Sharif Eid is portfolio manager, Global Sukuk and MENA Fixed Income, Franklin Templeton
‘Tis the time of the year to reflect on the one gone by and make predictions for the one to come.
Forecasts were remarkably wrong for what proved to be a difficult 2020; but a year-end tally of markets’ performance suggests anything but difficulty.
Many equity indices are up double digits (as of the start of December), with the Nasdaq posting exceptional gains of over 40 percent. Fixed income indices performed well alongside them, benefitting from lower rates. A closer look, though, tells a more nuanced tale. While emerging-market bond indices are up 3.3 percent, this was driven by investment-grade (IG) bonds that rose 7.2 percent, while high-yield bonds declined 2 percent. IG GCC Bonds have been a top performer, rising 9 percent for reasons we believe were justified, and look set to continue.
2021 is set for an eventful start as well: a historic change in US leadership (though Senate elections are yet to be concluded) and records numbers of Covid-19 virus cases (though the vaccines are seemingly effective).
Despite what seems like a lot of uncertainty, forecasters are quite uniform in their recommendations. To save you the time reading the dozens of economic and strategy reports, they can be summed up briefly: buy equities, buy emerging markets, buy high yield and sell the US dollar.
The collective wisdom favours positioning for a cyclical recovery driving synchronized global growth as we return to normalcy, aided by the vaccine and boosted by supportive policy.
Consensus can, at times, form for good reason. We believe we are likely to see the highest level of global growth in a decade amid exceptionally supportive financial conditions, with global benchmark rates looking set to remain at their lowest bounds. For the Gulf Cooperation Council (GCC) region, we may also have the additional benefit of the rebound in commodities prices.
Conditions look likely to provide a strong backdrop for one of the most reflationary assets: crude oil. Demand is set to rebound, and supply is only slowly on the rise. OPEC+ recently agreed to increase production but at a much more gradual rate than initially planned.
This strategy should benefit GCC countries, allowing them to increase market share, even though gradually, as global underinvestment reinforces the value of excess capacity available here. The group remains aligned in its approach towards revenue maximisation, where the right balance in supply increases can be met by increased OPEC+ production, rather than by US shale production. We have said it before, and still believe, that you shouldn’t fight OPEC – for now.
Consensus can also, at times, be the demise of many a market participant. The success of contrarian thinking feeds on the weakness of the herd mentality.
For starters, markets don’t necessarily follow the Gregorian calendar and in some respects, we may have already seen a turning point in November. We believe the most important factor in many of the highly anticipated events was their resolution, rather than their results, as markets moved their focus towards the recovery in the year ahead and started to price it in.
Markets by their very nature tend to anticipate change, rather than wait for it. After what was a record November in many respects, some of the potential gains expected in the new year have arrived early and it looks to us as if positioning grows increasingly crowded.
While cognizant of these risks, we are still positive in our outlook for a few reasons. First, despite gains in some risk assets, we believe that emerging-market high-yield bonds still offer value and are set to catch up, having lagged in 2020.
We find this to be the case in the GCC region as well; investment-grade spreads are now close to their pre-pandemic tights, while high-yield spreads are still above their long-run averages and well above previous lows. Second, positioning in emerging markets is still not stretched.
Flows into emerging markets have improved in the fourth quarter but still have significant room to grow after the large outflows earlier in the year. Despite strong performance seen in GCC bonds over several years, they continue to have an even larger underrepresentation in investor portfolios.
Third and finally, commodities prices (particularly oil) remain at somewhat low levels and the region should benefit from their potential recovery through improved fiscal balances. A better fiscal situation can support the longer-term benefit of political, social and governance reforms, which are in focus again after some deviations in the last two years.
As we position for the year ahead, we are optimistic but do expect the growing consensus to become a headwind – markets do not recover in a straight line. As a result, we are pairing our optimistic positioning with hedges against some key tail risks.
First, we are hedging long-term interest rates exposure. While we believe that short-term rates are unlikely to change, long-term rates could and the impact on fixed income portfolios can be large – particularly as the duration of indices has increased materially. An on-going recovery, an amended US Federal Reserve mandate that will tolerate more inflation, and further fiscal support in some capacity can cause rates to rise.
We don’t expect an excessive rise that can derail risk assets (essentially, another ‘taper tantrum’), but it is a highly disruptive risk to watch out for.
Second, while the recent OPEC+ compromise was encouraging, rifts are starting to form within the group. This is partly to be expected as the dramatic events that brought it together in March fade away. Longer-dated currency forwards on GCC pegged currencies offer cheap protection.
Finally, our most valuable hedge has consistently proven to be elevated cash levels. Moves in markets have been exacerbated recently through unpredictable liquidity; rallies and sell-offs can be exaggerated as a result. The flexibility to act in a downturn that is afforded by high levels of cash is increasingly making it a key part of the asset allocation decision, and an important source of alpha.
As we bid this eventful start to the decade farewell, we wish you a happy new year. As you navigate 2021; consider following the herd, but don’t follow it over the cliff.
Sharif Eid is portfolio manager, Global Sukuk and MENA Fixed Income, Franklin Templeton
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Collective wisdom or herd mentality
How optimism about a cyclical recovery is taking hold, tempered by concern over growing consensus and crowded positioning
Sharif Eid is portfolio manager, Global Sukuk and MENA Fixed Income, Franklin Templeton
‘Tis the time of the year to reflect on the one gone by and make predictions for the one to come.
Forecasts were remarkably wrong for what proved to be a difficult 2020; but a year-end tally of markets’ performance suggests anything but difficulty.
Many equity indices are up double digits (as of the start of December), with the Nasdaq posting exceptional gains of over 40 percent. Fixed income indices performed well alongside them, benefitting from lower rates. A closer look, though, tells a more nuanced tale. While emerging-market bond indices are up 3.3 percent, this was driven by investment-grade (IG) bonds that rose 7.2 percent, while high-yield bonds declined 2 percent. IG GCC Bonds have been a top performer, rising 9 percent for reasons we believe were justified, and look set to continue.
2021 is set for an eventful start as well: a historic change in US leadership (though Senate elections are yet to be concluded) and records numbers of Covid-19 virus cases (though the vaccines are seemingly effective).
Despite what seems like a lot of uncertainty, forecasters are quite uniform in their recommendations. To save you the time reading the dozens of economic and strategy reports, they can be summed up briefly: buy equities, buy emerging markets, buy high yield and sell the US dollar.
The collective wisdom favours positioning for a cyclical recovery driving synchronized global growth as we return to normalcy, aided by the vaccine and boosted by supportive policy.
Consensus can, at times, form for good reason. We believe we are likely to see the highest level of global growth in a decade amid exceptionally supportive financial conditions, with global benchmark rates looking set to remain at their lowest bounds. For the Gulf Cooperation Council (GCC) region, we may also have the additional benefit of the rebound in commodities prices.
Conditions look likely to provide a strong backdrop for one of the most reflationary assets: crude oil. Demand is set to rebound, and supply is only slowly on the rise. OPEC+ recently agreed to increase production but at a much more gradual rate than initially planned.
This strategy should benefit GCC countries, allowing them to increase market share, even though gradually, as global underinvestment reinforces the value of excess capacity available here. The group remains aligned in its approach towards revenue maximisation, where the right balance in supply increases can be met by increased OPEC+ production, rather than by US shale production. We have said it before, and still believe, that you shouldn’t fight OPEC – for now.
Consensus can also, at times, be the demise of many a market participant. The success of contrarian thinking feeds on the weakness of the herd mentality.
For starters, markets don’t necessarily follow the Gregorian calendar and in some respects, we may have already seen a turning point in November. We believe the most important factor in many of the highly anticipated events was their resolution, rather than their results, as markets moved their focus towards the recovery in the year ahead and started to price it in.
Markets by their very nature tend to anticipate change, rather than wait for it. After what was a record November in many respects, some of the potential gains expected in the new year have arrived early and it looks to us as if positioning grows increasingly crowded.
While cognizant of these risks, we are still positive in our outlook for a few reasons. First, despite gains in some risk assets, we believe that emerging-market high-yield bonds still offer value and are set to catch up, having lagged in 2020.
We find this to be the case in the GCC region as well; investment-grade spreads are now close to their pre-pandemic tights, while high-yield spreads are still above their long-run averages and well above previous lows. Second, positioning in emerging markets is still not stretched.
Flows into emerging markets have improved in the fourth quarter but still have significant room to grow after the large outflows earlier in the year. Despite strong performance seen in GCC bonds over several years, they continue to have an even larger underrepresentation in investor portfolios.
Third and finally, commodities prices (particularly oil) remain at somewhat low levels and the region should benefit from their potential recovery through improved fiscal balances. A better fiscal situation can support the longer-term benefit of political, social and governance reforms, which are in focus again after some deviations in the last two years.
As we position for the year ahead, we are optimistic but do expect the growing consensus to become a headwind – markets do not recover in a straight line. As a result, we are pairing our optimistic positioning with hedges against some key tail risks.
First, we are hedging long-term interest rates exposure. While we believe that short-term rates are unlikely to change, long-term rates could and the impact on fixed income portfolios can be large – particularly as the duration of indices has increased materially. An on-going recovery, an amended US Federal Reserve mandate that will tolerate more inflation, and further fiscal support in some capacity can cause rates to rise.
We don’t expect an excessive rise that can derail risk assets (essentially, another ‘taper tantrum’), but it is a highly disruptive risk to watch out for.
Second, while the recent OPEC+ compromise was encouraging, rifts are starting to form within the group. This is partly to be expected as the dramatic events that brought it together in March fade away. Longer-dated currency forwards on GCC pegged currencies offer cheap protection.
Finally, our most valuable hedge has consistently proven to be elevated cash levels. Moves in markets have been exacerbated recently through unpredictable liquidity; rallies and sell-offs can be exaggerated as a result. The flexibility to act in a downturn that is afforded by high levels of cash is increasingly making it a key part of the asset allocation decision, and an important source of alpha.
As we bid this eventful start to the decade farewell, we wish you a happy new year. As you navigate 2021; consider following the herd, but don’t follow it over the cliff.
Sharif Eid is portfolio manager, Global Sukuk and MENA Fixed Income, Franklin Templeton
Follow us on
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