Fastest out of the blocks in 2014 (and against almost everyone’s expectations) has been Fixed Income. Year to date an index of global governments bonds has returned 2.25%, while global corporates or US high yield has outpaced even that, returning around 2.70%. Consensus coming into the year was for a continuation to the outperformance of equities over bonds, witnessed during 2013, as improving economies and a U.S. Federal Reserve starting to “taper” should push core government bond yields higher. Instead those same government bonds have rallied hard, with U.S. Treasury 10yr yields falling 40bps, while equities are flat to up marginally.
Many reasons have been thrown around as to why the market has confounded expectations. Continual concerns regarding emerging markets, starting with Turkey in January and moving onto a possible military event in the Crimea between Russia and the Ukraine over the last week. Issues within the Chinese shadow banking system, combined with the largest daily depreciation in the Chinese Renminbi since the peg to the USD was removed. And finally the polar vortex which has gripped the US, effecting two thirds of the population and dumping 56 inches of snow (the height of an average 11 year old child) in New York City during February, disrupting the strength of the recovery and possibly impacting economic data.
These have all influenced markets to some extent, yet the consensus positioning coming into the year of being overweight stocks versus bonds also needs to be highlighted. As the reality of falling yields did not match people’s perception of how this year would start, the profits made from being long equities and short bonds during 2013 looked all too compelling to unwind and lock in.
However two months does not make a year, so following this great start for fixed income how will the remaining 10 months play out? A dose of realism needs to be taken as these returns, unfortunately, are not sustainable (2.25% annualized would be north of 13% for the year, implying over 1% fall in average government yields from here – only realistic if your base case is a depression.) That said this is not a time to sell your fixed income, this year has again highlighted the diversification benefits it brings to a balanced portfolio and opportunities within bonds remain abundant. With a slow global economic recovery, low default rates and central banks continuing to remain accommodative, credit continues to look appealing, especially when measured as a spread against government bonds. And within the torment of the emerging world opportunities are arising as active central banks and compelling valuations will entice in investors. However expect volatility across markets to stay, so how to access these opportunities remains the big question. An unconstrained fixed income style which can shift between the sectors will set you up nicely for the remainder of the 2014 market marathon.
Tensions in eastern Europe that have been bubbling up for the last several months finally hit the boiling point this week as Russia’s President Putin asked the Duma (Russian Parliament) to allow use of troops in Crimea and was approved unanimously. His aggressive move sent shockwaves throughout the wider international community and threatens to severely ratchet up what started out as a political crisis. Global leaders have reacted strongly to Putin’s response to an already tense situation. Sanctions are the next step.
While the world watches as leaders from around the globe try to defuse the situation, questions have also risen up regarding how this impacts the world economy and global markets. Do investors need to be worried? What are the potential impacts? What are the flash points? And what should we be keeping a very close eye on?
How did this happen?
Even before the problems with Putin, there were dire issues in Ukraine, both politically as well as economically. Last week protesters took control of the government after President Yanukovych fled the Capital. The parliament named a top opposition politician, Oleksandr Turchynov as acting president. The root of the conflict is the desire of many Ukrainian citizens to increase ties with the European Union. The protests were kicked off in November when preparations for a trade deal with the EU were stopped by the government. And then in December, Putin threw out a $15 billion economic lifeline, consisting of loans and cheaper gas supplies, for Ukraine which was perceived as the Russian buying off Yanukovych which set off the movement to overthrow their President and force an early election.
On the economic side, Ukraine is in a critical financial situation and is in danger of a full collapse. Fundaments are very poor, with the both the currency and foreign reserves at historic lows. There are two upcoming repayments that the Ukraine is very unlikely to be able to make and the new Finance Minister stated that Ukraine may request debt restructuring. Obviously, the situation is very fluid but we believe that the question around restructuring is “how will it happen” rather than “will it be done”. There are currently negotiation meetings being held between the interim government and the IMF regarding bailout agreements. The EU is working on an offer of a 1.6 billion Euros loan, but it will be dependent on Ukraine coming to an agreement with the IMF.
Why is this important?
A full or even partial default could send additional shockwaves coursing throughout emerging markets. In addition, Ukraine is an important piece of the energy market as pipelines that run through the country transport approximately 80% of Russia’s gas exports to Europe. On the agricultural side, Ukraine is a sizeable producer and exporter of corn (3rd largest in the world) and wheat (6th largest) – any disruptions in the country can change the balances and keep the prices from adjusting.
What happening now and what comes next?
Autonomous Republic of Crimea is creating more headlines, as its Parliament is voting for joining the Russian Federation (RF) and moving the referendum date to 16th March. The question proposed for the referendum is clarified and more radical – essentially asking the people of Crimea to vote for joining the RF or staying as a part of Ukraine. The response of the RF was to wait for the referendum. As one would expect, the response from the EU and US was negative, saying that both the decision and the referendum are illegitimate.
What does this mean for fixed income?
In the meantime the FX reserves have dropped by almost $2bln going to $ 15.46bln, or as we estimate at or just below two months of imports, which is very low and puts more pressure on Ukraine. The greatest concern right now for EMD markets is the risk of contagion, but we do believe that contagion would be limited. Investors should be prepared for increased volatility in both the region as well as across emerging markets.
At this point, there isn’t much else to do but continue to wait and see…and hope that things simmer down soon.