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Thematics Views - July 2020



Tackle the EU fragmentation risks

Brexit: don’t rule out a no-deal exit

BBB-BBs, best investment profile in credit

U.S. Housing Outlook  


July 2020


Juillet 2020


Auteurs 1

Public debt imbalances are a major source of tension in the Eurozone

Tackle the EU fragmentation risks

Covid-19 is a symmetric shock with asymmetric outcomes. Existing imbalances within Europe such as public debt, economic models or vision for the union, turn to cracks and the EU is facing fragmentation risks. However, the EU should be able to get over it as it did with the Global Financial Crisis.

The Conference on the Future of Europe, planned earlier this year, will probably open in September in a very different context than initially thought. Who will chair it and whether or not a new treaty for the union will be at the agenda is still unclear, but what is clear is the need to strengthen both the institutions and the financial architecture of Europe. Indeed the European Union (EU) is suffering from a risk of fragmentation along several lines, which could deeply undermine its ability to deal with the upcoming decade challenges.

Debt & growth fragmentation

More than twenty years since the inception of the euro, northern countries GDP per capita is nearly twice of the south. Monetary union proved to be conducive to economic convergence between 1999 and 2008. However, since the GFC, economic fragmentation has increased, particularly in the Eurozone (EZ) as a result of the sovereign debt crisis. To put it another way, Europe functioned well when «everything was going well», but has shown its shortcomings in times of crisis, especially on the EMU side. As a consequence of economic fragmentation, national debts are increasingly diverging. The decoupling between France and Germany is striking in this respect and shows that fragmentation is not confined to the North/South axis. Since the EZ crisis, the level and management of public debt is the major source of tensions and mistrust among member states. North vs. south public debt imbalances structures the bond market breakdown between core vs. periphery and spread movements incorporate a remainder of convertibility risk, which never fully disappeared.

The covid-19 crisis has amplified the real economic fragmentation of the EZ. By an unfortunate accident of history, it is indeed the countries with the highest debts and/ or which had suffered most economically from the sovereign debt crisis that are the first victims of the current crisis (Italy and Spain). Large deficits post Covid-19 will lead to further divergences between north & south, and subdued real growth in the South will raise a debt sustainability question at some point in time. The ECB’s asset purchase programmes play a key role in avoiding increased financial fragmentation (sovereign debt, corporate debt). Nevertheless, this can only be a temporary fix to a structural problem. Pan- European transfers and national reforms are the only way to deal with these imbalances and thus to strengthen the EZ’s resilience to future shocks. This crisis (like the previous one) shows the shortcomings of EMU’s financial and institutional architecture.

1. Graphique 1


Economic model fragmentation

The second fragmentation risk comes from another factor, which can be summarised as internal vs external dependency and type of economic models. Some countries rely more on external demand than others do. The EZ has an external trade surplus of 7% of GDP(2019 numbers). All EZ countries are showing a surplus (except France…) but several countries have a larger surplus extra Euro-zone such as Germany (6%) or The Netherlands (+11%). This illustrates that the surplus savings of Northern European countries do not come to finance the investment needs of Southern countries. Moreover the northern countries reliance on global trade is greater (autos, industrial goods) than that of the rest of the EU27. Other countries rely more on internal demand particularly those with a stronger service sector like France or Spain1. The Covid-19 crisis has shown that these differences are a source of vulnerability, since a symmetric shock brings asymmetric outcomes. Hence, the European Commission’s “Recovery Fund” proposal to address this issue.

1. Graphique 2

Diverging visions for the union have arisen among and within member states

Vision for the EU

The third fragmentation comes from the national vision for the EU, which is more complex than the traditional federalists vs nationalists dualistic debate. Whereas the EU project was considered, still a decade ago, as a positive way forward in bringing peace and wealth to Europeans, diverging aspirations have arisen among and within member states. It should be remembered that, at the origin of the euro, all EU countries were supposed to join the monetary union. Today the European project has become ambiguous. The Brexit requires a rethinking of objectives beyond the EZ’s economic and financial dimension. European institutions such as the ECB and the ECJ are being challenged by the German Constitutional Court, illustrating a deeper divide on the axis of the political legitimacy of the institutions. In addition, national opinions are keen to maintain a degree of sovereignty over sensitive issues (such as foreign policy and migration policy), which is reflected by the rise of ‘anti-establishment’ parties in national elections. The debate between federalists vs nationalists has changed into globalised elite vs real people. These tensions should not be underestimated as they are at the heart of the Brexit vote.

That said, the difficulties encountered by the British Government with Brexit (and the economic cost associated with it) are a deterrent. It can be observed that the anti-establishment parties (in France and Italy) no longer put an exit from the euro on the agenda. Ironically, Brexit could even open up new prospects for the EU project. Indeed, the Eurozone’s share of EU GDP rose from 72% (EU-28) to 86% EU-27). France and Germany, taken together (which account for more than 50% of the Eurozone’s GDP), are de facto becoming Europe’s new centre of gravity, which could make it easier to set up a “new project”.

The Covid-19 crisis has increased economic fragmentation in the EZ and illustrates once again the need to strengthen the Eurozone’s financial architecture. The debate on risk sharing goes far beyond the debate on fiscal federalism, which northern countries refuse to implement. The crisis illustrates the need to forge “tools” that can absorb asymmetric shocks without putting taxpayers in the north in a position of having to pay off the south’s debts one day. There are many proposals to share risks better. The strengthening of the capital market union, the creation of a common debt instrument, and the revision of the budgetary rules of the Growth and Stability Pact (which have proved too procyclical) are all on the table. But, like any compromise, it will require concessions from the countries that will potentially benefit from transfers in crisis times. Member states will request a ‘right of scrutiny’ of the policies put in place.

Increased imbalances and fragmentation could become irreversible if they are not addressed. The forces in play are more complex than the classic north/south public debt imbalance, as economic models and vision for the EU are two other axis of discord. The Next Generation EU instrument partially deals with those risks but requires more political support in order to help the union moving forward.

1“Countries and regions with economies dependent on client facing services, exports or a high number of small businesses, will be hit much harder than others. And while every Member State has supported its workers and companies as much as possible, not all can do this to the same extent. This creates the risk of an imbalanced recovery, an uneven playing field and widening disparities.” EU Recovery Fund proposal


2. Auteurs

The risk of a “Brexit cliff” at the end of 2020 is real

Brexit: don’t rule out a no-deal exit

The Brexit saga, somewhat overshadowed by the Covid-19 crisis, continues and could return to the spotlight this summer. While rounds of negotiations follow one another without concrete progress, the British refusal to extend the deadline raises the risk of an exit from the Single Market without an agreement at the end of the year. The consequences for sterling and UK equities could be negative. However, it is likely that in the face of the risk of disrupting the economic recovery from the historic recession we are going through, pragmatism will prevail in the end.

The Brexit theme has resurfaced after a few weeks during which all the attention was captured by the Covid-19 epidemic (which contaminated some of the main decision-makers on both sides of the Channel). Negotiations have resumed with new momentum under Prime Minister Boris Johnson in recent days, but with no significant progress as the timetable tightens and tensions rise between the parties.

No progress and no extension

At the time of writing, the United Kingdom refuses to ask for an extension of the transition period beyond the end of 2020 (the deadline for making this request is, in principle, 30 June), as suggested by Michel Barnier, the negotiator for the European Union. Barring an extension, and in the absence of other agreements, the UK, which left the E.U. on 31 January, would suddenly lose its access to the Single Market on 31 December.

On the other hand, the negotiation of a free trade agreement still faces significant differences of opinion. The E.U. wants a comprehensive agreement with a mechanism guaranteeing a level-playing field. The United Kingdom, for its part, intends to give priority to a number of sectors. Above all, the UK rejects any mechanism that would lead to a quasi-automatic adjustment of its legislation with the rules of the Single Market, and to the settlement of disputes by the European Court of Justice. Moreover, British negotiators are challenging the European interpretation of the agreement signed at the end of 2019 on the Irish border, which proved the most diffcult point to resolve to allow the UK to leave the EU. Finally, on sensitive issues such as fishing rights or judicial cooperation some key issues remain unresolved.

The prospects for rapid release are low

Political incentives do not, in fact, play in this direction. On the E.U. side, member states are concerned that the United Kingdom could gain “A la Carte” access to the Single Market and, ultimately, a regime more favourable outside the union than within. On the British side, Boris Johnson, although challenged for his handling of the epidemic, can count on a very strong parliamentary majority that does not force him to reach a quick agreement. Boris Johnson also does not want his mandate to focus solely on negotiating Brexit. In addition, the perception of the economic risks of a no-deal exit at the end of 2020 may have become a worry of secondary importance compared to the immediate damage caused by the epidemic.

2. Graphique 1

Markets may discount the risk way before the year-end deadline

Markets will discount the no deal exit in 2H2020

The risk of a “Brexit cliff” at the end of 2020 is therefore real, with trade between the EU and the UK governed only by WTO clauses. As this deadline approaches, markets may be concerned. Indeed, the economic cost of introducing tariffs and trade frictions (border controls, divergences in standards) could be significant. The perception of that cost could increase in a few months, when the UK economy starts its convalescence, and all the attention is no more grabbed by the immediate GDP collapse due to the pandemic. Moreover, if not fully resolved by this date, the issue of the Northern Irish border could have serious political implications both for the UK (as a physical border could threaten the 1998 peace agreement), and for the EU (as an open border could be a breach in the integrity of the Single Market).

Sterling, which has lost almost 20% against the US dollar since the June 2016 referendum, could fall again (especially against the euro) if the probability of a “no-deal” increases. The market for Gilts (British Treasury Bills), which is mainly driven by domestic investors, is not expected to be impacted, especially as the Bank of England is engaged in a substantial programme of repurchasing crown debt. However, the corporate bond market could be penalised, as could some sectors of the equity market that are strongly intertwined in the Single Market (such as industry and finance). Over the past four years, UK equities have underperformed the world’s major markets (-20% against Europe and -50% relative to the US in USD). As it usually happens with political catalysts, markets will probably discount the risk exists way before the year-end deadline, and then move in the opposite direction postevent. Therefore, the downside risk on UK risk assets could be concentrated a 2H2020 topic rather than a 2021.

2. Graphique 2

Eventually pragmatism should prevail

It remains possible, however, that the growing perception of these risks will lead policymakers to narrow their differences and keep trade from being based solely on WTO rules. Despite all the obstacles, the conclusion of a limited free trade agreement is not entirely impossible (remember that the initial situation is that of regulatory alignment, which is not the case in negotiations with third countries). Temporary sectorial measures to mitigate the trade shock could still be concluded. The 2019 negotiations showed that Johnson may be more pragmatic at the end of the race than his tone would suggest.

In any case, it is unlikely that this new episode of the Brexit saga will end for several months. An agreement, if any, must, in theory, be secured by this autumn to leave enough time for its approval by national and European bodies. While it could still end favourably, this soap opera, whose first episode dates back to 2016, certainly has new twists in store for us.

Finalised on 18/06/2020

Auteurs 3

We are not even thinking about thinking raising rates (Powell, June 2020)

BBB-BBs, best investment profile in credit

In an environment of low growth, low interest rates and rising default rates, investment grade and BB-rated issuers remain the ideal segment for investing. (1) The major central banks will support directly these issuers for an extended period through their asset purchase programmes. (2) Investor demand will remain strong, driven by a need for yield in a low interest rate environment. (3) The probability of default of these issuers remains very low.

A slow recovery underpinned by unprecedented coordination between fiscal policy and monetary policy

The shock caused by the Covid-19 crisis is unprecedented in scale. The lockdown measures that helped to save lives have also led to a significant and rapid decline in global economic activity. The OECD and the World Bank recently announced there would be a decline in global GDP in 2020 of 5-6%. In parallel, the responses to the crisis by the various governments and central banks were also unprecedented in scale and rapidity. The governments that initially put in place support measures to help companies maintain their operating capacity and to prevent households from losing too much income, are now putting in place stimulus measures. The crisis has brought government deficits to historically high levels. In the US, the CBO estimates that the federal deficit will reach $3,700 billion in 2020 and $2,100 billion in 2021, representing around 18% and 10% respectively of GDP. The European Commission estimates that the public deficit in the Eurozone will reach around one trillion euros in 2020, equal to 8.5% of GDP. All of these estimates are likely to be revised upward over the coming months.

We will continue to see low interest rates over the next few quarters. In our view, this massive supply of sovereign debt is not likely to give rise to a significant increase in interest rates. The major central banks are purchasing assets at an unprecedented rate and absorbing governments’ new financing needs.

  • The ECB increased the amount of its pandemic emergency purchase programme (PEPP) by €600 billion to €1,350 billion and has extended it until the end of June 2021 at least.
  • At its last meeting in March, the Fed announced unlimited purchases of Treasuries and MBS. Federal Reserve Chairman Jerome Powell specified that the pace of purchases would be at least $ 120bn per month with $80bn of Treasuries and $40bn of Mortgage Backed Securities.
3. Graphique 1


We believe that economic activity will not return to pre-crisis levels before 2022. There are clear objectives behind the coordinated central bank and government action: (1) limit the decrease in activity, (2) avoid massive company defaults, and (3) prevent a sharp increase in unemployment. A sharp increase in unemployment and company defaults would cause a depression and not just a temporary weakening of our economies. For this reason, the support measures for companies are a central element of the stimulus measures and the credit markets have become a central tool in the monetary policy of the major central banks.

The central banks have taken substantial measures to improve financing conditions

The impact of the Covid-19 crisis on the credit markets has been remarkable. Spreads have widened, especially on the US market. Spread curves have flattened significantly or even inverted. Activity on the primary market has slowed considerably. This hardening of financing conditions and the lack of liquidity would have had second-round effects on economic activity without CBs.

Strong central bank support will benefit BBB-BBs

3. Graphique 2


The central banks took substantial measures to improve financing conditions on the credit markets. 

Progress were rapid.

  • Spreads tightened, particularly on shorter maturities.
  • The markets benefited again from inflows as investor demand was underpinned by the central banks’ engagement.
  • Activity on the primary market for investment grade issues reached record levels in the US and Europe. Volumes on the US IG primary market have already reached one trillion dollars in 2020, equivalent to the total full-year issuance seen in 2019.
  • Activity on the high yield market resumed in the US following the Fed’s decision to expand its support to investment grade securities that dropped into high yield (fallen angels) due to the crisis.
  • Companies used the funds raised to strengthen their balance sheets and raised their cash holdings
3. Graphique 3



Default rates are expected to increase over the next few quarters

It is difficult at this point to assess the impact of the crisis on the solvency of companies. There continues to be easy access to liquidity for most issuers: stateguaranteed loans, use of existing credit lines or deferral of maturities. This is a sharp contrast with the great financial crisis when banks withheld credit to protect their balance sheets exacerbating the downturn. Banks are better capitalized and benefit from the strong support of central banks than during the great financial crisis. Otherwise, the ECB long-term refinancing operation was a success: banks borrowed a record of 1.31 trillion euros from the ECB. Banks will use about €760bn of ultra-cheap loans to repay earlier ECB loans and will use the €549bn remaining to lend to corporates and to buy bonds issued by their own governments.

It is important that we make a distinction between companies in difficulty whose situation will normalize and those whose situation will continue to deteriorate. When the state-guaranteed measures run out, companies with very high debt and low capacity to generate profit will be in trouble. It should be noted that many companies already had high debt before the Covid-19 crisis, and companies that borrow to maintain their production capacity are simply increasing their debt.

Moreover, an increase in nonperforming loans could cause banks to tighten their financial conditions. In this scenario, companies would not benefit from increased bank liquidity which would give rise to an increase in surplus reserves.

Default rates are on the rise

We anticipate an increase in defaults over the next few quarters. The company default profile could spread out over time and differ from the peak seen in 2008. This would see companies not going into default due to a lack of liquidity but rather due to a lack of profitability in relation to high debt levels.

3. Graphique 4

In this context, investment grade and BB-rated issuers remain the ideal strategy in an environment of low growth, low interest rates and rising default rates.

  1. The major central banks will support these issuers for an extended period through their asset purchase programmes. These companies will be favoured to bolster the recovery and limit an increase in unemployment.
  2. Investor demand will continue to be driven by a need for returns in an environment of low interest rates. The coordination of fiscal and monetary policies should help to avoid an increase in bond yields.
  3. The probability of default of these issuers remains very low. Companies have used the funds raised to shore up their balance sheets.

Finalised on 22/06/2020

4. Auteur


Many investors are using the Global
Financial Crisis as a stress test for what may come in the years ahead

U.S. Housing Outlook

Why We Don’t Expect a Collapse in Home Prices

With median incomes expected to decline, we expect modest declines in home prices in 2020. The base case scenario for home prices has deteriorated. Of greater importance, in our view, is that the stress scenario of substantial home price declines remains remote. A retrospective analysis of the 2008 Global Financial Crisis suggests that home prices are unlikely to decline substantially, because the conditions that led to the crisis were unique and in most cases the opposite of the current environment.

In a few short weeks, the public policy response to COVID-19 has drastically changed the economic outlook. Faced with the prospect of double-digit unemployment, many investors are using the Global Financial Crisis (GFC) as a stress test for what may come in the years ahead. While this is an instructive exercise, the applicability of the GFC’s headline numbers to today’s housing market is limited by the drastic differences between today’s housing market and the one that led to the GFC. Rather, by dissecting the drivers of home prices, one can form more realistic expectations and sensitivities around those expectations. We currently forecast modest single-digit home price declines in the coming years, and we maintain our focus on median income as the most important driver of home prices going forward.

What causes home price changes?

Though they are intertwined, it is helpful to separate the drivers of changes in home prices into four categories:

  1. Affordability Correction
  2. Supply Surplus
  3. Distressed Selling
  4. Declining Income

Affordability correction

Affordability is destiny for home prices. Historically, homeowners have been willing to spend roughly one-third of their monthly after-tax income on housing. This is captured in the chart below, where we compare the “market value” (median home sale price) with an estimate of “fair value”. We estimate fair value by calculating the home price that is affordable to the median income household spending 30% of its after-tax income on a home using traditional financing (a 20% down payment and conforming mortgage rates). In the years immediately before the GFC, the chart shows that the long term relationship between market value and fair value broke down, with market prices skyrocketing amidst a debt-fuelled speculative bubble. When the bubble popped, prices overcorrected to the downside. In the roughly eight years since home prices bottomed out, we have seen home prices recover, but not enough to reach fair value. Because the housing market entered into the current recession with broadly affordable home prices, we do not expect a correction as we witnessed during the GFC.

4. Graphique 1

While housing demand decreases as unemployment and uncertainty spike, a new equilibrium could largely be me  through quantity rather than price

Supply surplus

Every year, new homes are built in order to satisfy the incremental demand from the new households that are being formed. In the near term, home prices fluctuate to balance housing supply and housing demand. In the years immediately before the GFC, spurred by an errant price signal, home builders rushed to add supply, only to see housing demand plummet at the onset of the crisis. The subsequent surplus exacerbated price declines. Since then, single-family housing starts (new construction) have yet to recover to a rate that matches long-term household formation rates. As a result, the housing market entered the current crisis with the lowest inventory levels in decades. In our view, there are two implications for home prices going forward. First, entering the current crisis from a position of shortage rather than surplus could insulate the housing market from drastic home price declines. Second, while housing demand decreases as unemployment and uncertainty spike, a new equilibrium could largely be met through quantity rather than price, as new home construction will decline far more than prices.

4. Graphique 2

Housing is a real asset whose price
has tended to fluctuate with incomes

Distressed selling

During the GFC, distressed housing supply skyrocketed, creating a feedback loop that furthered home price declines. Millions of newly unemployed homeowners elected to quit making payments when overly optimistic pre-crisis appraisals left them with no equity to defend in their homes. Millions more experienced financial distress despite stable employment when the short-term “teaser rates” expired on their mortgages, causing their monthly payments to become unaffordable. Before foreclosure moratoriums were announced in 2010, distressed sales had climbed from 6-8% to above 40% of all home sales. (Source: Attom Data Solutions, 1/31/2017)

Distressed sales tend to trade at a discount to non-distressed sales, because the buyer has pricing power. The transactions are often cash-only, and in many cases prospective buyers have been unable to conduct an internal inspection. Historically, distressed home sales have tended to drag all prices lower, due to the ‘substitution effect’. Though distressed sales are expected to rise in the current crisis, we do not forecast anything near the magnitude seen during the GFC, because of the lessons learned during that crisis. We expect the impact of distressed sales on aggregate home prices to be limited because the supply will be limited as a result of better underwriting, appraisals, mortgage products and loss mitigation procedures that prioritize modifications over foreclosures. Additionally, for the minority of mortgage delinquencies that are ultimately resolved via liquidation, the foreclosure process will take even longer subsequent to the forbearance programs that have been announced. By the time distressed housing supply arrives, we expect aggregate incomes will already be in recovery mode.

4. Graphique 3

We assign low probabilities to
scenarios that mirror the home price experience witnessed during the GFC

Declining income

Housing is a real asset whose price has tended to fluctuate with incomes. With incomes expected to decline, home prices should be expected to decline as well. This is the one factor affecting home prices that overlaps with the experience of the GFC. In fact, we believe unemployment could climb more rapidly during the current recession compared to prior recessions. That said, we believe the focus for home prices belongs on income, due to the long-term and intuitive relationship between home prices and income, and because unemployment has historically been an imperfect proxy for income. Unemployment statistics are distorted by underemployed and discouraged workers, and there is a mismatch between the employment trends across the broad labour market versus the subset of the labour market that comprises current and potential homeowners. Finally, in the current recession, we note that the unprecedented income stabilization programs from the federal government should alter the historic relationship between unemployment and income.

Like many investors, we have leaned upon the lessons from the GFC to inform our expectations for the current crisis. Given the aforementioned differences between the GFC and today’s crisis, we assign low probabilities to scenarios that mirror the home price experience witnessed during the GFC. We note that in the three recessions since the 1980s, the only one in which housing declined in the aggregate was the recession that housing itself caused.

Where Do We Go From Here?

We expect home prices to follow the broader economy lower, with modest single-digit declines in the coming year, followed by a recovery in home prices alongside an expected recovery in income and employment. In terms of supply and demand for housing, equilibrium should be reached largely through quantity rather than price. We expect extensive mortgage forbearance and modification programs to take place prior to lenders resorting to foreclosures and short-sales. With Fannie Mae and Freddie Mac having already announced up to twelve months of forbearance for borrowers experiencing hardship, and with typical liquidation timelines in the range of 12 to 24 months for borrowers who are unable to recover, we expect several years to pass before distressed supply meaningfully arrives, at which point incomes will have already begun to recover.


What Could Go Wrong?

The rate of unemployment has spiked following the lockdowns on economic activity and could reach 20%, but we believe it should begin to decline after social distancing measures are relaxed and the economy begins to reopen. It could take several years for income and employment to fully recover, and the exact timing and path remains highly uncertain. A prolonged second or third wave of infection could set back the recovery, as could delays in the arrival of longer-term treatments against the virus. Additionally, the economic recovery is partially predicated on the effectiveness of fiscal and monetary policy. Should these prove to be insufficient or ineffective, median home prices will follow median incomes lower. Finally, we note that real estate is local. Home prices in the aggregate should not determine the outcome for all geographies and all price points.

4. Graphique 4

Any improvement to the macroeconomic environment should translate into marginally higher home prices through marginally higher incomes and a return to a market characterized by a housing shortage

What Could Go Right?

We entered into this crisis with the expectation that home price gains would modestly outpace inflation, but with risk to the upside due to the tight housing supply situation. We believe any improvement to the macroeconomic environment should translate into marginally higher home prices through marginally higher incomes and a return to a market characterized by a housing shortage. In addition, interest rates provide an upside scenario, even in less benign environments. Mortgage rates are currently near all-time lows, and yet mortgage rates are at their widest levels versus Treasury yields since the 1980s (with the notable exception of the three months immediately after the failure of Lehman Brothers in 2008). Today’s record-low mortgage rates already provide a tailwind for home prices, but to the extent that the spread between mortgage rates and Treasury yields normalizes to historically normal levels, we believe this tailwind will only grow stronger.

Finalised on 17/06/2020

BLANCHET Pierre , Head of Investment Intelligence
BOROWSKI Didier , Head of Global Views
PERRIER Tristan , Global Views Analyst
AINOUZ Valentine , Deputy Head of Developed Markets Strategy Research
BELLAÏCHE Mickael , Fixed Income and Credit Research Strategist
FUNDERBURK Noah , US portfolio manager
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Thematics Views - July 2020
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