Three investment themes for Q1 2019
Brexit and bonds: is there safety in gilts?
How is $10 trillion of fixed income assets positioned?
Abhishek Kumar: ‘The opportunities and challenges when investing in EMD’
SPDR ETFs Bond Compass Q1 2019
Welcome to Bond Compass, a global, quarterly report that aims to help investors navigate the global bond market. This includes analysis from State Street Global Markets that analyses bond flows and holdings indicators from Q4 2018, taken from a data set that represents some $10 trillion of assets*. This data shows that institutional investors, far from rushing to safety in the midst of the turbulent end to 2018, are selling Treasuries and, in December at least, began to dip a tentative toe back into Italian and emerging market debt. This was a surprisingly upbeat set of readings to begin 2019. In this quarter’s edition of Bond Compass, the PriceStats® information provides timely inflation analysis for the US, eurozone and emerging markets and reveals that the pace of inflation in these regions is already slowing in response to lower energy prices. This change will help the Federal Reserve and emerging market central banks to justify a pause in interest rate hikes — but it will also potentially complicate the ECB’s hopes to normalise policy. The report also includes an interview with Abhishek Kumar, portfolio manager for the SPDR Bloomberg Barclays Emerging Markets Local Bond UCITS ETF, who discusses the opportunities and challenges for the exposure, as well as the impact of investing in hard versus local currency. For investors looking to gain further insight into the data and the insights that the Bond Compass provides, SPDR ETFs is hosting a series of client-facing webinars and events across the globe.
For more information, please visit www.spdrs.com/fixedincome
* Source: State Street Form 10-K. As of 31 December 2018.
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Evaluating the impact of inflation in real time
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Disclaimer
Contrary to expectations, Q4 turned out to be more difficult than expected for risky assets. However, long term investor behaviour in fixed income markets indicates less panic than price and yield moves suggested
Flows & Holdings Q4 2018
INVESTOR SENTIMENT
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Source: State Street Global Markets. As of 31 December 2018. *As at quarter end.
Gilts had their best month in more than a year to end 2018. The weaker turn in the global environment along with lower oil prices proved to be supportive for safe fixed income investments. It was notable, however, that long-term investors were reluctant to chase these returns; flows into the Gilt market across the quarter remained close to their five-year average. The only bright spot from the point of view of investor behaviour was an improvement in demand for 30-year Gilts in December, although even this did not offset selling seen in the first two months of Q4. This supports State Street Global Markets’ (SSGM) view that Brexit risks, far from encouraging robust safe haven demand for Gilts, are keeping long-term investors on the side lines. The holdings metrics suggest that investors have been underweight Gilts for more than a year. At first glance, this may seem surprising given the economic risks associated with Brexit, especially a hard exit or no deal. Brexit, however, is a double edged sword for Gilt markets, even in some of the more pessimistic scenarios.
Institutional flows: uncertainty around Brexit restricted demand for Gilts in 2018*
*Source: State Street Global Markets. As of 31 December 2018.
The main challenge is what happens to short-term interest rates. The Bank of England has made it clear that the uncertainty surrounding Brexit is a key restraining factor in its rate cycle. This may change over first quarter if weak December data prove to be a sign of a much weaker economic trend. For the moment, SSGM still assume that any news suggesting Brexit uncertainty will diminish is a potential negative for the front end of the Gilt market. For now, the good news for Gilts is that the uncertainty surrounding Brexit is proving remarkably stubborn. Deadline after crucial deadline has passed without providing any clarity on the likely path. Recall the original “critical” deadline for a deal was back in October. Nevertheless, as the clock ticks down towards the March exit date, it still seems likely that greater clarity must come, even if it is just narrowing down the potential options. In theory, one might expect that the best case scenario for Gilts would be the worst case economic scenario, a no deal Brexit with the UK crashing out of the European Union on 29th March 2019. In contrast to the original referendum result, which posed a threat to confidence rather than an immediate impact to the real economy, it is assumed that a no deal Brexit and abrupt shift to WTO terms for trade would have an instant impact on the real economy. In the scenarios published by the Bank of England, growth could contract by as much as 5% in 2019 as a result of this shock. As the Bank did in 2016, such a shock would likely to be accompanied by the resumption of quantitative easing and Gilt purchases.
For now, the good news for Gilts is that the uncertainty surrounding Brexit is proving remarkably stubborn
However, challenges to Gilt markets would come if a sharp depreciation in sterling (more than 20%), a ramp up in inflation and the likely Gilt sales by international investors that might follow. The implication is that even the best case scenario for Gilts is complex. Set against the downside risks for Gilts from a more benign version of Brexit, or even no Brexit at all, this skewed risk reward highlights why investors might be sidelined for now. Against the neutral flows in Gilts, SSGM’s data records an improvement in aggregate flows into Eurozone bonds over the quarter, even into Italy. This was especially the case in December. This is partly driven by a change in investor attitudes to Italy. Recent outflows from Italian sovereign bonds were modest because investors had already established an underweight after dramatic selling in May.
Institutional holdings: average weight for European debt but underweight in gilts*
That remained the case across Q4: a bumpy ride for Italian bonds as the budget dispute escalated, but one that ended on a more constructive note. SSGM’s metrics of long-term investor flows, which lean towards international investors, showed a robust improvement in December. Investors should be cautious that the improved sentiment towards Italian bonds has often been fleeting in the past six months but, for the moment at least, investors are no longer adding to an underweight. This does not mean European populism is over as a market theme. Italy’s budget could come back into focus if growth fails to rebound; demand for OATs** was shaken in late Q4 as the ‘gilet jaunes’ protests in France escalated. And if Europe’s parliamentary elections in May deliver a populist slant, further fiscal clashes (or reform?) look inevitable.
**Obligations assimilables du Trésor (OATs) - 7 to 50 year French bonds.
90-day flows percentile
Holdings percentile
GILTS
Yields fell across developed markets in December as a tumultuous year came to a close. In 2019, support may not be as robust, as central banks either stop expanding their balance sheets (e.g. ECB, BoE) or reduce them (e.g. the Fed). Inflation may not spill over, but it is still alive and, thus, will keep pressure on yields. At the same time, economic growth looks like it could soften in 2019; although, the convergence of monetary policy is expected to accelerate in the first quarter. Given the stage at which developed markets currently stand, the US Treasury market looks relatively more attractive than its EUR or GBP counterparts.
Navigating Interest Rate Risk by Focusing on Duration and Quality
*Source: State Street Global Advisors, Bloomberg Finance L.P. As of 30 November 2018.
Monthly Average of 3-Month Cumulative G4 Central Bank Purchases*
For further information about these investment themes and how investors can navigate them, please visit
OVERVIEW
Exhausting returns in fixed income — could converts lift performance?
**Source: State Street Global Advisors, Thomson Reuters. As of 28 December 2018.
Global Convertible Bond Index: Average Weighted Implied Volatility vs. Observed Volatility**
In volatile markets, convertible bonds can provide investors a degree of downside buffer while still retaining the ability to participate in an equity rally. Convertible bonds tend to exhibit lower interest rate sensitivity than high yield and investment grade thanks to the implied equity option and a generally shorter maturity issuance. Looking at the global convertible bond universe, recent market activity has driven observed volatility closer to implied volatility — a phenomenon that rarely occurs. While this convergence represents a sign of stress in the markets over the long run, it tends to provide opportunities to re-allocate convertible bonds.
After a challenging 2018, emerging markets (EM) could overtake developed markets (DM), which are forecast to slow from 2.4% in 2018 to 2.1% in 2019. Meanwhile, inflation is expected to stabilise in EM economies. Although further tightening may be in store for more internationally linked economies, like Turkey, the expected performance impact on local currency bonds would be more limited going forward as pre-emptive rate hikes have already occurred in order to anchor inflation. According to the International Monetary Fund (IMF), EM economies are forecast to grow at 4.7% in 2019 (unchanged versus 2018). US dollar evolution could be key to returns in the short run. As growth slows in the US, and if the Fed’s rate path becomes shallower, EM currencies may look relatively more attractive.
Emerging market debt local currency overtakes developed markets
***Source: State Street Global Advisors, Bloomberg Finance L.P. As of 31 December 2018.
Fair Value Emerging Market Currencies: Index vs. USD***
Theme #1
INVESTMENT THEMES
Theme #2
Theme #3
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Emerging Market Debt Active Manager Performance (%)
2013
Outperforming Managers
2014
2015
2016
2017
2018
11%
30%
23%
27%
37%
3%
89%
70%
77%
73%
63%
97%
Underperforming Managers
'A slower pace of Fed normalisation, combined with moderating growth could bring some respite for EM financial conditions and support growth'
We chose Barclays for its transparency, diversification and historical risk-adjusted returns. Index inclusion rules vary from one provider to another, and differences can affect performance. This was particularly evident last year when economic conditions weighed on EMD. During this period, our ETF Bloomberg Barclays benchmark outperformed its JPMorgan** peer partly due to better diversification of our index and also by including higher rated countries, such as South Korea.
*Morningstar Direct, State Street Global Advisors, as of 31December 2018 - The analysis is ran focusing on the net performance relative to the JP Morgan EM GBI Global Diversified index of the 30 largest Emerging Market Debt funds registered in Europe using the oldest and lowest (published) institutional share-class. The sample is the same for each calendar year. This universe represents circa 35bn US$ of assets under management. **JPMorgan Government Bond Index Emerging Markets Global 10% Cap 1% Floor Index.
The opportunities and challenges when investing in EMD
Abhishek Kumar, Sector Head, Emerging Markets, Fixed Income Beta Team, discusses the outlook for emerging markets in 2019 and the challenges for active managers in the sector
'In 2018, only 3% of the active managers in the universe outperformed their benchmark'*
Why do you track the Bloomberg Barclays index as opposed to the JPM benchmark?
Over time, our Bloomberg Barclays index has exhibited a better risk-adjusted return profile compared to the JPMorgan index. The investment universe of our index is broader with a greater number of countries and constituents, thus providing a broader pool of securities in which to invest. This is an important consideration, especially for investors who may be concerned about fund sizes, market impact and liquidity constraints.
The reality is very different. EMD now offers much greater liquidity and diversity, and the majority of active managers fail to outperform their benchmarks in the long run. A study of the 30 largest active managers* tracking the JPMorgan GBIEM Global Diversified Index highlights the performance concerns in the chart below. While some active managers outperform their benchmark, the majority have failed to do so over the longer term. In 2017, 37% of the funds in the universe did outperform the GBI-EM, but it was an exceptionally strong year for the asset class as a whole.
In the past, adopting an active management approach was perceived as the best way to invest in EMD based on various assumptions. For example, many investors thought indexed EMD would be too expensive to implement, and that because EMD is an inefficient market, active managers would be able to extract value. Moreover, an index would hold 'weak' countries that drag on performance, which active managers could theoretically avoid.
Why should investors consider using a passive exposure for emerging market debt (EMD)?
In 2018, only 3% of the active managers in the universe outperformed their benchmark*. In each of the five years of the study, less than 40% of the active managers outperformed. These results show us that underperformance is not the result of a single bad year or a one-off 'black swan' event but, rather, a consistent and persistent problem for active managers.
Source: Morningstar. As of 31 December 2018. The information contained above is for illustrative purposes only. For more details, see footnote.
For example, the yield to maturity of the JPMorgan EMBI Global Diversified Index is now ~6.98% with a duration of 6.4yrs. In comparison, the Bloomberg Barclays US Corporate Bond Index has yield to maturity of 4.37% with a duration of 7.05 years. For some investors the trade-off between credit quality and yield pick-up is attractive.
Country exposures are another area where divergences can be seen. What you find is that hard currency has a higher allocation to so-called ‘frontier markets’, which can be more sensitive to external global stress. To compensate, investors tend to be rewarded with a higher yield.
There is a place for both exposures in asset allocations. The characteristic profile of EM local and EM hard currency contrast in certain areas. For example, some investors find the currency diversification benefits of holding EM local market debt attractive. This is a key difference to hard currency, where bonds tend to be issued in US dollar. Currency is a major driver of short-term EM local market debt performance, which differentiates it from hard currency.
How should an investor think about allocating across local and hard currency debt?
EM central banks are also likely to hike rates in 2019, albeit at a slower pace versus the Fed, which would also benefit the asset class. Markets have largely priced in a China slowdown, although the Chinese government has employed various measures to stabilise growth, including delaying financial deleveraging coupled with monetary and fiscal stimulus. If China’s growth surprises to the upside, we could see a positive spill-over effect into the broader EM, especially to the countries with close trade links with China and commodity exporters. With this economic backdrop, 2019 could prove to be a bullish year for EMD.
The Fed hiking cycle will play a prominent role in 2019 EM performance. The current forecast is for 2-3 hikes in 2019, with the pace of normalisation dependent on signs of stress in the market and economic data. This could indicate that the US dollar may have peaked, as the Fed leads other central banks in hiking rates. A slower pace of Fed normalisation, combined with moderating growth and, therefore, a weaker US dollar outlook, could bring some respite for EM financial conditions and support growth.
What is the outlook for EM in 2019?
About the Portfolio Manager
Location: London Fund name: SPDR Bloomberg Barclays Emerging Markets Local Bond UCITS ETF Industry experience: 12 years First industry role: Assistant Portfolio Manager, ICICI Bank First song purchased: ‘Everything I do, I do it for you’ Bryan Adams
INTERVIEW
US inflation headlines ‘too flattering’
PriceStats® provides high-frequency measures of inflation and real exchange rates drawn from prices on millions of items sold by online retailers. This real-time pulse of global economic trends helps investors anticipate and evaluate the impact of inflation, including the impact on monetary policy and the degree of exchange rate misalignments. This information is available on a daily basis from State Street Global Markets.
Introduction to PriceStats®
PriceStats®
SCRAPING
ONLINE RETAILERS
PROCESSING
STATISTICS
1. Scraping PriceStats® uses web scraping technologies to monitor online prices every day. Web scraping is the process of automatically collecting information from the web by converting unstructured data (typically in HTML format) into structured datasets that can be stored and analyzed.
Using online prices to calculate real-time inflation
2. Online Retailers A key step of our approach is to identify the best retailers we can use for inflation and PPP measurement. PriceStats® makes a significant effort to select retailers with large market shares, in relevant cities, that sell both offline and online. In most countries, our data covers key economic sectors such as food, clothing, electronics, furniture and energy.
3. Processing Once the data collection is complete, PriceStats® runs a set of automatic procedures to ensure that the data can be used for inflation and PPP measurement. A red-flag system and manual checks are applied to all datasets daily to identify and resolve potential data issues.
4. Statistics We finally compute our daily statistics using proprietary methodologies and online prices.
The PriceStats® annual inflation rate fell below 2% for the first time in 15 months on 30 December 2018. The official annual inflation rate is likely to follow suit soon. Investors should not read too much into this softer trend, which owes much to the collapse in gasoline prices. PriceStats® sector series show little evidence of a softer inflation trend outside of energy, which suggests that core inflation looks set to remain close to 2% for now.
UK PriceStats® has generally shown a firmer inflation trend than official data in 2018, but online data weakened significantly in December. UK inflation is not typically weak in December, so this constitutes an unusually soft reading. Although partially attributable to weakness in energy prices, UK price formation is worth monitoring in the coming months for evidence that Brexit uncertainty is finally hurting consumer confidence. It is also consistent with evidence from the British Retail Consortium in terms of the sharper than usual discounting over Christmas. This was followed by weaker than expected retail sales, suggesting that discounting did not increase sales volumes.
UK PriceStats®: Is Brexit hitting consumer confidence?
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