Hedging G-20 Bets: Rising tide, but dangerous currents
Even as rising odds on further Fed stimulus pump up financial asset prices across the board , with some help from the ECB and BoJ, the barrage of messages from Washington on trade have kept speculation about a potential U.S.-China trade deal at a fever pitch.
Ahead of the Osaka G-20 summit this weekend, this has meant both ebullience and caution.
Ebullience has triggered a notable re-rating of global equities: over the past month, the price-earnings ratio on the S&P has increased by more than 6%, and for global equities ex-US by 4.5%
The renewed hunt for yield has also helped fuel bitcoin prices (which have spiked by over 40% just since last week). This, in turn, feeds into ongoing concern about asset price bubbles more broadly.
At the same time, the clouded global growth outlook and bets on more dovish monetary policy have driven flows to bonds: institutional holdings of government money market funds, for example, have surged over the past several weeks to a record high of $1.68 trillion.
Investors have also been extending duration: the value of global debt securities with negative yields also hit a record high this week of over $13 trillion.
At present, government bonds (mostly JGBs, Bunds and OATs) account for over 75% of outstanding negative-yielding debt securities, but the stock of corporate bonds and securitized instruments with negative yields has also increased, topping $500 billion and $1 trillion, respectively.
Pileup of negative-yielding bonds
Emerging market assets have also seen some respite, though appetite remains subdued.
Similarly, the rebound in EM currencies has been muted, highlighting concern about the economic outlook and export prospects.
On the brighter side, declining USD borrowing rates will make it easier for many EMs to meet government financing needs.
However, countries with relatively large government funding gaps, including Pakistan, Lebanon, Egypt and Brazil, remain exposed to large swings in global risk sentiment.
Moreover, any upswing in inflationary pressures amid rising oil prices and geopolitical tensions, or a stronger than anticipated rebound in business sentiment, could induce the Fed to postpone monetary stimulus, which in turn would be a renewed drag investor appetite for EMs.
Maturing debt and budget deficit as % of GDP
Emerging markets look more vulnerable to climate change risks: The regulatory and policy debate on how climate change risks impact the global economy and financial system continues to heat up.
With extreme weather events leading to some $160 billion of losses in 2018 (the fourth-costliest year since 1980), estimates by Grantham Research Institute suggest that the potential value of world’s non-bank financial assets that are at risk from the impact of climate change could be anywhere from $2.5 to $24 trillion through the end of the century.
While there is growing awareness of climate change risks across the board, countries vary significantly in their level of vulnerability and ability to adapt to the adverse effects of these changes.
Looking at G20 countries in terms of exposures, sensitivities, and capacity to adapt to the negative impact of climate change, it is clear that many are relatively unprepared to mitigate fallout: on this metric, India and Indonesia look particularly fragile.
More broadly, emerging markets as a group tend to have relatively limited capacity to mobilize the domestic resources necessary for adaptation.
This represents a major tail risk to be taken seriously—not least by international investors with exposures to those countries.
While mature markets are better able to alleviate the impact of climate change on their domestic economies, they also tend to have higher levels of cross-border asset exposures, which present climate change risks.
We estimate that over $29 trillion of cross-border investments among G20 countries are exposed to a significant level of climate change risk, with G7 countries accounting for 80% of the total.
We found that one-third of U.S. international assets (or $8.2 trillion) are exposed to climate risk, followed by the UK, Germany, and Japan.
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As a percentage of GDP, the climate risk exposure of international assets is the largest in the UK and France, which may help explain why these countries have been leading efforts to counteract climate change.
Indeed, the decision by the Bank of England to conduct climate stress tests for financial institutions in 2021 will be another incentive for investors and asset owners to focus more closely on the carbon footprint of their investments and investment portfolio—both domestically and internationally.
Build-up in corporate debt
Looking ahead, rising carbon consciousness will continue to encourage sovereigns and corporates to promote new eco-friendly debt instruments, such as green bonds and green loans.
Strong investor interest in green assets has been particularly evident in green bond markets: our Green Flows Tracker, which uses fund flows as a starting point, suggests that dedicated green bond ETFs attracted some $2 billion of net inflows in Q2—a major jump from the $300 million of inflows recorded in Q1.
LIBOR transition—insurer perspectives:
Despite undeniable progress towards new reference rates ahead of the LIBOR discontinuation, the varying pace of adoption across different financial institutions (and jurisdictions) highlights the complexity of the task.
The UK Financial Conduct Authority (FCA) notes that buy-side firms (insurers and other asset managers) have been experiencing a slower transition and still hold some $870bn in LIBOR-linked bonds that mature past the December 2021 deadline.
Given policy uncertainty and flat yield curves, insurers have been favouring short duration instruments—such as LIBOR-linked floating rate notes—which further underscores the need for a smooth transition.
Insurers may well be waiting for liquidity to develop further before making the switch—including for new derivatives that facilitate hedging.
Nonetheless, the FCA emphasizes the need for faster progress towards transition readiness—i.e., mapping LIBOR exposure (including for hedging) and firm-wide due diligence regarding fall back provisions.
Greater regulatory constraints pose additional challenges for the insurance industry: Solvency II—the regulatory framework for insurers in the EU—still requires the use of a LIBOR-based term structure as the discount rate for insurance obligations.
Since differences between LIBOR and the new reference rates can generate considerable financial discrepancies, holding assets or hedging instruments referencing alternative benchmarks could translate into unwanted balance sheet basis risk.
Hence, market participants are closely following policymakers’ efforts to address the issue: in the U.S., SOFR-based OIS (Overnight Index Swaps) only became a permitted benchmark for hedge accounting this year.
On a more positive note, concerns over benchmark reform have prompted the International Accounting Standards Board (IASB) to consider more flexibility in IFRS 9—a set of reporting standards that will apply to hedge accounting across insurance companies starting in 2022.
Growth in Panda bond issuance
Global insurers are faced with further complications. While LIBOR provided a common standard across-jurisdictions, locally-defined benchmarks make FX risk management more complex—as the frequency of payments, interest convention, and other aspects of cross-currency swaps differ across countries.
To address these concerns, U.S. ARRC—the Alternative Reference Rates Committee—has recently released a preliminary report on Potential Inter dealer Cross-Currency Swap Market Conventions.
Hedging G-20 Bets: Rising tide, but dangerous currents