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Sun 31 May 2020 04:00 PM

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Opinion: Don't fight the Fed, don't fight OPEC

GCC bonds are uniquely positioned to benefit from the rebalancing of energy markets and the improvement in sentiment towards investment grade credit, according to Franklin Templeton

Opinion: Don't fight the Fed, don't fight OPEC

Sharif Eid is portfolio manager, Global Sukuk and MENA Fixed Income at Franklin Templeton

The ongoing volatility as a result of the Covid-19 pandemic has significant implications for global fixed income.

The Federal Reserve has initiated corporate bond ETF purchases, marking the start of a historic level of intervention, which came along with support measures for primary and secondary credit markets.

The significance of the move was evident as the mere announcement of these programs caused a tightening of credit spreads and reignited the new issuance market.

Meanwhile, the adjustment in oil markets has been fast and dramatic, with the US rig count declining at an unprecedented pace as storage neared capacity and prices going negative at one time. Compounding this is the fact that long-term investments in oil projects were already falling from their 2014 peak. These events raise the specter for a rise in oil prices starting in 2021.

Against this backdrop, there are three broader trends we are seeing unfold in GCC bond markets.

First, the region is poised to benefit from an improvement in oil prices as the global economy recovers, a higher oil market share through the utilization of spare capacity, and reform plans that have been accelerated by the current decline in oil prices.

In the near-term, fiscal balances will suffer and economic growth weaken, however we have already seen governments quickly take steps to address fiscal deficits.

Saudi Arabia announced increases in tax rates and a reduction in capital and social spending, which Moody’s believes will decrease its fiscal oil break-even price by $14-15. In Oman, several steps were taken to reduce spending including a reported 10 percent budget cut across its ministries and agencies, plus a new 5 percent cut in current spending. Bahrain also announced it will cut back spending by 30 percent.

This leads us to have a relatively positive outlook on the future of government finances and new oil breakeven levels.

Second, US investment grade spreads are likely to improve – directly through Fed initiatives and indirectly through the stimulus bills that will support the economy. We also believe the Fed’s ability to support the market can grow and as a result, US BBB spreads can normalise to their 10-year average of 195bps (from around 280bps at the start of May) and potentially fall below that.

We expect GCC bond spreads to also normalise, as they have shown a high correlation to those of US investment grade credit – between 0.6 and 0.8 since 2018.

Third, and perhaps what offers the timeliest opportunity in our view, is the current elevated differential between GCC bonds and US investment grade.

As our markets catch up, we expect this differential to narrow, which in combination with a continued improvement in global investment credit markets, presents a unique opportunity for spreads in our region to decline from their levels of around 350bps at the start of May to their five-year average of 225bps.

The capital appreciation and higher yield lay the foundation for attractive risk adjusted returns over the next 12-18 months, consistent with the historically attractive Sharpe ratios enjoyed in the past. GCC bonds have also had smaller drawdowns than other asset classes during periods of volatility, including the oil price declines of 2015 and 2020.

In the midst of these developments, we have deployed significant cash and adjusted portfolios, finding valuations compelling. We also generally favour sovereign over corporate debt as we reassess some of the longer-term implications of this downturn. Demand has been strong with new issues oversubscribed and performing well.

In short, don’t fight the Fed - credit markets are slowly healing. And don’t fight OPEC - oil markets are rebalancing.

GCC bonds are at the intersection of both. Looking forward, our opinion is that the coronavirus is a shock to global markets and economies that will ultimately subside. The pace of policy response has been significantly faster than in previous crises, and this will continue to have important implications for markets and economies.

Volatility - an important measure of risk - has declined materially from its peak indicating, in our view, that central bank interventions are working. We are looking beyond the short term for investment opportunities and while we do not expect smooth sailing, the roughest waters are likely behind us.

Sharif Eid is portfolio manager, Global Sukuk and MENA Fixed Income at Franklin Templeton

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