Investment strategy

Downgrade EM IG bonds as duration risk weighs

10 March 2021 • 5 mins read

The healthy US jobs report last Friday was a firm signal to the markets that the economic recovery is heading in the right direction, and as a result, the10-year US Treasury yield rose again to around 1.60% due to higher inflation expectations and stronger economic prospects.

Our economics team remains confident of the trajectory of the US economy, and have recently moved up our 12-month forecast for the 10-year US Treasury yield to 1.90%.

Given our expectation that rates will rise further, we have last week in our views downgraded ourposition in Emerging Markets (EM) Investment Grade (IG) bonds from neutral to negative.

Given the firm performance of EM IG bonds in 2020, we believe that valuations relative to EM High Yield (HY) have become less attractive. EM IG also has a significantly higher duration relative to HY and therefore is more susceptible to the impact from rising rates, and finally the tighter spreads in EM IG also results in a smaller buffer against rising rates.

Recall that we had earlier downgraded our position in Developed Markets (DM) IG bonds to underweight in the fourth quarter of 2020, which has helped to shelter our clients’ portfolios from duration risk as Treasury yields rose sharply in 1Q 2021.

With the EM IG bonds downgrade, we are now underweight both DM and EM IG bonds in our view.

For equities, while we believe that rising yields will not derail the long-term post-pandemic bull market, we should not be surprised to see market turbulence persist over the near-term, especially as inflation fears may intensify in mid- 2021 as CPI numbers rise mechanically due to base effects, which would (for a time, in our view) lend credence to the views of inflation hawks that the ultra-loose monetary policy by central banks in response to the Covid-19 pandemic will unleash severe inflation.

Our base case view is that the mid-year spike in inflation is likely to be transitory which is in line with the Fed’s thinking – and that structural forces related to technological disruption and demographic changes would continue to exert countervailing disinflationary pressures. Our view remains that the Fed will not taper QE in 2021 and will not hike until 2024.

The cessation of inflation fears and bond market volatility are likely necessary conditions for a decisive bottom in the equity market. While it is difficult to say when this will happen, the odds of this improve as yields rise. First, the Fed is more likely to speak out against rising yields as the 10-year Treasury yield rate draws closer to the 2% level to avoid potential disruptions to their plans for an orderly recovery. Second, at current levels, the rates market is pricing in one 25bp hike in 2023 and at least three hikes by end-2024, which seems excessive.

Many investors are also concerned about rising real yields, given that extremely low real yields have been one of the key drivers of the post-pandemic rebound. Over recent months we have seen the US 10-year real yield move up from about -1.0% to about -0.65% currently.

Historically, on a net basis, a rise in real yields driven by stronger economic prospects tends to be good news for equities as the positive effects of higher growth in corporate earnings and a reduction in equity risk premium outweighs the negative effects of a higher discount rate in valuing share prices.

In addition, while real yields could rise further from here, they are still broadly at very low levels versus average historical levels. Despite its recent move up, the US 10-year real yield is still far below the S&P500 earnings yield and the current differential is significantly above the average level from 1990 to the present. This tells us that very low real yields continues to act as a broad supportive factor for equities.

Finally, system liquidity remains abundant. Excessive deposit accumulation in US banks arenear record levels, and this points to a source of continued demand for bonds as banks are required to match the duration of their liabilities even as their balance sheets continue to grow with the Fed’s aggressive QE program and still subdued loan growth. This is one factor why a collapse in US Treasuries pricing (in other words, a very sharp spike in yields) remains a bear case scenario and is not our baseline.

And more liquidity is slated to enter the system as the US Congress makes significant progress towards passing the next US stimulus package. The Senate has passed its version of the pandemic relief bill over the weekend. Although the bill was scaled back in some areas, the savings was reallocated to other provisions so it now appears that the headline size of the bill will be close to USD1.9 trillion and this is expected to be passed by mid-March.

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Eli Lee
Head of Investment Strategy
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