion of re-lending and re-discounting by ¥1.8 trillion and reduction on interest rates across these facilities and on repo markets. Whilst the Chinese government’s implementation of fiscal policies was rapid, with an estimated ¥4.8 trillion (4.7% GDP) of discretionary measures including: increased spending on epidemic control, production of medical equipment, tax reliefs and waived social security contributions. The variation seen in Figure 1.2 is apparent due to the measures described previously. As the spread prevention methods began to reduce the rate of infections in mid-March, this paved the way for the monetary and fiscal policies to take effect on markets.
The point I’m trying to make is the fact that in a period where the market sentiment is severely threatened, outlook is vague and opinions are vast, many other regional markets would not have fared the same; and didn’t. It is important to note the scale of which the difference is, but I will touch upon that later in the conclusion of this section. So, the trend in Asian policies allowed economies in this region to perform better than those in other areas of the world. And as mentioned above, mid-March introduced the first signs of the notion of a V-Shaped recovery in most parts of the more developed nations in Asia. Considering the Nikkei 225 index which is largely Japan’s equivalent of the US Dow Jones Industrial Average, the effects of monetary/fiscal stimulus is apparent.
A natural progression from Asia is the Eurozone – defined as countries in Europe in addition to having denoted local currency as the euro. Even before the onset of coronavirus, the Eurozone had slowed to its weakest growth rate since its sovereign debt crisis. Disruptions to supply chains, trade and tourism amplified the hardship of a pandemic for the Eurozone, alongside a lack of impactful and effective measures to contain the virus early on.
For most Europeans, the moment coronavirus arrived on their continent was on February 23rd when Italian authorities quarantined 10 small towns south-east of Milan. Few imagined the drastic measures imposed by China in Wuhan would be necessary or feasible in a European democracy. The quarantine in Italy however should have portrayed the necessities of action to the onlooking countries. Yet it took another two to three weeks for governments across the continent to appreciate the scale of infection in their own countries and take the necessary measures to contain it. Unfortunately, as is the case in many regions, these measures were too little too late. Some European countries proved to attain good fortune with minimal exposure to the virus, whilst the rest suffered from indecisive leadership. Some more specific causes of the severity in Europe also came down to more local infrastructures. The regional healthcare systems in Italy, particularly the Lombardy region, weren’t prepared and it is widely believed the virus had been in fact spreading in this region for months prior to their first case. Within days the large majority of ICUs had been occupied and the mortality rate was around 5%. Up to this point, it seems rational in fact that many policy makers didn’t impose measures given the fact the advisory scientists were analysing the data of China and Korea, concluding a very mild alternative for Europe. Though Italy’s flooded hospitals did then initiate more impactful actions across the continent, with epidemiology analysts at Imperial College London predicting that ICUs in the UK would quickly reach capacity, and hundreds of thousands were likely to die.  However this theme of underestimation did continue to occur, with Spain’s leading doctor stating “There is no virus in Spain”. In fact, at the time of his comments, contrary to his belief of no cases or community transmission, Covid-19 was spreading like wildfire in Spain, soon to be hit harder than any other country in the EU. Ultimately, this notion of denial is what led the Eurozone’s downfall in the battle against coronavirus.
As one might expect, the consequences of the above actions, or lack of, had significant impact on the respective economies of eurozone countries. Drastic monetary and fiscal policies were required across the continent, and in larger volumes in comparison to Asia.
CURRENT CAPITAL FLOWS, POSITIONING AND SUPPLY
In the current economic climate, it can be hard to find investment opportunities within rates in the three largest fixed income markets: The U.S, Japan and the U.K. since rates are within an arbitrarily small distance to zero in all three markets, when looking at longer durations.
Currently the yields on U.S treasuries are sitting at around (0.82%) and have been since the onset of Covid-19, meaning ETFs such as the iShares 7-10 Year Treasury Bond ETF have essentially already priced in on the sub-optimal saving environment.
Currently, not only do longer maturity U.S Treasuries not offer an interesting hedge against equity volatility, they also lack sufficient upside potential given the already near-zero yield, and prospect of a steepening yield curve. Long-term interest rates in the U.S are likely to rise in the short term. Whilst something to consider is the fact that further fiscal stimulus – very likely during the Democrat Joe Biden’s administration, will continue to prop up equities and the S&P500. On the other hand, yield on the 10Y treasuries is likely to also rise towards the 1-1.25% range given the flurry of positive vaccine news and decrease in demand of safe haven assets. Now, if one thought that there is still potential for this optimism to reverse there could potentially be an entry point on treasuries, however in my opinion even under the assumptions of this belief, the risk posed is too great given the very restrictive boundary conditions i.e very little room for yields to decrease from this point. The other point to consider is the effects of QE/Asset Purchasing programs. These tend to drive yields lower depending on the scale of the program relative to the issuance of government debt opportunities. A Biden administration is likely to issue a lot, though it is unclear how much the Fed is likely to buy. In light of this, and the other points above, I still feel as though the yields are far too low currently, especially given the context of wanting to find a more medium-long term position.
Japanese Government Bonds
I was particularly interested in a potential opening in the JGB market given the very low risk on an unhedged investment. In short, a Biden administration is likely to be kinder to China, boosting its economy and allowing china to devalue the Yuan to increase their trade surplus. As a result, other Asian currencies are likely to appreciate, including the Japanese Yen.
Upon review however, the themes in savings and investment dynamics in Japan have shaped a fixed income market in which individuals save a large portion of their income in government debt. The macroeconomic backdrop is formed essentially by corporate deleveraging, an aging population and the fact that the overall indebtedness of the Japanese government, relative to GDP, is higher than that of any other G20 country pre-pandemic. Briefly touching upon these points, Japanese households have historically been characterised by high savings rates, while this generational behaviour has been present since WW2. This rate has been in decline for some time now, probably attributable to the fact said generation are now most likely in retirement. This period was beneficial and sufficient to finance the investment needs for corporate sector and government expenditures.
This figure describes the savings and investment dynamic of households, corporates and government. Interestingly, from the mid-to late-1980s, the strong expansion resulting from these high levels of corporate investment increased government revenues to the extent of temporarily turning the public sector into a net supplier of savings. Loose monetary policy conditions that accompanied this booming economy with circa zero rates set by the BoJ, encouraged extreme high levels of corporate indebtedness and leverage. Consequently, the burst of the economic bubble at the end of the 1980s produced an era of dismal stock returns, low real growth, and falling nominal prices. In reaction, as seen in the figure, the corporate sector underwent the latter stages of the classic debt cycle in debt reduction and balance sheet deleveraging at the expense of capital investments to such an extent to become net savers. After this period government debt and the JGB markets took over as the main occupant of household savings. More recently, the graph still applies when considering the foreign sector’s behaviour. Consistent current account surpluses have resulted in Japan’s accumulation of a sizable, international creditor position. So, since government expenditure is very high and public finances are underperforming in Japan, in addition to providing resources to improve its fiscal position, this holding of foreign assets hedges Japan against an underperforming domestic economy. Around half the income from foreign assets is interest from bonds purchased abroad.
So, to summarise, given also the fact that Asian countries are likely to remain in control of handling the pandemic, (considered previously), the yields in the JBG market are historically low by the dynamics of Japan’s culture, but also are likely to only go up in light of a recovering economy. This also presents the issue of no clear opening for a medium to long term position in my opinion.
The figures illustrate current yield changes in UK Gilt securities as of late November. It is no surprise that yields have fallen substantially this year as investors rush to safe haven assets, whilst more recently yields have been edging up on increased market sentiment towards equities amid vaccination prospects. To keep this report somewhat concise, the question for U.K government debt positions is whether there is an opportunity to go long. The short answer is no.
Back in June longer-term gilts yield sunk below Japan’s, which in a concise way provides a brief idea of what conditions are like. Without extrapolating this to today however, yields are still very low relative to conditions seen in a healthy economy. There also doesn’t seem to be any real prospects of the BoE to introduce negative rates or implement any particularly drastic measures anytime in the near future, as long as the vaccination prospects remain sound. It is worth noting the bank did
Therefore, in my opinion the yields are almost certain to continue their trend in increasing, which doesn’t really provide an entry point.
TECHNICAL ANALYSIS ON CHOICE OF ETF
So, at this stage it is quite apparent that the largest government debt markets host a sub-optimal environment for an investor looking to go long. In order to have an ETF to suggest, I’m going to look at economies with slightly lower credit ratings, that provide some higher yields and therefore room to work with. Whilst it is worth noting that I will only consider investment grade in this scenario, not Junk.
After talking to Krisztián about the potential FX risks, it seems as though significant challenges and pressure placed on ill-equipped healthcare systems in emerging markets will play a large role in the volatility of their currencies. His conclusion points towards appreciation in both the Indian Rupee and Brazilian Real, suggesting these countries offer an opportunity for an unhedged investment. I will begin by noting many asset managers have continued to hold a positive outlook for emerging market debt as an asset class. And given the fact credit risk is substantially more of an issue in such cases, I will not suggest investment in an individual bond ETF, I am going to suggest a broad index ETF instead. In this case being an EM debt local currency ETF.
My suggestion is the iShares J.P. Morgan EM Local Currency Bond ETF. This ETF provides a diversified exposure to emerging market bonds, denominated in local currency, whilst it directly invests in sovereign bonds. Whilst all constituents of the ETF are investment grade or on the upper end of high yield. I have chosen in favour of this ETF on the basis that the chosen ETF provides success in the very real prospect of a boom in EM in 2021, as well as success given the potential problem of vaccination distribution. My initial thoughts where that many EM will struggle with the distribution of the vaccine, and I still do believe in this, however given the recent surge in equities, bond yields and currencies in EM, i considered the fact that in both scenarios the price of EM treasuries are likely to rise. Firstly, in the case of continued surge, governments will require funding to keep up with the development in the private sector as a result of the increase in investment aimed at equities and corporate debt. Secondly, if my initial thoughts that a handful of EMs will struggle distributing the vaccine, a rush to government bonds from investors will also result in a positive outcome for the ETF.
To further explain, back in March this year, the EM’s lost over $90 bn in investments in bonds and stocks in this month alone. EM investments where obviously hit hard by the notion of having to find safe havens, though more recently the market is making a rather hefty comeback. The past two weeks has seen a rather large rally in stocks and even bond have picked up too. This month’s breakthrough in the hunt for a Covid-19 vaccine has increased overall investor sentiment towards EM opportunities and as a result respective currency have also increased. Whilst I thought that all this did was remove FX risk on my initial government debt idea, courtesy of FT and Reuters, there seem to be a plethora of anecdotes suggesting EM will be just fine. One particular example is Renaissance Capital – an emerging and frontier market specialist often wary of making bullish calls – advised investors “to buy anything and everything’ in the sector.
Goldman Sachs’ bullish view is based on its forecast of a strong global economic recovery over the next 12 months, helping EM in particular given the “snapback potential” presented by low valuations. It picks out Mexico, which the bank thinks will benefit from a strengthening US economy, as well as having room for further policy easing next year to support growth, and Brazil, which it thinks could be lifted by rising commodity prices. 
The main risks opposing our investment can be sub-sectioned into interest rate risk, credit risk and FX risk.
Credit risk refers to the possibility that the issuer of the bond will not be able to repay the principal and make interest payments. Fixed income securities issued by governments can be affected by the perceived stability of the country concerned and proposed or actual credit rating downgrades. Certain developing countries are especially large debtors to commercial banks and foreign governments. Though as this ETF is a broader index with lots of constituents, its diversity dilutes any potential credit risks associated with individual governments. Whilst also it is very unlikely multiple governments would default simultaneously.
A major issue with any fixed-income debt security, excepts TIPS (Treasury Inflation-Protected Securities), is the risk associated with an increase in interest rates. It is natural that longer-dated maturity assets will be more exposed to this, though my choice of ETF has a range of maturities and maturity dates which offers a hedge against some of this risk. JPMorgan have also announced that they will be rolling down the yield curve towards shorter duration bonds in order to mitigate some of this risk.
A more specific risk that falls under the rates risk is the exposure of a rates hike in the U.S. Given the nature of many EM market currencies being essentially pegged to the U.S. dollar, our choice of ETF is somewhat exposed to the rates decisions of the Fed. However, from my understanding, recent measures adopted by the fed such as the announcement of an average inflation target supposed to an absolute nominal value of 2%, suggest rates are expected to remain low for a long time.
In 2021, the prospect of a vaccine and gradual economic recovery should see the 10-year benchmark rate lift off its lows. JPMorgan sees the benchmark peaking at 1.3% by the end of the year. As for how fast it gets there, and how much more room it has to rise, all eyes will be on the Fed, for any signs of flinching in its commitment to keep rates rock-bottom for years to come to ensure a full economic recovery. For purposes of our ETF, the relatively slow nature of rate increases, given the commitments made by the Fed means that rate risk for dollar-pegged EM currencies isn’t necessarily an issue at this moment in time.
Given the fact the ETF in question is denominated in local currency, it is natural to expect FX risk to be our largest call for concern. However as mentioned previously, the surge in EM equities, currency and bond yields in recent weeks and expectation of this to carry through to the new year provides sufficient assurance that this isn’t our main concern in this occasion.