Shutting off the thought process is not rejuvenating; the mind is like a car battery — it recharges by running. This week, we took a closer look at inequality across countries after Covid-19 and we analyzed the effect that changes in long-term sovereign yields and tapering have on US and Eurozone investment grade corporate spreads.
The middle-income trap: Inequality across countries after Covid-19
In 2020, Covid-19 narrowed the prosperity gap between rich and poor countries as the former were at first the most affected. But over the medium and long run, its consequences could hit emerging markets harder. We analyzed which economies are most at risk of falling into the "middle-income trap". The main takeaways are:
- Covid-19 will increase income inequality between richer and poorer countries since the latter have less policy room to mitigate the impact of the crisis and slower access to vaccines. In addition, the crisis may also have accelerated long-term structural trends that will not be favorable to many emerging economies: In the post-Covid-19 world, the comparative advantages of relatively cheap labor – on which the rise of emerging markets and the global middle-class was primarily based – would count for less. In this context, the path to high-income status could become longer and more difficult for these countries.
- Which countries are most at risk of facing a middle-income trap? To investigate the potential long-term scarring effects on per capita income, we look at the risk of a "middle-income trap", a situation in which countries that have rapidly transitioned from low-income to middle-income status fail to further catch up to high-income countries. Based on our pre-crisis and post-crisis long-term economic growth forecasts, we find that by 2029, Hungary, Romania and Latvia are likely to see their transition delayed by a few years, though their EU membership will prevent a descent into the middle-income trap. However, Kazakhstan, Panama and Seychelles will not move to high-income status during our forecast horizon. Somewhat surprisingly, Turkey and Russia could achieve high-income status in the medium run sooner than previously expected, likely due to crisis-related fiscal stimuli more than compensating for the initial growth slowdown, thus creating base effects that feed forward, or higher-than-previously-expected oil prices. That said, their long-term outlooks face considerable downside risks, including swings in commodity prices (Russia) and risks to balance of payments, currency and monetary policy (Turkey). Our analysis of long-term catch-up trends further identifies 10 countries (Argentina, Bulgaria, Colombia, Croatia, Greece, Laos, Nigeria, Slovakia, Trinidad & Tobago, Uruguay) that are or will be in the middle-income trap over 1950-2029 – with or without the Covid-19 crisis.
- In this context, the insurance industry has an essential role to play in helping countries overcome the middle-income trap. Many countries that have successfully transitioned to the high-income level have strong insurance markets, and this is no coincidence: Insurance markets contribute significantly to resilience, the crucial ability to cope with crises, thus making it easier for poorer countries to escape the middle-income trap. In this context, the insurance industry must help to close protection gaps by focusing on simpler products, risk prevention and building public-private partnerships – be it for risk protection or infrastructure investments. It’s a fitting task to its corporate purpose.
?You’ll find the full report here.
Corporate credit - life after policy support
Together with Allianz Investment Management, we have written a paper about the effect that changes in long-term sovereign yields and tapering have on US and Eurozone investment grade corporate spreads. The key takeaways of the paper are the following:
- Monetary policy has helped keep credit spreads extremely narrow. As part of their generally accommodative monetary policy, central banks’ direct purchases and an implicit “whatever it takes” put protection have contributed to spreads being anchored close to multi-year lows and remarkably reduced volatility vis-a-vis equity market swings.
- Our analysis suggests that changes in long-term sovereign yields have an impact on corporate spreads only when those are extreme. In other words, if moves in long-term yields move in a gradual pattern their impact on investment grade corporate spread should be close to negligible. However, when moving towards the extremes of the yield change distribution we see substantial effect being passed through to corporate spreads.
- In this context and as long as central banks do not surprise with emergency tightening measures, we expect the upcoming hiking cycle to have a close to negligible effect on EUR and US investment grade spreads in the near future.
- But long-term yields are not all that matters. The combination of an economic component, a market volatility indicator and the contribution of monetary policies seems to better explain moves in investment grade corporate credit spreads both in the Eurozone and the US.
- In the case of the Eurozone, renewed economic tailwinds together with plunging equity volatility and the ramp up of monetary policy have maintained spreads on a downward trending path. As of today, a healthy combination of the three elements is keeping spreads anchored at low levels, building a cushion against bad news.
- In the case of the US, the devil is in the details as it seems that US spreads’ reliance on equity volatility is far higher than that of the Eurozone, making US IG spreads more vulnerable to changes in investor sentiment. At the same time, US spreads seem to be later in the cycle as the renewed economic tailwinds and the initial Fed intervention have been fully priced in, leaving spreads at an unstable equilibrium situation.
- In this context, we expect investment grade credit spreads to remain close to 2021 levels in 2022, while experiencing a mild widening in 2023 (10-20bps per annum). More so, as from a credit cycle perspective, economic recovery and expansion periods tend to be favorable for investment grade corporate credit spreads as those phases are usually associated with periods of improved corporate profitability and solvency which, at the same time, translate in corporate spread stability with diminished market volatility and easy funding conditions.
- Lastly, and as an additional confirmation, fundamentals also point towards market stability. Several fundamental valuation metrics are accompanying this stabilizing and recovering phase, with key credit cycle metrics showing signs of improvement and resilience.
