Eric Stein

Despite continued growth and inflation, long rates back off first-quarter highs, as outlined by Eric Stein, Eaton Vance chief investment officer, fixed income, in his latest commentary.

Mr Stein notes: “The markets got a bit overextended with the first quarter surge in long-term rates and inflation expectations, and the second quarter reversal appears to reflect a belief that U.S. growth and inflation rates may have peaked. While inflation is being taken seriously by the Fed and the markets, there is now a growing consensus that it mostly stems from transitory, pandemic-related issues.”

He says: The big story of the second quarter of 2021 was the sharp reversal in the trend of both long-term U.S. Treasury rates as well as U.S. inflation expectations, which both fell.

Long-term rates fell 25 bps during the second quarter, in sharp contrast to their 81 bps rise during the first quarter, while inflation expectations (as measured by the U.S. Treasury breakeven rate), cooled from their May high of 2.54% to 2.32% on June 30.

So even if the retracing downward didn’t match the first quarter surge, it is useful to consider why we saw the reversal.

Generally, the economic expansion remained strong, though the delta declined with the latest upticks in GDP having not matched the initial prints that reflected the change from the depths of the pandemic-induced slowdown. Inflation prints continued to trend higher, but, as mentioned, expectations waned.

The growth story is certainly intact in the credit markets, where spreads remain at or near all-time historical tight levels, across the quality spectrum. For example, investment-grade corporate-bond yields are negative in real terms. As of June 30, the spread on the ICE BofAML U.S. High-Yield Index was 3.04 percentage points — its lowest level since 2007.

However, I don’t believe that long-term rates necessarily reflect a change in the “real” economy. Rather, I think it is a case of the market getting ahead of itself in pushing Treasury rates and inflation expectations up so fast in the first quarter. Keep in mind that rates were falling through most of the second quarter, even before the June 16 meeting of the U.S. Federal Reserve, when it adopted a surprisingly (but still modestly) more hawkish stance.

A new Fed consensus The Fed’s consensus projection for new rate hikes moved up to 2023, compared with March when no FOMC members predicted hikes that early. The Fed’s traditional “dot plot” for 2022 also showed a hawkish shift, with seven members predicting a hike by then, compared with four in March (though these are not median projections).

The Fed also advanced from the phrase “talking about talking about tapering” to simply “talking about tapering.” Two days after the meeting, St. Louis Fed Bank President James Bullard indicated the first rate hike could come as soon as late next year. It is still very much an open question how the newly hawkish talk correlates with the Fed’s average inflation targeting (AIT) policy, which it announced almost a year ago. Under AIT, the Fed has said it is willing to let inflation run “hotter” than its long-term goal of 2% for a period, taking into account the years in which it has remained under that target.

I think the market is still trying to gauge exactly how much the Fed will let inflation run above 2 percent in order to meet both its AIT framework as well as other policy objectives. The June 16 meeting seemed to potentially indicate that the current answer is, “not much.”

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Eaton Vance common stockholders were offered 0.5833 Morgan Stanley common shares and $28.25 per share in cash for each Eaton Vance common share, and had the opportunity to elect to receive the merger consideration all in cash or all in stock, subject to proration and adjustment. As provided under the merger agreement, Eaton Vance shareholders also received a special dividend of $4.25 per share, which was paid on December 18, 2020 to shareholders of record on December 4, 2020.

“This acquisition further advances our strategic transformation by continuing to add more fee-based revenues to complement our world-class, integrated investment bank. With the addition of Eaton Vance, Morgan Stanley will oversee $5.4 trillion of client assets across its Wealth Management and Investment Management segments. The Morgan Stanley Investment Management and Eaton Vance businesses are delivering strong growth and their complementary investment and distribution capabilities will deliver significant incremental value to our investment management clients,” said James P. Gorman, Chairman and Chief Executive Officer of Morgan Stanley.

Thomas E. Faust, Jr., Chairman and Chief Executive Officer of Eaton Vance, will become Chairman of Morgan Stanley Investment Management and will join the Morgan Stanley Management Committee.

“We are excited to welcome Eaton Vance. Our combined organisation is exceptionally well positioned to deliver differentiated value to our clients and growth opportunities for our employees,” said Dan Simkowitz, Head of Morgan Stanley Investment Management.

”My Eaton Vance colleagues and I are pleased to join Morgan Stanley to begin the work of building the world’s premier asset management organisation,” said Mr. Faust. “On a combined basis, Morgan Stanley Investment Management and Eaton Vance have unrivaled investment capabilities, distribution reach and client relationships around the globe.”

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Michael Cirami

Eaton Vance is currently upbeat about the investment prospects for local-currency-denominated Emerging Market Debt (EMD).

The Eaton Vance EMD team, managing U.S.$8.4 billion in assets, has EM FX as a clear “overweight” risk factor for the first time ever. The team is simultaneously positive (“moderate overweight”) on EM local interest rates, EM sovereign credit and EM corporate credit.

Michael Cirami, Director of Global Income and Matthew Murphy Jr., Senior Institutional Portfolio Manager at Eaton Vance Management, in a recent paper note: “Reasons for this bullish stance include dovish policies of G3 central banks, low yields in core bond markets, increasing deficits in the United States and attractive relative valuations.”

Below is a summary of the reasons for this upbeat outlook, particularly in relation to local-currency:

1. Emerging economies are driving the rebound in global economic growth: Emerging-market economies did not shut down to the degree that occurred in developed-market economies in the face of COVID-19 in 2020, and neither are they are shutting down as aggressively now.
2. Emerging-market debt assets have lagged the rally in developed-market assets: Despite the positive growth differentials (EMD) assets lagged the recovery in a number of developed-market assets in 2020.
3. The macro environment is very favourable for EM debt: Further, we believe we are seeing one of the most favourable macro environment for EM debt in decades
4. Positives for EM debt assets are not priced in: The positives for EMD – better growth in emerging market economies, relatively attractively priced EM debt assets and a very favourable macro environment in decades – are, on the whole, not priced in.
5. Capital markets are open to issuers: In the first half of 2020, there was a lot of fear about solvency as it relates to liquidity in different emerging markets. Investors wanted to know whether funding would be available to countries and credits, including in the corporate space. The good news is that over the second half of 2020 and continuing into January 2021, capital markets have been wide open to issuers.

Cirami adds: “Eaton Vance’s EMD team sees attractive FX investment opportunities in Uruguay, Colombia, Mexico and Indonesia, countries that are in the widely used local currency benchmark: J.P. Morgan Government Bond Index Emerging Markets (GBI EM) Global Diversified. We also see some attractive opportunities outside of the benchmark – notably Egypt, Serbia, Ukraine and Uzbekistan. Within the benchmark, we are positive on duration in Indonesia, Uruguay, Russia, Thailand and Malaysia. Outside of the benchmark, we are also positive on duration in Serbia and Ukraine.

“While highlighting specific opportunities, it is worth highlighting that, within EMD, investors need to be careful and selective when approaching this highly differentiated asset class. On the flip side to the investment opportunities we have mentioned, there is also the growing problem in some countries – Oman being one, South Africa being another – of budget deficits and debt build up. This is an important topic and one that is not going away anytime soon,” says Cirami.

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“Default rates rose throughout the year, but they did not come close to the most pessimistic forecasts made in March and April. In bonds, we saw the trailing 12-month default rate finish 2020 north of 6%, while in loans it was touching 4%,” say Stephen C. Concannon, Co-Director of High Yield Bonds and Andrew N. Sveen,  Co-Director of Floating-Rate Loans at Eaton Vance Management.

Credit markets feel like they are starting 2021 in something of a tug-of-war between two competing forces, they add. This is because:

• Developed markets are in the midst of a significant additional wave of COVID-19 cases with increased restrictions in place across much of the U.S. and lockdowns once again in force in Western Europe.
• Against this, rock-bottom interest rates, additional fiscal stimulus and the start of vaccination programs around the world have given financial markets much to be optimistic about.

“More broadly for debt investors, we suspect credit feels like one of the only games in town for keeping yield in a portfolio. Historically, investors would not get excited about yields between 4% and 5%, but those yields are significant improvements on what’s available in investment-grade markets. We have only to look at the European experience of the last decade for evidence of demand for sub-investment grade credit at these all-in yield levels.

“With the loan market coming into 2021 at an average price just over US $96, we think there is some capital appreciation to supplement the coupon income available in this market. In high-yield corporate bonds, we believe the rebound in economic activity has the potential to drive spreads a little bit tighter. However, both markets are susceptible to volatility as the pandemic continues.

“Significantly, we saw net inflows return to the loan market in December after a year mostly dominated by outflows. The results of the Georgia Senate run-off have brought the theme of reflation back into focus, which may provide a technical tailwind for the floating-rate loan markets. With increased demand for the asset class, we expect a busier year for supply.

“Looking across both markets, we think relative value is more finely balanced at the start of 2021, with opportunities for positive total returns. Though current valuations across credit markets imply an improved fundamental situation, they also point to the potential for higher prices ahead.

“Whatever appreciation potential exists is probably modest. Yet that’s not likely to diminish the attractiveness of credits, as yields and spreads outshine much of what’s on offer in today’s yield-starved fixed income environment. In particular, we still see opportunities to lend to companies in some more challenged sectors such as leisure and gaming, focusing on those with both sufficient liquidity to weather the current economic disruption and a clear reason to exist in a post-pandemic world.

“For our credit mandates with the most flexibility, we continue to look to collateralised loan obligations (CLOs) as a great place to pick up some extra yield and total return potential.

“And we believe that emerging markets — both sovereign and corporate bonds — are offering opportunities,” they add.

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As Chief Investment Officer, Fixed Income, Mr. Stein will be responsible for overseeing the management of investment strategies for EVM and its affiliate Calvert Research and Management (Calvert) across the income markets, including floating-rate loans, high-yield bonds, municipal bonds, emerging market debt, mortgage-backed and asset-backed securities, investment-grade corporate and government bonds, and multi-asset income solutions for individual and institutional clients.  As of July 31, 2020, assets under management in EVM and Calvert income strategies totaled $90.2 billion.

Mr. Stein has served as Co-Director of Global Income Investments with Michael A. Cirami, CFA, since 2012.  Mr. Cirami will become sole Director of Global Income Investments, in which capacity he will continue to lead EVM’s Global Income group, reporting to Mr. Stein.

“I am pleased to announce Eric’s promotion to Chief Investment Officer, Fixed Income,” said Mr. Faust. “Under his leadership, I am confident that EVM’s income investment teams will continue the commitment to investment excellence and outstanding client service that has been their hallmark throughout Payson’s long tenure.”

Addressing Mr. Cirami’s elevation to sole Director of Global Income Investments, Mr. Stein commented, “Mike is an incredibly talented investor and passionate business builder whose leadership and vision have been instrumental to our success in global income investing.  I look forward to continuing to work closely with Mike in our new roles.”

Mr. Stein joined EVM in 2002, serving as a trading associate and research associate in the Global Income group before leaving to attend business school in 2005.  He rejoined EVM’s Global Income group in 2008 as a research analyst from the Federal Reserve Bank of New York, where he worked on the Markets Desk. He has additional experience at Citigroup Alternative Investments.  Mr. Stein earned a B.S., cum laude, from Boston University and an MBA, with honors, from the University of Chicago Booth School of Business. He is a CFA charterholder, term member of the Council on Foreign Relations and member of the CFA Society Boston, Boston Committee on Foreign Relations, Boston Economic Club, Enterprise Club and AEI Boston Council.

Mr. Cirami joined EVM in 2003 and started his career in the investment management industry in 1998. Before joining EVM, he worked at State Street Bank and BT&T Asset Management. Mr. Cirami earned a B.S., cum laude, from Mary Washington College and an MBA with honors from the William E. Simon School at the University of Rochester. He also studied at WHU Otto Beisheim School of Management in Koblenz, Germany. He is a CFA charterholder and member of the CFA Society Boston, Boston Committee on Foreign Relations and the Ludwig von Mises Institute.

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Eric Stein

In the US presidential election, the polls have tightened over the past several weeks and market-implied betting probabilities have started to close.

Eric Stein, Co-Director of Global Income at Eaton Vance Management notes: “At this point, however, I think Joe Biden should still be considered the frontrunner. Recent momentum for President Trump depends heavily on what happens with the economy and the coronavirus. Only a month ago, large majorities of potential US voters expressed fear about how much the pandemic seemed to be accelerating, which lowered the probability of Trump’s re-election. Now, with the number of new infections slowing somewhat in the US, Trump’s prospect of winning — implied by either the polls or the market — appears to be going up.”

He adds: “Much has been said about the economic impacts of President Trump getting re-elected, Biden winning but the Republicans keeping the Senate, or Biden winning with a clean Democratic sweep of Congress. Certainly, there would be a big impact on tax rates and regulatory policy depending on these outcomes.

“I think it’s also important geopolitically whether Trump or Biden wins. Clearly, the Trump administration has shifted the narrative on China — essentially the only bipartisan issue in Washington where everyone has been trying to out hawk each other.

“If Biden gets elected, I don’t expect him to go soft on China as Trump has claimed, but rather to be far more hawkish than he was as Vice President in the Obama administration.

“That being said, I anticipate that Biden’s approach would be different — far more multilateral with US allies in Asia, and with Europe more in the fold than it has been under President Trump.

“So I think the geopolitical ramifications of the US election should not underestimated and could even be more important than the impacts from a domestic tax and regulatory policy perspective,” Stein says.

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He notes: “We’ve seen a contraction across earnings, revenue growth and interest coverage, along with an increase in leverage. The key takeaway here is that fundamentals have weakened and that has contributed to a rise in defaults and a tremendous surge in “fallen angels” – debt downgraded from investment-grade to high-yield ratings.”

Mueller says: “Fed support has kept the market in check. Softer fundamentals have contributed to a big pickup in defaults, which began to increase sharply in March and continued to climb in Q2 and thus far in Q3.

“We’re seeing distress across most sectors, though it is most pronounced in energy. Through the end of Q2, $191 billion of previously investment-grade-rated debt was downgraded to high yield.1 That is a hugely meaningful number, and we think it will continue to climb. However, credit facilities launched by the Federal Reserve (the Fed) will help mitigate this situation. In effect, what the Fed has done is help ensure that fallen angels do not overwhelm the high-yield market. We think what prompted the Fed’s actions here was the downgrade of Ford, given the size of the company and how large an employer it is. Notably, as a whole, fallen angels performed extremely well during the second quarter.

“Yet, at the end of June, the default rate for the overall high-yield market was at a 10-year high, at 6.2%. Energy constituted 46% of the last 12-month volume of bond defaults. As of June 30, energy was 63% of all high-yield bonds trading below $0.50, and 48% of all bonds trading below $0.70. We expect a continuation of this default trend, and we’ve keeping a close eye on a number of credits in this sector.

“At the end of 2019, energy represented 12.5% of the high-yield market. Now, it’s 13%, but this includes 4% from fallen angels that entered the index this year. If we exclude fallen angels, the legacy energy index is almost 30% smaller relative to year-end 2019, and this is due to the depreciation of bond prices and defaulted companies that have exited the index.

“Unfortunately, we think the outlook is clear as mud. The fundamentals are pretty bleak, with high US unemployment, at around 80 million people. It’s getting better sequentially, but obviously, from a historical perspective, unemployment is quite high.

“As we’ve discussed, defaults have accelerated, particularly in the energy sector, and recovery is slow. However, countering all this is the Fed and US government, which have passed $3.7 trillion in stimulus for a variety of different programs, and they’re not done should the need arise. Meanwhile, the European Central Bank (ECB) has issued $2 trillion in stimulus, and these global central banks have done this over the course of only a few short months. That’s lit a fire under the US high-yield market and caused a rapid move toward recovery, including spurring some robust flows into the asset class.

“While central bank and fiscal stimulus represent a significant silver lining, we also think it’s important not to ignore the risks inherent in the high-yield market and global economies as we face the ongoing challenges of the coronavirus, compounded by difficult geopolitics,” says Mueller.

————

1. Source: JP Morgan as of June 30, 2020.

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Bradford Godfrey, Institutional Portfolio Manager Director of Alternative & Asset Allocation Strategies at Eaton Vance says: “We believe the market has entered a new phase following the broad-based recovery in the second quarter that will see greater differentiation in performance across the EM debt investment universe.  In our view, a focus on country analysis, investment flexibility and the ability to appropriately weigh shorter and longer-term factors will be critical for investment success in EM debt ahead.

“While we see attractive relative value at the sector level in EM credit, we believe that selective opportunities remain in rates and currencies away from many of the large benchmark constituents.”

In a broad sense, the outlook is rather challenging. The IMF recently revised GDP forecasts down for EM by two percentage points, to -3.0%. For several bellwether countries, the outlook appears far worse. For instance, India’s GDP forecast is at -4.5%, Russia’s -6.6%, Brazil’s -9.1%, Mexico’s 10.5% and South Africa’s is -8.0%.

Godfrey says: “These countries, which typically grow at a decent rate, often define the general narrative for emerging markets as a whole. While these core countries are really in a quite a difficult position, we must also remember that the emerging-market debt opportunity set is formed by a much broader universe of countries.

“Egypt is one country within the wider opportunity set where we see opportunity. The country is expecting positive growth in 2020, bucking the wider EM trend. The high fiscal deficit (7.6% of GDP) needs to be monitored, of course, but we must note that Egypt was already trying to address budget issues before the pandemic. In our opinion, the country is managing the crisis reasonably well from an economic perspective, having put in place many temporary measures, which we find reassuring.

“Other countries we’d highlight include Romania, Uzbekistan and Uruguay. Although Romania faces an economic contraction, forecast at -5%, we believe relatively healthy debt metrics will help the country weather the current storm. Uzbekistan, for its part, is a country that’s not on many people’s radar. However, Uzbekistan’s growth forecast is positive, the budget deficit is manageable and its reform-minded leaders have been moving toward a more market-based system.

“Similarly, Uruguay’s government has also been implementing reforms, even in the midst of the pandemic. While the growth outlook appears somewhat challenging, like other parts of the region, the country has taken steps to move forward a sustainable reform program.

So how does the outlook look from an investment perspective?

“For starters, we believe the broad-based rally is now over and that we’re entering a period of differentiation. In this environment, how one invests in EMD is going to be critically important, in our view.

We are focused on three areas:

1. The critical role of country-level analysis
2. Investment flexibility, geographically and in terms of risk factors
3. Balancing short-, medium- and long-term factors

“On the first point, we believe that fundamental analysis is always critical, but all the more so in a period of differentiation. With the pandemic not over, we are closely watching how countries confront the virus to protect the public and manage their economies.

“Policymakers are trying to maximise economic output, while not overrunning health care systems. It’s become a calibration process, with variations in levels of effectiveness by country. In our view, many of the bellwether countries mentioned earlier are not managing the process well, while other smaller EM countries are doing relatively better.

“In terms of investment flexibility, we believe that exploiting the full breadth of the EMD investment universe on a country and risk-factor basis will remain a critical factor for investment success. Within the EMD universe, investible risk factors include currencies, local interest rates, and sovereign and corporate spreads.

“At Eaton Vance, we take active positions only in the risk factors for which we believe we will be adequately compensated, while at the same time trying to eliminate unintended exposures, through hedges if necessary.

“Thirdly, while we are medium-to-long-term investors, the situation in global markets at present is still very fluid. In this respect, we believe it is prudent to weigh short-term factors appropriately, possibly giving them greater weight, while EM debt markets remain dynamic,” he notes.

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The Emerging Markets Debt Team at Eaton Vance Management report: “But at the same time, investor sentiment was buoyed by the massive policy responses around the world and the perception that a lot of the bad news was already reflected in lower asset prices, resulting in broadly compelling valuations. The positive tone was reinforced by high investor cash levels and the easing of lockdown measures, which convinced many investors that peak uncertainty is likely past and that forthcoming economic surprises are likely to be to the upside.

“We entered the quarter cautious, turned bullish mid-quarter, and are now more neutral overall. Pockets of opportunity still remain in the EM sector, but professional due diligence and selectivity remain more important than ever for taking advantage of them.

Eaton Vance notes: “Looking ahead from a macro perspective, easy monetary and fiscal policies from the world’s major central banks will likely provide support for the asset class as will the low yields available in core sovereign bond markets (USTs, bunds, etc.).

“As the financial shocks from COVID-19 and oil settle in, focus has turned to individual country fundamentals. While the rally in Q2 was broad, differentiation among countries was evident, based on varying policy responses and resulting economic outcomes, and the reverberations will continue over the rest of the year throughout the world.

“Many EM countries cannot afford to remain on lockdown and we are seeing continued re-openings, for better or worse. The trouble spots that we have identified in the past, like Lebanon, Argentina, Zambia, Ecuador and Sri Lanka, remain under significant pressure and we expect additional countries to be added to the list.”

The three main EMD indexes experienced significant gains during the quarter, with FX, local rates, sovereign credit spreads and corporate credit spreads all rallying (see chart).

Every EM debt risk factor turned sharply positive in 2Q

• Local-currency sovereign debt, as measured by the JP Morgan Government Bond Index – Emerging Markets (GBI-EM), gained 9.8%, largely as a result of strong FX and interest-rate performance.
• External sovereign (dollar-denominated) debt, as measured by the JP Morgan Emerging Markets Bond Index – Global Diversified (EMBI), advanced 12.3%, thanks to significant compression of sovereign spreads over US Treasuries.
• EM corporate debt index gained 11.15%, as measured by the JP Morgan Corporate Emerging Market Bond Index (CEMBI), on the strength of big gains from both corporate and sovereign spread compression.

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Aidan Farrell

While volatility recorded in the first quarter of 2020 has been unprecedented and challenges remain, global investment manager, Eaton Vance, continues to see opportunities for investors with a long- term mindset in small-cap equities.

In a recent research paper, Aidan Farrell, Director of Global Small Cap Equity at Eaton Vance, presents his analysis of factor returns for the global small-cap equity universe and explains why long-term investment opportunities remain for the asset class.

“Our findings show that high-quality companies reaped attractive excess returns during the heightened volatility of Q1 2020. Strong balance sheets also proved critical in protecting capital during the heightened market turbulence in the first quarter.

“Given that targeting financially strong, high-quality companies at attractive valuations is core to our investment philosophy, these findings are particularly relevant at this crucial time for small-cap investing.”

The truth is that nobody knows what the future holds, says Mr Aidan.

He notes: “As of early May 2020, equity markets have moved significantly from the lows seen just two months earlier in March. Investors are taking hope from the enormous monetary and fiscal policy responses across the world, and the first tentative steps by some countries to reignite their economies by easing stringent lockdown measures.

“In the short term, until a vaccine or effective treatment for COVID-19 is developed, equity market sentiment will be shaped by the path the virus takes and any additional policy measures applied. As to possible longer-term implications, there is no shortage of commentary in the financial (and other) press as to likely structural and behavioural changes in a post pandemic world.

“Irrespective of the duration and shape of recovery, we firmly believe that we will look back at factor returns in 20 years’ time and once again see that higher-quality companies with healthy balance sheets purchased at attractive free cash flow yields will be a winning strategy for investors.

“Our faith in this investment style is the “compass” that helps us navigate even the most challenging of market environments. Key to our ‘Quality, Valuation and Time investment’ philosophy is a preference for targeting financially strong, high-quality, small-cap companies at attractive valuations. Our investment style, which we maintain regardless of changes in the economic cycle, has served us well historically and, we believe, will continue to do so going forward.

“In the Eaton Vance small-cap equity team, our QVT investment philosophy is biased toward higher-quality companies with healthy balance sheets, irrespective of the economic cycle. The aim being not only to ensure healthy capital appreciation when markets rise, but also to exhibit a degree of capital preservation in times of challenge.

“Notwithstanding the analysis suggesting that companies with stronger-than-average balance sheets have not been as alpha-generating over time (Exhibit A), the fact remains that the world economy can and does hit periods of significant stress.

“ In our view, these periods of pronounced stress are reason enough to invest in companies with strong balance sheets.

“We believe that trends observed in Q1 2020 validate such an approach. Simply put, financial strength allows a company to better withstand periods of economic uncertainty, while at the same time amassing capital that can be deployed to strengthen its strategic position, often during periods of uncertainty. To be able to “withstand” and “deploy” in this manner goes to the heart of how and why capital preservation and capital appreciation form a central role in our Quality, Valuation and Time investment philosophy.”

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