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The US government and the Federal Reserve both reacted to the Covid-19 crisis by unleashing an unprecedented amount of fiscal policy measures together with the first intra-meeting rate cuts since the global financial crisis. With interest rates already cut and the future macro environment uncertain, we cannot see the Fed hiking rates this year, thus putting a limit to how much yields can rise. However, while fiscal expenditure should add an upward pressure on yields, the Fed remains the main buyer through its quantitative easing (QE) programs. As such, any moves wider will be led by short-term investors repositioning to take on more risk. Treasury yields are rich on every measure we see and the low carry offered means that fixed income investors are not compensated for inflation or small adverse price moves. We have a preference for strong investment grade rated bonds (up to A rated) due to a combination of the Fed becoming a buyer of this asset class, the widening of credit spreads during the equity market sell-off and the potential re-allocation of funds from treasuries offering no yield to investment grade in pursuit of safer yields. We stay away from high yield despite the cheapness of the asset class as the macro picture remains uncertain.
Along with the US, the UK has implemented wide fiscal and monetary measures. However, the UK faces an additional uncertainty in the form of the Brexit transition period. Gilts face pressure from larger issuance and richness of the asset offset by an even more uncertain macro picture. With the virus showing up, the chances of the transition period being extended have increased further. We do not see any rate hikes, but it is the low yields that is of most concern for us and as such, we prefer to allocate towards strong investment grade issuers, especially those with a strong cash pile and more global exposure over gilts. The UK high yield market is very small and we continue to avoid.
The greatest challenge for the EU is to coordinate a joint approach to the virus, making the recovery for the zone likely to occur in stages. Despite this, individual countries have announced fiscal stimulus plans and the European Central Bank (ECB) has announced that they will increase their programs to support the economy. As such, the support for periphery countries like Italy and Greece has increased with the ECB now being able to buy more of the debt. We maintain our stance of not investing into negative yielding bonds and instead look to hold Greek and Italian government bonds along with strong investment grade bonds where the ECB is also a buyer of the asset class. Once more, we stay away from high yield due to the uncertain macro environment.
EM faces not only the challenge of a stronger dollar, weaker demand from developed countries but also appears to be catching the Covid-19 virus late, partly due to limited testing capabilities compared to the US and Europe. As they enforce their own lockdowns and look likely to remerge from the virus later than the rest of the world, it may prove more difficult due to the lack of medical infrastructure and concentrated population densities. While the focus will be on China as it emerges from its lockdown, the rest of the emerging market class may still be lagging behind. As one example, Argentina unilaterally postponed the payment on $10bn of dollar-denominated debt governed by local law until 2021. As a result, we hold a negative view to the asset class for the coming quarter despite the high yields currently on offer. The USD denominated sovereign index now has a 7% yield but country selection will be key.
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If not otherwise indicated, all graphs are sourced from Dolfin research, April 2020.
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