Emerging Markets Bond ETF (EMBD): Q1 2022 Commentary

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For the period December 31, 2021, to March 31, 2022 (the “Period”), the Global X Emerging Markets Bond ETF (the “Fund”) sub-advised by Mirae Asset Global Investments (USA) LLC posted a loss of 6.87% (including distributions paid to unitholders). This performance compares to a loss of 9.93% for the Fund’s benchmark, the JP Morgan EMBI Global Core Index (the “Index”) during the same period.

The Index tracks liquid, U.S.-dollar emerging market (EM) fixed and floating-rate debt instruments issued by sovereign and quasi-sovereign entities.

The Global X Income Outlook for Q1 2022 can be viewed here. This report seeks to provide macro-level data and insights across several income-oriented asset classes and strategies.

We spoke last quarter about the hawkish pivot by the Federal Reserve (Fed), and the likelihood of stickier inflationary pressures. These trends continued to materialize in 2022 as market expectations for aggressive monetary policy tightening took hold, and headline inflation data printed at extremely high levels by developed market standards. For investors, we believe there are some key themes and solutions to pay close attention to in the income investing markets.

Key Takeaways:

  • The potential for numerous rate hikes by the Fed and other central banks, as well as aggressive balance sheet unwinding seems increasingly likely for the remainder of the year.
  • Low duration instruments, like variable rate preferreds, may be an alternative for fixed income investors looking to reduce interest rate risk but still pursue income objectives.
  • Energy assets with strong fundamentals, like master limited partnerships (MLPs) and energy infrastructure equities, look appealing in a rising oil price environment.
  • Options based strategies, such as covered calls, could be attractive with elevated volatility and the defensive posturing in the equity markets.

Hawkish Central Bank Policies Make Further Rate and Credit Spread Rises More Likely

Persistent inflation in the United States and limited monetary policy response put the Fed in a precarious position to start the year. The Fed was forced to play catch up after leaving loose monetary policies in place, despite inflationary pressures spreading across the global economy. However, the Fed reacted sharply in Q1, raising rates for the first time in three years. The Fed wasn’t alone, though. The Bank of England and Bank of Canada, among others, raised rates, opening the door to broader global hawkish monetary policy this year.

Additionally, it’s unlikely this pace of rate hikes and tapering will slow down. The European Central Bank (ECB), historically very dovish compared to other developed central banks, said they could end their bond buying program in Q3.1 The futures market is currently projecting a move to zero interest rate levels from negative 50 basis points (bps) by year end.2 The U.S. and U.K. central banks are forecasted to be even more aggressive, with 125 bps in hikes by the United Kingdom and 200 bps in hikes by the United States forecasted in the futures market.3 Clearly, these would be the most aggressive policy actions in that short of a timespan that we’ve seen this cycle.

We think the Fed, as an example, is being forced to play catch up as inflation levels in the United States reached 8.5% in the month of March. The last time headline inflation reached these levels in the United States was in the 1980s. The bond market is already moving in lockstep with inflation, so hawkish policy was priced into sovereign bond yields.

Credit spread widening is also more likely in light of central bank rate hikes and further monetary policy tightening. There was a spike in credit spreads in Q1 as the equity markets sold off and the rate hiking path began. The rise in geopolitical tensions could also make financing conditions more challenging for high yield issuers.

Variable Rate Preferreds as a Fixed Income Alternative

For fixed income investors, aggressive monetary policy shifts raise two risks: rate hikes, which are already permeating into the market, and potential credit spread widening for corporate credit. For income investors, the key in this environment is balancing interest rate risk with the need for yield.

Real (inflation-adjusted) yields turned negative in the midst of the pandemic, putting income investors in a challenging situation. The recent rise in sovereign bond yields is mitigating some of this risk, but real yields are still barely on the brink of turning positive. Persistent inflationary pressures, such as supply chain issues and labor shortages, are causing headline inflation to keep moving higher, with March’s figures coming in at 8.5%. This increases the need for real income levels to keep pace.

Variable rate preferreds historically hold up well in rising rate environments with their lower duration characteristics. The outperformance of variable rate preferreds also occurred when compared to broader fixed income as well.

Master Limited Partnerships as an Income Play on Commodities

Commodity investments have been one of the shining spots in the market this year, as global supply shortages and inflationary pressures drove raw material prices higher. For income investors, though, the non-yielding nature of commodities futures makes that route less appealing to generate cash flow. The equity of companies in commodities businesses are more attractive given the return of capital potential through dividends or share buybacks.

Master Limited Partnerships (MLPs) are one avenue for income investors to potentially both generate income and benefit from the commodity trade of oil. These pipeline businesses could be well positioned for a rise in U.S. energy production, and this year’s spike in oil and gas prices has also boosted natural resource assets, such as MLPs. The tax advantaged nature of the distributions and yield spreads compared to other asset classes could make MLPs a compelling option for income investors.

Elevated Volatility Makes Covered Call Strategies Attractive in a Rising Rate Environment

Central bank tightening did not just lead to a spike in yields and credit implications. Increased volatility began flowing into the equity markets as investors began re-pricing valuation multiples and growth equities began selling off in favor of value.

Volatility increases were notable across major indices, after the equity market selloff earlier in Q1. For income investors, covered call strategies on major indices like the Nasdaq 100 or S&P 500 could be a way to generate income outside of traditional dividend paying stocks and fixed income.

The potential for earnings growth may lead investors to desire some level of equity upside potential, while also collecting a potential income stream. With 6.5% earnings growth for Q2 expected in the S&P 500, and 11.1% for Q3, some income investors may want to maintain equity exposure.4 Below, we can see a comparison of the options premiums generated from writing covered calls both at-the-money with 100% notional coverage and also using 50% notional coverage to retain upside potential. For further information on options premiums for the Global X covered call strategies, including on the Russell 2000 and Dow Jones Industrial Average , please click the report in this link.

Conclusion

The ramp up in Treasury yields and other sovereign bonds globally means income investors need to be on the lookout for the impact on their income portfolios. Broader fixed income assets are likely to face pressure amid aggressive tightening policies by central banks, and growth equity assets may be volatile for the foreseeable future with rising rates. Variable rate preferreds offer a balanced approach to duration risk and income levels from the preferreds. Sectors able to withstand inflation pushed through the supply chain could bode well in this environment compared to other segments of the market. Energy related assets, like MLPs, and options strategies, such as covered calls, that are able to monetize volatility could be solutions in this rising rate environment.

The performance data quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than the performance quoted. For performance data current to the most recent month or quarter-end, please click hereTotal expense ratio: 0.39%.

Cumulative return is the aggregate amount that an investment has gained or lost over time.

General Market Review

Heading into 2022, the macro backdrop for risk-assets was already facing challenges from the expected slowdown in global growth, due to the resurgence of the Omicron variant and persistent inflationary dynamics. Further headwinds arose in the first quarter, with the threat of tighter monetary policy and escalating geopolitical tensions. At the beginning of the year, the market expected the U.S. Federal Reserve (Fed) to hike interest rates three times in 2022.1 This was considered aggressive at the time, given that the Fed was still expanding its balance sheet and growth rates were declining. However, the policy path quickly evolved as fears of persistent inflation began rising. With full support from the Biden administration, the Fed became very hawkish and led the market to price in more than 10 interest rate hikes for 2022, implying multiple Federal Open Market Committee (FOMC) meetings with 50 basis point hikes.2 Consequently, U.S. 10-year Treasury rates rose more than 83 basis points to 2.33%.3

In the first quarter of 2022, Russia’s full-scale invasion of Ukraine put further pressure on risk assets as well as inflation dynamics. Even though Russia makes up only 2.5% of the global GDP, the outsized influence of Russia on key global commodity export markets, such as oil (11%), gas (17%), wheat (11%), and nickel (7%), created anxiety among market participants.4 Russian-related sanctions and self-imposed sanctions by business communities further disrupted the global supply chain. Consequently, global energy and agricultural prices rose sharply, further pressuring inflation expectations. However, Russia did not cut off its natural gas flows to European markets, a move markets initially feared would be part of Russia’s counter measures against the West’s severe sanctions. Nevertheless, geopolitical tensions centered around the Russia-Ukraine war increased pressure on the global growth trajectory, while elevating the inflation outlook for the rest of 2022. One interesting observation by global central banks, post Russia-Ukraine escalation, was that central banks appeared to prioritize policy focus around stemming inflation as opposed to boosting growth.

A macro development that received less media attention was China’s major policy pivot in mid-March. Contributions to China’s deteriorating domestic growth momentum include (1) the regulatory crackdowns in Chinese technology sectors, (2) the liquidity crunch experienced by real estate property developers, and (3) the risk of large-scale lockdowns in major cities due to surging COVID-19 cases. These finally forced the Chinese government to announce a major policy pivot when China’s Financial Stability and Development Committee (FSDC) signaled State-Owned Enterprises, including major Chinese banks, to support growth initiatives. Consequently, Chinese financial asset markets and assets sensitive to China’s growth impulse rebounded as the risk of China’s hard landing declined.

For EM investors, Q1 2022 was an even more challenging environment as they had to recognize the losses from exposures to Russia in their portfolios. The swift countermeasures by the West in the form of economic and financial sanctions, including the coordinated efforts to freeze the foreign reserves of Central Bank of Russia, risked forcing Russia to default on foreign debt obligations. Furthermore, index providers’ decision to exclude Russia from widely followed bond and equity indices forced passive investors to crystalize losses at inopportune market timing. That being said, EM investors quickly differentiated winners and losers from the geopolitical crisis as the cost of the war was going to be unevenly distributed between commodity exporters and commodity importers. The terms of trade shock effects from higher commodity prices will likely show up in EM countries’ trade and budget balances in the coming quarters.

EM credit markets faced multiple headwinds coming from (1) the sell-off in U.S. Treasuries triggered by the tightening monetary policy and (2) the credit spread widening driven by a deteriorating outlook from a growth slowdown and losses from Russian assets. Interestingly, EM credit markets were much more resilient than anticipated at the onset of Russia’s invasion, as the EM credit sector, excluding Russian assets, performed similarly to Developed Market credit markets during the Period. One likely explanation of the EM resilience could be that the surging commodity prices were a net positive factor for the majority of EM issuers.

Portfolio Review

During the Period, the Fund outperformed the Index by 306 basis points. The Fund’s lower duration relative to the Index and country selections positively contributed to performance (+108 and +232 basis points, respectively). However, the Fund’s security selection was a detractor (-34 basis points).5

Heading into the first quarter, we maintained our underweight duration exposure as we expected global bond yields to move higher in the first half of the year while credit spreads were expected to remain elevated. Thus, our decision to overweight high-yielding assets over the investment-grade sector, given that there were more spread buffers to absorb in high-yield sovereign bonds, positively impacted the Fund’s performance.

The largest positive contribution derived from our underweights in Russia and Ukraine, which added to performance by 256 and 17 basis points, respectively.6 We maintained our underweight position in Russia as the credit spreads were not sufficiently attractive relative to the ongoing headline risks of the military build-up. As the war broke out, we maintained our underweight positions in Russia and sold our remaining Russian exposures when the Euroclear settlement firm unblocked the settlement process of Russian securities. As for our Ukraine exposure, we headed into Q1 2022 with market neutral exposure as Ukraine bonds sold off aggressively in Q4 2021 in line with other bonds that have high volatility. However, we reduced our Ukrainian exposure as headline risks related to Russia’s invasion increased.

On the other hand, the Fund’s underweight in Turkey detracted from performance. Given that Turkey’s external positions were vulnerable to tightening U.S. monetary policy and to higher commodity prices as a major oil and agricultural goods importer, we maintained underweight positions in Turkey. Furthermore, our overweight positions in Colombia, Brazil, and Morocco were further detractors from performance. Colombia lagged as the market remained cautious of election risks. Our security selection detracted from performance due to the Fund’s exposure to a South African technology holding company, Nasper, which had investment exposure to China’s leading platform (Tencent). The regulatory crackdown on the Chinese technology sector elevated the perceived credit risks of the issuer.

During the Period, we reduced our exposure to higher yielding African issuers, as we believed that the negative shock to EM risk appetite will make it difficult for these issuers to raise capital from the new issue market, which may raise refinancing risks.

Note: Asset class representations are as follows: MLPs, S&P MLP Index; High Yield Bonds, Bloomberg US Corporate High Yield Total Return Index; Emerging Market Bonds, Bloomberg EM USD Aggregate Total Return Index; Corporate Bonds, Bloomberg US Corporate Total Return Index; REITs, FTSE NAREIT All Equity REITS Index; Equities, S&P 500 Index; and Fixed Rate Preferreds,ICE BofA Fixed Rate Preferred Securities Index. The performance data quoted represents past performance and does not guarantee future results.

Outlook & Strategy

Key investment themes heading into Q2 2022 are: (1) the market’s pricing of the Fed’s aggressive quantitative tightening (QT) path, (2) the repercussion of global commodity prices on the growth and inflation mix, (3) the risk of an elongated pandemic lockdown versus delivering on pro-growth commitment by the Chinese policymakers, and (4) geopolitical escalation.

At the time of writing, the 10-year U.S. Treasury has continued to rise due to expectations of a more hawkish path for U.S. monetary policy. However, the recent sell-off in U.S. rates was not driven by the Fed’s policy rate path, which is already pricing in 250bp in 2022 and another 75bp in 2023, but by the market’s pricing of the Fed’s aggressive QT path. The Fed’s QT plan is more aggressive than many in the market had anticipated, not only in terms of the speed at which maximum cap should be reached, but also in terms of the size of the maximum cap with potential for Mortgage-Backed Securities sale. We expect the rise in rate volatility to dampen the general risk asset sentiments.

Secondly, the longer the Russia-Ukraine conflict continues, the more likely global commodity prices may remain elevated, further deteriorating the growth-inflation mix. The market already shifted the expectation of global inflation fading from Q1 2022 to the latter half of the year. With global central banks already prioritizing inflation risks over growth slowdown risks in their policy focus, global growth momentum will likely deteriorate further in Q2 2022.

Thirdly, the big uncertainty for global growth momentum is whether China will be able to quickly overcome the slowdown brought about by COVID-19 lockdown measures. We note that China’s credit impulse, namely the monthly change of flows in new credit, was trending higher prior to the lockdown measures. We believe this reflects how China’s government wanted to stimulate growth before the Communist Party National Congress gathers in the Fall to announce President Xi’s third term as party chief. Similar to what we have seen in Europe and in the United States, we expect China’s growth activity to quickly recover as the Omicron variant appears less concerning to authorities than prior variants. Furthermore, we expect authorities in China to provide more fiscal support to offset COVID-19 lockdown losses and to support EM asset risk appetite.

Lastly, there remains a risk that the Russia-Ukraine geopolitical crisis could expand to a broader European event by inadvertently dragging one of the NATO members into the conflict. With all of the top-down macro risks mentioned above, we believe one positive catalyst for EM markets heading into Q2 2022 is that investors have likely incorporated these risks in their portfolios.

Given that the risk-reward mix appears tilted more towards downside risks than upside potential, we plan to position the portfolio more defensively in terms of duration and credit risks relative to the Index. However, we plan to use the weaknesses in the credit markets triggered by the market’s overly aggressive assumptions of the Fed’s policy stance to add to duration risks. We feel that the sell-off in U.S. Treasury markets are excessive, given that the current level already reflects expectations for more than 10 interest rate hikes in 2022, in addition to the aggressive QT path.

From a credit risk perspective, we plan to move up the credit quality spectrum by adding high-quality issuers while reducing lower quality and high-beta exposures. We find the investment grade corporate sector attractive from a risk-reward perspective as they may provide better protection from downside growth risks given that their credit fundamentals remain solid. Our regional allocation mix favors Latin America over Asia and the Middle East as higher commodity prices and hawkish regional EM central banks could potentially provide safeguards against tightening U.S. monetary policy. From a country allocation perspective, we believe credit differentiation driven by sovereigns with healthy external balance sheets will be the central theme for EM assets as the Fed withdraws liquidity support from the system.

Credit Ratings noted are by Fitch, Moody’s, and Standard & Poor’s. Ratings are measured on a scale that generally ranges from Aaa (highest) to D (lowest). If more than one of these rating agencies rated the security, then an average of the ratings was taken to decide to security’s rating.

 

1Graffeo, E. & Ferro, J. (2021, December 27). Stocks’ rally will likely survive the Fed’s first hike, Crossmark says.

2Bloomberg L.P. (n.d.). [WIRP function, 10.47 hikes priced in at time of writing] [Data set]. Retrieved April 21, 2022 from Global X Bloomberg terminal.

3McCormick, L. (2022, March 31). Investors brace for QT’s ‘profound effect’ on cost of liquidity.

4Statista Research Department. (2022, April 6). Russia’s share in global production 2020, by commodity.

5Analysis provided by Mirae Asset, as of March 31, 2022.

6Ibid.

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