Investors should hope for the best but prepare for the worst, says Tabula
European fixed income ETF provider Tabula Investment Management Limited (Tabula) is telling investors to hope for the best but prepare for the worst, warning of the potential double threat from lower liquidity in the bond markets at year end, and a change to the decade-long trend of low and stable US inflation.
Tabula warns that bond markets often see lower liquidity towards year end, as the sell-side prepares to slim balance sheets and the buy-side closes its books, but uncertainty this year means liquidity could prove worse than in recent history. Meanwhile, while inflation forecasts vary widely, fiscal stimulus which should be supported by the incoming Biden administration is likely to increase inflationary pressure.
“The current slew of negative factors means markets may experience more than just a seasonal liquidity slump this year,” says Tabula CEO Michael John Lytle. “As European lockdowns ease there is a risk of a third wave of cases in the middle of winter. President Trump’s resistance to the election result also remains a wildcard and expectations of worsening economic data is beginning to grow. All of these have the potential to temper the recent vaccine-led relief rally. It seems like we have had all the good news.”
Inflation is also an escalating concern among institutional investors. The US Federal Reserve has committed to a new inflation regime, allowing inflation to run ahead of its historic 2 per cent target, and the President-elect will likely be more supportive of an accommodative monetary policy. Biden’s pick for Treasury Secretary of ex-Fed chair Yellen suggests a close tie-up between fiscal and monetary authorities. Tabula warns that these factors, combined with the demand/supply fallout from Covid-19, mean that inflation is once again on the agenda.
“This year, we have witnessed extraordinary monetary stimulus, which when combined with loose monetary policy, introduces impetus for future inflation,” says Michael John Lytle. “The Federal Reserve Board balance sheet has doubled in six months, and global narrow & broad money supply are up 22% and 14% respectively this year - annual growth rates last seen in 1993 and 2008 respectively. Changing Central Bank mandates and new fiscal policies are also putting pressure on inflation. The incoming Biden administration is committed to further Covid-19-related stimulus, including more direct payments to households. This, combined with what the Fed does next, could significantly affect the outlook for US inflation,” says Lytle.
The Tabula US Enhanced Inflation UCITS ETF, which launched last month, provides exposure to both realised and expected inflation in a single index. It combines a TIPS portfolio with exposure to US inflation expectations (break-evens). Working with Bloomberg, Tabula created the new Bloomberg Barclays US Enhanced Inflation Index. Historic analysis of the index shows that it can provide positive performance when inflation is rising.
The index delivers realised US inflation via exposure to US Treasury Inflation-Protected Securities (TIPS) across a wide range of maturities. In addition, it takes exposure to 7-10y US TIPS, in combination with a short position in 7-10y US Treasuries – this provides reactive but liquid exposure to medium-term inflation expectations. The Index is calculated daily and rebalanced monthly.
The Tabula iTraxx IG Bond UCITS ETF (London Stock Exchange: TTRX) tracks a benchmark developed by Tabula in conjunction with IHS Markit. The index reflects the performance of a basket of EUR corporate investment grade bonds and replicates the credit risk profile of the iTraxx Europe Index. iTraxx Europe is the most liquid European investment grade corporate credit instrument, covering 125 liquid European investment grade entities and used as a reference for both long and short credit default swap positions.
The iBoxx iTraxx Europe Bond Index selects up to three of the most liquid bonds for each entity in the current iTraxx Europe series. It includes only bonds with a minimum outstanding amount of EUR500 million and remaining time to maturity of 3-7 years (extended to 1-10 years if an issuer has no bonds satisfying the 3-7 years range). The index is rebalanced semi-annually in March and September in line with the iTraxx Europe Index roll dates. Bonds are weighted such that each entity has equal notional weighting, and the Index has an average maturity of 5 years.