Fixed Income 2021 Preview - Unmasking Opportunities

The pandemic has ensured that 2020 will go down in history, but the reverberations won't stop once the new year rolls in. The sharp contraction of economic activity registered worldwide this year paves the way for a recovery next year. The positive momentum will be further accentuated by the emerging availability of vaccines, a likely reduction in US-China trade tensions and the prospect of new stimulus packages in the US and Europe. For market strategists, these factors send a clear signal: the dollar will weaken, particularly against EM currencies, while pro-cyclicals should thrive, as higher demand will lift commodities and industrials, and the banking sector will enjoy economic expansion. The major factor that poses a structural risk to this outlook is a potential hawkish shift of major central banks if the economic recovery surprises to the upside. Looking at this part of the picture, the risks for Russian tradable assets may appear one-sided. The ruble will be supported by global dollar weakening and rising energy prices, while Russian tradable assets have the potential to outperform peers, as the country's economy and corporate profits will be lifted by increased demand for commodity exports. We expect the Russian economy to post 3.5% growth in 2021 after a 4.0% drop in real terms this year. Geopolitics was a key topic for Russian assets in 2020 and will remain so next year. However, because the incoming US administration has yet to formulate its policy toward Russia, there is considerable uncertainty about how relations will evolve between the two countries. There are many moving parts here, but one area to highlight is if the new administration seeks to restore the nuclear deal with Iran or extend the new Strategic Arms Reduction Treaty. Either of these developments could help establish a constructive dialogue between the two countries. In our base scenario, we expect the geopolitical risk premium in Russia's tradable assets to soften somewhat. Geopolitical risks in the FSU region and the local political agenda as Russia approaches its parliamentary elections will also be things to keep an eye on. Overall, as we look into 2021, we have a positive view on all Russian asset classes, while keeping in mind the downside risks associated with political uncertainties. > With accommodative monetary policy to be continued into 2021, supply normalizing and elevated real yields being priced into OFZs, we think the long end of the OFZ curve will look appealing next year, with the caveat that this scenario assumes no market-relevant escalation on the geopolitical front. Demand for extra yield will increasingly drive flows into local EM bonds. > We expect the post-Covid-19 recovery to translate into stronger cash flow generation and improving leverage metrics for Russian corporates, which retained a high level of financial flexibility though 2020. We think the debt of Russian O&G companies provides opportunities among cyclical sectors.> As the economy recovers further in 2021 and the ruble has the potential to strengthen in the absence of major shocks on the geopolitical front, we think the Russian banking sector will be a fair bet in terms of risk versus return, although the performance of restructured loans will be something to follow for individual banks.> Technical factors will continue to be supportive for the Russian hard-currency space. Supply of Russian corporate bonds will continue to be limited, only marginally exceeding scheduled debt repayments. Meanwhile, as we approach the peak of corporate debt repayments in 2022 and 2023, we think that next year borrowers will be increasingly looking for structured maturity extensions amid the low interest-rate environment. This will provide opportunities to pick up additional price premiums. > We think that the broader FSU space will continue to provide selective opportunities for additional yield above the yields offered by more seasoned markets with a high share of local investors, such as Russia and Kazakhstan. We would also highlight Uzbekistan as a quality exposure. With some of the economies in the FSU region still facing political risks, we expect investors to be increasingly tempted by Ukraine's and Belarus's relatively wide spreads. If those countries can avoid a major escalation on the political front, their sovereign bonds should perform well. We expect the global economy to recover next year in all three scenarios. However, the speed of the recovery will be crucial for governments' fiscal and monetary responses and will go a long way toward determining how various markets perform next year. > In our base scenario, we assume that global economic growth will be in line with current expectations (5.2% for the global economy and 3.9% for advanced economies, based on IMF forecasts). Most advanced economies will continue to see a negative output gap, which will close only after 2022. Most central banks will therefore continue monetary stimulus to support the recovery. Already announced fiscal measures will be implemented, but we don't expect any further fiscal easing. The remaining slack in the economy will continue to put pressure on inflation, so risks of higher inflation expectations will be limited. US Treasury yields will gradually pick up following the economic recovery but will remain close to 1%, as they will be still capped by low policy rates and low inflation expectations. The economic recovery will also be positive for commodity markets, with Brent rising on stronger demand. For EM markets, this combination of economic growth and low rates will mean some spread tightening due to better fundamentals.> However, if current expectations about Covid-19 vaccines prove to be too optimistic, governments across the world will face hard choices between lockdowns and economic recovery. Even if vaccines prove to be effective, economic growth could still come in below expectations due to fundamental shifts in behavior (less travel, more remote work, further business optimizations, etc.). In this scenario, we would still expect the global economy to grow, albeit at a slower pace, but the recovery in the labor market and in consumer demand would be much slower. However, this would force governments and global central banks to roll out further monetary and fiscal stimulus. Inflation expectations would drop and interest rates could move even lower, further facilitating the hunt for yield. This would push EM bond yields even lower. However, the slower economic recovery would result in weaker demand for oil, pushing prices lower. > Last but not least, we consider a scenario with a much faster than expected economic recovery. As the risks associated with Covid-19 decline, economic activity could rebound quite quickly to pre-Covid levels. Significant fiscal stimulus and loose monetary policy coupled with strong economic growth would inevitably lead to an acceleration of inflation and inflation expectations. Even if central banks could tolerate higher than expected inflation for some time without raising rates, higher inflation expectations would result in higher government yields and a widening of spreads in the EM universe. Countries with large fiscal deficits and dependent on foreign capital inflows would be affected the most, due to an increase in yields and a stronger dollar. Oil exporters would benefit from higher oil prices as crude would be supported by a buoyant economy.