5 December 2017
As highlighted by JP Morgan in one of the latest research pieces, “the main driver of the spread tightening over the past year has arguably been the global demand for higher yielding assets following the record level of QE deployed by the DM central banks.
The negative yields in Eurozone government bonds and compression in European credit spreads following the CSPP purchases led to a cascading demand for assets that provide better yields, and some of this demand supported EM corporate bonds as well. At the same time, local investor appetite for external bonds remained strong in Asia, absorbing most of the net supply that mainly emanated out of China.
As spread products continued to tighten and compress valuations, the main question has been how long and how far this trend can continue. The unprecedented nature of QE and magnitude in the expansion of central bank balance sheets makes it difficult to predict how the market will react to the unwinding in coming years.
The announcements of the Fed balance sheet reduction and ECB tapering in September and October 2017 were seen as potential catalysts for a reversal, but this did not materialize as markets brushed off these developments with the outcome considered to be well anticipated. The investors should assume a very gradual unwinding of QE, which should keep the aggregate size of the G4 central bank balance sheet at around $15.0tn until the end of 2020 after hitting a peak of $15.6tn in mid-2018 (see figure 1). In addition, central banks may try to minimize market disruption and exit in a predictable manner, which should contribute towards keeping the stable backdrop in place.
The view assumes a continuation of the stable macro and rate environment, but the main risk could come from an unexpected pick-up in inflation which leads to large upward move in global rates. Investors should be less concerned about the fundamental implications as the EM sovereign fundamentals are in a stronger position while EM corporate credit metrics should remain on an improving trajectory and keep default rates low. The question would be whether the strong demand for higher yielding assets could unwind due to a combination of negative performance and rise in risk free rates, which reduces the need to reach down to riskier assets. Indeed, over 20% of DM government bonds are still negative yielding according to our index team, and although this is off from the peak of over 30% recorded in mid-2016, it remains elevated and has been a supportive backdrop.
Figure 1: G4 Balance Sheet
TThe pace of ECB CSPP purchases to slow to €3bn/month net from January 2018. In their view, this is enough to keep volatility low, but not to drive continued spread tightening. Most importantly, it is no longer close to covering growth in the size of the market: they are forecasting a net supply-demand balance of €127bn next year after subtracting redemptions, coupons and central bank purchases. Investors should pay attention that this may trigger some indigestion in the market, and so, are forecasting 6bp of benchmark spread widening to 105bp next year.
Despite such cautious outlook, should be noted that the yield differential of CEMBI Broad IG and HY over the respective European credit segments is substantial, which suggests that the there may be room for demand to remain in place for EM corporates.
Figure 2: EM GDP vs US Fed Funds Rate
EM fixed income has historically maintained positive performance during US policy rate hikes, but the outlook for 2018 has some important differences to previous periods that make a simple EM beta trade less easy to forecast based on historical precedents. The 1998 and 2004 Fed hiking cycles occurred against a backdrop of significantly increasing EM GDP growth rates, with EM growth rising 4-5%pts in these periods. The importance of this is that the large improvement in EM fundamentals meant that EM market risk premia could compress to counteract the impact of higher rates and returns remained mostly positive. Two features of the 2018 outlook make it difficult to extrapolate these prior episodes. First, the forecast for 2018 EM GDP does not entail a big increase year-on-year. This may make it difficult to have further significant compression in EM risk premia, although we forecast some credit spread tightening.
Second, the US rates normalization is abnormal, coming from an exceptionally long period of very low rates. How fixed income markets will react to this will remain a source of uncertainty for EM and other fixed income asset classes with no real precedent. The near-term potential for US tax cuts may also add upward pressure on US rates, but the impacts of these tax changes are already imbedded in our US forecasts.
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