Fixed income CIO says differences will have important implications for investors and their risk assessments
Barring distressing pockets of extreme COVID-19, like India, the global economic recovery has lift-off. The Western word is rolling out vaccine programmes that are starting to have a real impact on the statistics. Confidence is returning, albeit slowly and cautiously.
There are, however, significant differences between countries and regions on the path toward normalcy. Franklin Templeton’s Fixed Income CIO Sonal Desai believes the divergence between the United States and Europe particularly stands out.
U.S. President Joe Biden’s administration has outlined another $2.3 trillion spending package, which followed the $1.9 trillion stimulus approved last month, which in turn followed about $3 trillion in 2020. Meanwhile, the European policy response pales by comparison and remains troubled by internal divisions. The European Recovery Package is an important step toward region-wide fiscal stimulus but it’s a lot smaller than its U.S. counterpart, and was only agreed upon after very contentious negotiations.
In terms of vaccination efforts, the U.S. has been more decisive and effective than Europe. America has vaccinated more than one third of its population (39.7% had received at least one dose by April 18); Europe only 18.4%.
The result is that while U.S states are looking at reopening their economies, EU countries have been tightening their lockdowns yet again to bring another wave of contagion under control. Europe’s delay is further underscored by progress in the United Kingdom, which has vaccinated nearly half of its population and is also beginning to lift restrictions.
Desai said these divergences have important implications for investment strategies and risk assessments.
“In the short term, I see less scope for inflation to pick up in the eurozone, given the delayed and less dynamic recovery; the home-grown uplift to bond yields will be correspondingly weaker. All this makes European fixed income less exposed to duration risk than US fixed income, and more attractive at the margin; the slower normalization also suggests a cautious approach to the European corporate high yield sectors more directly exposed to COVID-19 restrictions.
“The ECB’s less-convincing stance, meanwhile, flags an important tail risk. Eurozone yields will feel the pull of US Treasury (UST) yields, particularly if the latter surprise to the upside on the back of a stronger-than-anticipated US recovery. This might re-awaken concerns on higher-debt periphery countries, such as Italy, and cause the spreads of their government bonds to German Bunds to widen.”
Meanwhile, a stronger US rebound bodes well for emerging markets, especially when combined with the ongoing recovery in China and the fact that Asia overall has made significant progress in bringing infections under control, with the notable exception of India.
“From an investment perspective, we have to weigh the improved macro outlook for EM against the potential stress from higher UST yields,” Desai said. “Indeed, both hard currency and local currency EM bonds have had a challenging start to 2021 as the reflation narrative pushed up benchmark US yields.
“Here, differentiation and security selection will be the name of the game. EM countries and companies better positioned to benefit from a pick-up in global trade and less exposed to currency risk on the funding side should prove to be better bets, in our view, but security selection will be key, and a successful investment strategy will require even more hard work than usual. In this context, we also need to pay greater attention to China’s role as a direct investor and funding provider across emerging markets.”