Friday, March 6th, 2020

EM Bonds: the new safe haven

The corona virus has finally arrived in the developed world and securities analysts are now supposed to be epidemiologists, as well as everything else. We cannot know what the eventual infection or mortality rates will be and even if we could, the amount of economic damage is unforecastable. It will depend on (a) the level of enforced or voluntary withdrawal from consumption and production (b) the knock-on effects on investment (c) the number of corporate and financial sector bankruptcies resulting from the first two, (d) the ability of government to provide fiscal support in the right place and the right way and (e) the willingness of currency and bond markets finance this. And finally, there is always the possibility of a new variant of the virus next winter.

All our asset allocation models reveal a dramatic acceleration in the search for safety. This was under way before the big sell-off in equities, but after last week there can be no doubt that all financial markets will be highly volatile for some time. Our all-asset volatility index is just below the last peak set in March 2016. If we beat that, we have to go back to the euro-crisis of 2012 to see similar levels. In periods of elevated volatility, our models will always seek the safety of fixed income.

We have downgraded global equities to neutral in the dollar, euro and sterling models, and it is highly likely that we will downgrade to underweight in the near future. Even if there were a sudden recovery in equities, the spike in volatility would force us to seek protection against further downside risk. It is worth noting that our dollar model is less favourable towards equities than our euro model. This is because the dollar fixed income markets offer higher yields and a greater variety of instruments than their European counterparts.

None of this is really surprising – unlike the ranking within our fixed income model. In both the US$ and euro models, dollar-denominated EM sovereign bonds are ranked higher than the host government bond (7-10 year Treasuries or Bunds, as appropriate). They are upgraded to overweight in the US$ fixed income model and they go top of our euro fixed income model. In the overall models (including equities) they rank #1 in the euro model and #2 in the dollar model, just below US Investment Grade bonds. Five years ago, if we had forecast that EM Bonds would be preferred to Treasuries or Bunds after a crisis originating in China, the reaction would have one of disbelief – hopefully polite, but possibly not.

The fundamental reasons are well understood: compression of government yields in the G7; lower volatility across all fixed income assets; wider pool of investors thanks to increased acceptance of ETFs. But none of this does justice to the importance of the headline that EM Bonds have become a safe haven asset – at least for the moment. It is possible that we are just dealing with a lag in the progress of the disease and that important economies like India, Mexico, Brazil etc will soon be suffering their own epidemics. However, even if individual countries are badly affected, the superior yield of the portfolio as a whole may offer significant protection when Bund yields are below zero and Treasuries are heading in that direction.

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