BlueBay AM: It isn’t just Spurs fans who need to watch out for nasty surprises

November 22, 2019

By Mark Dowding, CIO at BlueBay Asset Management

Things are looking upbeat now, but the wheels could come crashing off at any moment. We wait patiently for entry points.

Global yields have traded a little lower over the past few days, but broadly speaking bonds and equities have not moved particularly far over the past week. 

Research meetings with US policymakers has added confirmation to our view that the economy is growing at trend, with inflation close to the Federal Reserve’s target and appearing set to remain so for the next several quarters. In our view, the US consumer is in good shape, the service sector of the economy remains robust and housing investment and fiscal spending should be additive to growth in H1 2020. 

At the same time, business investment remains sluggish and there is little evidence of speculative behaviour which could lead inflation pressures to start to build. Unfashionable as it may sound, there is almost a sense that policymakers have hit a sweet spot (as much by luck as design) and it is even possible to project an economy that stays in a Goldilocks zone for the next 10 years – subverting the narrative of the business cycle and mirroring the pattern seen in Australia this millennium.

However, this benign backdrop, which has helped equity markets scale new highs of late, still faces several risks. In this context, we are wary of a reversal should we see year-end cheer build complacency in markets. 

Worries to address

The first risk is trade and the US/China relationship. Our meetings in Washington lead us to believe that an initial trade deal may not be concluded until later in Q1 and this could lead to some market disappointment. Rhetoric in the Senate and Congress continues to move in a direction that is more hawkish towards China – shown by this week’s bill on Hong Kong. This is serving to antagonise Beijing and Xi can’t afford to come across as weak. 

The consensus in the US is that China will allow events in Hong Kong to run their course, as media bans mean that events there have little coverage or relevance for the mainland. This said, it is ever clearer that we are seeing the evolution of a China-US relationship characterised as ‘strategic adversaries’. Many even fret that a new Cold War is likely to be an inevitable direction of travel.

Beyond Hong Kong

On trade, there is also the thought that Beijing won’t trust any deal done now as it expects this to be ripped up after the US election. Consequently, it seems a little surprising that markets are currently happy to look the other way on trade, even as the signs become less promising. 

At least on Europe and Japan, no more tariffs are expected and ratification of USMCA is looking closer – though we would highlight that even if it were to fail, then existing NAFTA provisions will remain intact.

Impeachment indifference

On US politics, it seems like Congress will vote to impeach Trump in the third week of December. In the US nobody sees this as mattering much, with the process going nowhere in the Senate in January/ February.

However, overseas investors could be spooked and with the timeline also coinciding with legislation needed on the continuing resolution to fund the government (which expires 20 December), this could lead to a few bumpy days at a time of very little liquidity. 

Moreover, some may (prematurely) conclude that impeachment makes Trump a less likely 2020 election winner and, as covered previously, should markets price a higher probability on a Warren Presidency, then this could weigh on valuations.

Latam vulnerability increases

Elsewhere, Latin American worries continue to build, with Ecuador the latest country to see a sharp drop in bond prices. There have been a number of negative idiosyncratic stories impacting the region, but given the global landscape has been helped by Federal Reserve cuts and a risk-on sentiment in markets, one does wonder how vulnerable some assets could be in a more adverse global scenario, especially in a region many investors continue to run overweight according to the aggregated observations coming from senior fund allocators. 

In some policy circles there is now fear of Latin America returning to the 1980s, against a backdrop of increasing inequality and social unrest. Hopefully that won’t come to pass – although in Argentina we could see an early debt restructuring, which is materially more penal to investors than many currently are discounting. Should recovery rates surprise to the downside, this could see some reassessment or weak credits if bondholders worry about their subordination to the official sector.

European drama lull

Conversely, the landscape in Europe remains comparatively quiet. Some may talk of the risk that the Italian coalition fails and triggers fresh elections and some chaos associated with a return to La Lega. However, we see this as unlikely, with nothing to incentivise any of the coalition members down this path. 

Elsewhere, the UK election campaign is now in full swing and we are still trying to assess whether there is too much complacency attached to a clear Tory win by way of extrapolation of national polls. When looked at on a seat-by-seat basis, everything seems closer. Although a Johnson majority is the most likely outcome, there is also a sense that investors could be heading into December with a degree of complacency attached to political risks.

Looking ahead

As we enter Thanksgiving week, markets may remain quiet over the next few days. Thereafter, issuance and liquidity are likely to experience a seasonal dip into December.

Generally speaking, we can look at the macro backdrop in a constructive light. We still think too many investors are too bearish on growth and we can see a fairly constructive outlook supported by past fiscal and monetary easing delivering a supportive picture.

That said, we can see some signs of complacency around trade, domestic politics and broader geopolitical issues. In this context, we would rather be buyers on weakness. For example, if markets discount two more rate cuts should there be a short-term flight to quality, then this could be a good moment to get short rates. It could also offer a more compelling moment to lift hedges and increase credit exposure.

However, for now, we think we can be a little patient and wait for entry points into trades which can offer more opportunity. As Tottenham Hotspur fans can identify, it is possible for everything to be looking upbeat one minute, only for the wheels to come crashing off. At least financial markets won’t have to turn to Mourinho if that is the case! No way Jose!