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TWN Info
Service on Finance and Development (Mar21/05) Geneva, 17 Mar (Kanaga Raja) – Risky assets strengthened further during the period from 1 December 2020 to 22 February 2021, against a backdrop of continued monetary accommodation, expectations of greater fiscal support and cautious optimism over recovery from the COVID-19 pandemic, according to the Bank for International Settlements (BIS). In its latest Quarterly Review, BIS said that during the period under review, policy support and overall positive, if uneven, pandemic-related developments benefited risky-asset valuations but also drove long-term bond yields up. Against the background of loose financial conditions and continued monetary accommodation, some asset prices reacted strongly to the prospect of fiscal expansion, it added. “Equities extended gains and credit spreads tightened further, with cross-country and sectoral differences reflecting delays in some vaccination programmes. While short-term sovereign yields remained firmly anchored, rising market-based inflation expectations accompanied a steepening of the yield curve.” Stock prices continued their ascent in many jurisdictions, often exceeding pre-pandemic levels and, in some cases, setting all-time highs, said the Basel-based central bank for the world’s central banks. On the other hand, BIS said that global financial conditions turned less favourable for emerging market economies (EMEs) in 2021. It added that as the dollar bounced back from its post-election slide in January on the prospect of US fiscal support, the currencies of EMEs more strongly stricken by the pandemic depreciated more. “Local currency bond yields reversed their downward trend. Even so, the overall sentiment towards EME assets remained positive.” According to the Quarterly Review, with monetary policy remaining very easy, global equity markets rose in response to indications of stronger fiscal policy support, notably in the United States, and a brightening earnings outlook. The increase in stock prices was broad-based, but particularly strong in EMEs other than China and in selected advanced economies (AEs) such as Japan, it said. Over time, equity indices waxed and waned in line with the prospect of a major US fiscal package, said BIS. Later in the review period, the run-up in US stock prices paused just as the reflation trade gained momentum. In the background, earnings forecasts continued to improve in the United States but stayed rather flat in Europe. BIS said actual earnings also largely surprised on the upside, with about three quarters of US companies exceeding analysts’ estimates for the fourth quarter (Q4) of 2020. That said, investors did not seem to neglect tail risks altogether. Their concerns were visible in the historically high levels of the SKEW index, which measures the price of insurance against large negative stock returns, said BIS, adding that delays in vaccine roll-outs were possible manifestations of such risk. “Indeed, the prices of European stocks most exposed to the pandemic lost ground suddenly, if only temporarily, when delays in the EU vaccination programme emerged in mid-January.” BIS noted that low long-term interest rates have been critical in supporting valuations. Since recent US price/earnings ratios were among the highest on record, they suggest stretched valuations if considered in isolation, it said. However, assessments that also take into account the prevailing low level of interest rates indicate that valuations were in line with their historical average. Even if equity valuations did not appear excessive in the light of low rates, some signs of exuberance had a familiar ring, said BIS. Just as during the dotcom boom in the late 1990s, initial public offerings (IPOs) saw a major expansion and stock prices often soared on the first day of trading. The share of unprofitable firms among those tapping equity markets also kept growing. In addition, strong investor appetite supported the rise of special purpose acquisition companies (SPACs) – otherwise known as “blank cheque” companies. These are conduits that raise funds without an immediate investment plan. The increasing footprint of retail investors and the appeal of alternative asset classes also pointed to brisk risk- taking, said BIS. An index gauging interest in the stock market on the basis of internet searches surged, eclipsing its previous highest level in 2009. This rise went hand-in-hand with the growing market influence of retail investors. “In a sign of strong risk appetite, funds investing in the main crypto-assets grew rapidly in size following sustained inflows, and the prices of these assets reached all-time peaks.” According to the Quarterly Review, signs of strong risk appetite were also visible in credit markets. Corporate bond spreads continued to decline steadily through early January, across rating grades and geographies, and remained firmly below historical averages. Especially in the high-yield (HY) segment, the high issuance volume that characterized the first quarter of 2021 was more than twice the first quarter average from 2010 to 2019. BIS also said that in the leveraged finance market, prices kept rising. The increase benefited all types of securities, including leveraged loans, collateralized loan obligations (CLOs) and private credit, which refers to loans made to smaller companies by alternative asset managers with little bank participation. Similarly to equities, private credit proved particularly sensitive to rising expectations of US fiscal expansion in early January. BIS said survey data from 2020 indicate that private credit volumes were likely to stay close to those observed in the previous record year. “Pricing in credit markets reflected upbeat sentiment on the back of low levels of realized risk. The number of corporate bankruptcies barely inched up in the United States and actually fell below 2015-19 averages in France and Germany, thanks to forceful public support programmes, looser filing requirements and lender leniency.” Generally loose financial conditions underscored the buoyant mood in financial markets, said BIS. In EMEs and the United States, financial conditions were more accommodative at the beginning of 2021 than at any point over the previous 10 years. While they had not fully retraced the tightening that occurred in March, financial conditions in the euro area stood at relatively neutral levels, it added. THE “REFLATION” TRADE According to BIS, government bond markets in AEs reflected the improved macroeconomic outlook around the turn of the year. With the continuous backdrop of vigorous monetary policy support and brighter pandemic prognoses, the stiffening prospect of a US fiscal spur unleashed a so-called “reflation trade”: yield curves steepened and inflation break- evens rose. Moreover, the US dollar bounced back from its post-election slide. Central banks across the globe continued to maintain a very accommodative stance. Policy rates stayed unchanged across most AEs and EMEs, and some central banks increased the size or pace of their asset purchase programmes. In the core jurisdictions, policymakers maintained forward guidance of continued strong accommodation, despite inflation figures that surprised on the upside in December and January. BIS said their stance reflected concerns that economic activity had not fully recovered, that economic scars could linger, that new lockdowns heralded further weakness, and that the factors behind higher inflation figures were temporary. In contrast, some EME central banks broadcast a more cautious message as inflationary pressures continued to build up during the second half of 2020. Long-term yields surged in core markets during January and February, and yield curves steepened as short-term rates remained pinned at historically low levels, said BIS. The rotation was most pronounced in the United States, where 10-year yields resumed the trend initiated in August when the Treasury announced large increases in the issuance of long-term bonds. The steepening of yield curves in core markets mirrored the increase in market measures of interest rate risk and inflation compensation, said BIS. “Continuing their trend after a turning point in early August, term premia climbed gradually throughout the review period.” A close examination of the inflation break-even rates reveals that investors were expecting inflation to flare up in the medium term and to ease subsequently, said BIS. This is the message of five-year US break-evens surpassing and rising above the corresponding 10-year benchmarks since early January. In a qualitatively similar development, the spread between the corresponding German break-evens dropped by about 10 basis points during the review period. BIS said a number of factors seem to have been at work. Probably the most important one was central banks vowing to be patient and allow full economic recovery before tightening policy – and to do so even if that meant moderate overshoots of their targets in the short and medium term, as clearly stated in the new Federal Reserve framework. “This makes it more likely that the more expansionary fiscal policy and the recent rally in oil and other highly cyclical commodity prices will have an inflationary impact.” By the end of the review period, the prices of grains and industrial metals had surpassed their pre-pandemic levels by about 25%. And while oil prices have not staged a similar recovery, they increased by roughly 35% during the review period, said BIS. In line with the prevailing high risk appetite, European sovereign spreads relative to German bunds narrowed up to the end of the year. This reflected, in part, a relatively smooth completion of Brexit. In January, European sovereign spreads fluctuated in response to setbacks in vaccine procurement and swinging perceptions of political risk in Italy. According to BIS, the US dollar picked up somewhat during the review period, following a post-election slide. The currency tentatively strengthened from early January, as the US outlook improved relative to the rest of the world. “Fiscal support and a relatively successful rollout of the vaccination campaign in the United States contrasted with a global picture beset by evidence of procurement set-backs, new virus strains and relatively limited fiscal space,” said BIS. The greenback still faced significant headwinds. It is possible that the expansionary tilt of the new Fed strategy has muted the appreciation pressure, it added. Falling inflation-adjusted yield spreads have been gradually eroding the advantage of US dollar assets, and a global upswing in real yields late in the review period did not change that trend. Going forward, said BIS, as the fiscal stimulus is rolled out, the likely increase in US current account deficits may put downward pressure on the dollar, especially if US yields remain relatively restrained by monetary policy. SENTIMENT TOWARDS EME ASSETS According to the Quarterly Review, EME assets saw heightened volatility in January as global vaccination efforts hit various roadblocks. When the dollar strengthened, it did so most against the currencies of the EMEs most affected by the pandemic. Sentiment towards EME assets as a whole remained generally favourable throughout most of the review period, although differentiation appeared to increase across some dimensions, said BIS. Pandemic management and associated monetary policy actions showed through in exchange rates. As the dollar appreciated somewhat after December, countries with higher infection rates during second half (H2) of 2020 saw their currencies depreciate more. In particular, currencies fell the most in South America, where looser monetary policies were needed to cushion the blow of higher infection rates. Policy rates in the region had dropped by 200 basis points on average, substantially more than in most other EMEs. “In contrast, the currencies of Asian countries, which sustained lower infection rates, proved more resilient.” BIS noted that some of the largest EMEs had seen inflation escalating since mid-2020. During the review period, monthly inflation figures surpassed central bank targets of those economies. BIS said substantially higher food prices added to inflationary pressures. Central banks may thus face challenging trade-offs, with inflation prompting them to tighten monetary conditions preemptively, before economic activity has fully recovered from the pandemic shock, it added. In this context, favourable global financial conditions would provide valuable room for manoeuvre, said BIS. Government bond yields, however, met a turning point in January. Going into the end of 2020, local currency- denominated bond yields had continued to fall on the back of investors’ relentless search for yield. As the “reflation” trade scenario shaped up in early January, yields began to rise again, and then jumped up towards the end of the review period, together with AE yields. The increase in yields was sharpest for Latin American countries, possibly revealing investors’ higher inflation and depreciation expectations for the region. Overall, investors maintained a sanguine view of EME government credit. Spreads on US dollar-denominated debt continued to tighten up to the end of the review period, irrespective of the jitters in local currency yields. Sovereign spreads were approaching early 2020 levels at the regional level, even though EMEs’ credit ratings had worsened since the outbreak of the pandemic, said BIS. Portfolio flows through the review period also revealed a positive tilt towards some EMEs. Flows into bond funds strengthened after the US election, and investors focused their search for yield on China. In early 2021, portfolio equity flows rotated towards emerging Asia, consistent with investors pursuing growth in some key economies in the region, said BIS.
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