Europe gets it together…temporarily

Via the excellent Damien Boey at Credit Suisse:

Temporary fiscal union forming. The European Commission (EC) is launching an unprecedented fiscal package of €750 billion (5.6% of GDP) to deal with the fallout of COVID-19. Under the plan, €500 billion will be distributed to member states in the form of grants, while the remaining €250 billion will be available as loans, with the grants not counting towards any countries’ debt tally. The package will be part of the European Union (EU) budget and funded by mutual debt issuance in the EU’s name. Some member states are reluctant to participate in mutual debt issuance, but importantly, Germany and France are on board. The stimulus package is not overwhelmingly large, and still needs to be ratified through the appropriate legislative processes. But the good news is that it represents a step toward a temporary fiscal union, with a central body able to provide help to troubled and funding constrained member states when they are in need of help. If only someone would provide the funding …

European Central Bank expands quantitative easing. Enter the European Central Bank (ECB) and its quantitative easing program (QE). The latest iteration of the ECB’s version of QE, the Pandemic Emergency Purchase Program (PEPP), will be increased by a much larger-than-expected €600 billion, and extended through to June 2021, with reinvestment of the proceeds of maturing bonds through to June 2022. From the start of 2020 through to mid-2021, the ECB should buy over €1.8tn of assets (15% of GDP), sufficient to fund major stimulus packages, including that of the EC. Recall that in the EU, member states do not have access to overdraft-like funding facilities at the ECB, and therefore cannot automatically create deposits through fiscal deficit spending. They cannot spend funds before raising them – rather they have to raise them first before spending, creating funding risks. This is where ECB QE in secondary bond markets is so critical, because it renders member state borrowing a risk free exercise. Marginal buyers of debt are guaranteed of being able to sell new issuance to the ECB by virtue of its QE program. Therefore, indirectly, the ECB funds fiscal deficit spending. The European monetary system might be more like a manual car than an automatic one – but the ECB makes sure that the transition between gears is quick and seamless, making the system look more like its other developed world counterparts.

Price in higher inflation despite today’s reality. Europe has long been a source of deflation for the world, because the absence of fiscal and monetary unions has eroded the credibility of policy makers to consistently run counter-cyclical policy to boost growth and inflation, especially in the presence of many shocks. Indeed, Europe is in recession now, and is on the precipice of deflation again, with some member states in particularly poor health. We have seen before many attempts by policy makers to recapture inflation targeting credibility, and many of these attempts have failed. But hopes have been renewed by the simultaneous establishment of risk free funding, and a central body to distribute funds. To be sure, we would not go so far as to say that Europe’s plumbing issues have been completely fixed. After all, the legality of ECB QE has been challenged in Germany, and the EC fiscal package has not yet been passed into legislation. But policy makers have shown strong intent recently, and in this regard, have gotten off to their strongest re-start to the journey in years.

Price in lower growth dispersion despite today’s reality. Historically, one of the most powerful leading indicators of peripheral European sovereign spreads to German bunds, is the dispersion of year-ended real GDP growth across EU member states. Recently, with real GDP plunging, growth dispersion is starting to rise again. All nations are experiencing recessions – but some much deeper than others. This makes the “one size fits all” solution of the monetary union a poor fit for individual countries. Some might need more stimulus than others, but find themselves hamstrung from a funding perspective to achieve this outcome, raising funding risks. More generally, growth dispersion increases public dissatisfaction with the regime, and forces investors to price in fat tail break up risks. However, with the ECB expanding QE, and the EC moving towards a temporary fiscal union, policy makers are taking credible steps to reduce funding risks and growth dispersion. Therefore, despite the present reality of divergences between economies, it is quite possible that pereipheral spreads can remain tight. And this matters a lot for sovereign bond pricing globally.

Bonds should sell off, but strong recovery needed for it to be broadly based. The seminal works of Cochrane and Piazzesi (2002), and Kim and Wright (2005) show us that the term risk premium in bonds – that is, the spread between the long-term bond yield and neutral rate – can be reliably modelled as a non-linear combination of today’s cross section of bond yields. Specifically a tent-shaped combination of today’s 2-, 5- and 10-year bond yields, with maximum positive weight on the belly, and low or negative weights on the wings, is able to quantify the premium, and predict at least 40% of the year-ahead variation in total bond returns (capital growth and running yield). We find that the modelling framework can be generally applied across major markets. Our innovation is to add peripheral European sovereign spreads into the mix, because the past decade teaches us that peripheral European sovereign bonds contain credit risk, but for ECB QE. Therefore, when spreads blow out, investors are expressing the view that these bonds are uninvestable, and choose to reallocate their funds towards “core bonds” with no funding risk – a safehaven rotation. In turn, the pricing dislocation causes core bonds to trade on artificially low yields. On the flipside, when concerns about peripheral European sovereign risk dissipate, credit spreads narrow, and core bonds sell off on the unwinding of the safehaven bid. Reflecting this logic, we find that peripheral European sovereign spreads add information to our term risk premium models for US, Germany and Japan. Wider (narrower) spreads contribute to higher (lower) core bond returns tomorrow over and above what the tent-shaped factor would suggest. Right now, our augmented term premium models are suggesting that US Treasuries are priced to sell – but German bunds and Japanese Government Bonds (JGBs) are not. In aggregate, G3+ bonds are likely to weaken, especially given growth positive developments in Europe. Another complication is that there are systematic errors in our bond return forecasting models that we also need to account for. Typically bond returns over- (under-) shoot our forecasts when the Institute of Supply Management (ISM) manufacturing index is weak (strong). Bond returns are counter-cyclical. Therefore, if the ISM recovers strongly, we should expect undershooting across the board. For what it is worth, the best leading indicators of the ISM point to a decent bounce. Therefore, we err on the side of bearishness on the bond complex for now.

Be careful what we wish for longer term. We understand that investors will celebrate higher bond yields as a sign that growth is returning amid stimulus and re-opening efforts. Some might even be tempted to interpret curve steepening as a signal for value, financial and cyclical recovery in earnest within the equity market. However, we also note that US equities are trading on such stretched valuations on a through-the-cycle basis, that they are priced for negative returns on a 10-year horizon, and vastly inferior returns to bonds. In other words, the equity risk premium is effectively negative, meaning that valuation is a major constraint on the market, notwithstanding recovering growth expectations. Beyond near-term optimism, they cannot absorb higher interest rates. One of our concerns is that if inflation becomes a threat, central bankers will at some point have to upset the applecart by tapering or tightening, wrong footing anyone positioned for lower-for-longer rates and lower-for-longer volatility. We are also concerned that more shocks, or higher uncertainty could tip the balance anyway, causing passive and risk parity investors to liquidate in a potentially broad and disorderly fashion. In the circumstances, we want protection against a passive unwind, from both factor and asset allocation perspectives. The usual suspects (ie bonds, and bond proxies) may not do. Commodity exposures are interesting, provided we believe in reflation. Value and small cap factors are interesting, provided that a passive unwind does not cause or correspond with de-leveraging. But the clear outperformers in our view are unloved, and uncrowded quality exposures. We think there is alpha to be captured in anti-momentum and quality exposures, that are not necessarily cheap.

Anything positive for Europe puts more upwards pressure on the Australian dollar.

David Llewellyn-Smith
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