BlueBay AM: Vaccine hopes mask virus worries

BlueBay AM: Vaccine hopes mask virus worries

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Mark Dowding, CIO at BlueBay Asset Management

While we wait on drug-trial outcomes, inflation returns as a talking point. Consumer prices remain up for discussion, but it seems we’ll pay to get away…

Risk assets continued to rally over the past week, as optimism for a COVID vaccine gained ground, with constructive newsflow from Modena and the Oxford group following on from upbeat soundings from Pfizer last week. These hopes continue to dominate the concern that the number of infections continues to climb, partly also thanks to mortality rates appearing to moderate as therapeutic treatments improve survival rates.

It appears that the risk of return to a full lockdown seems to be receding in the absence of exponential growth in the virus which could threaten to overwhelm healthcare systems. Ongoing social distancing practices coupled with increased usage of face masks appear to be flattening the trajectory of COVID-19, although the risk of a more material acceleration persists. However, for the time being at least, concerns relating to a second wave seem to be more focused on developments next winter, unless of course, vaccines are ready for deployment by that point.

Negative Europe vs surging Nasdaq

Developments surrounding the virus continue to be a key determinant in terms of the future path of the economy and, in turn, financial markets. Broadly speaking, monthly data have pointed to a more rapid bounce in economic activity during May and June than many may have predicted, as lockdowns were eased.

We believe that in Europe this momentum may carry over into July data; conversely, in the US we believe that a dip is more likely when figures get published next month, marking some divergence in outcomes.

That said, we continue to see US growth prospects as stronger on a relative basis over the medium to longer term. US tech leadership is an important factor in this respect and it is striking to note the performance of the Nasdaq index up 17% year-to-date, while many European bourses continue to nurse double-digit losses.

From this point of view, we may not be surprised to see some continued outperformance of the euro versus the dollar in the short term, especially if there is a positive conclusion to discussions around the European recovery fund in coming days, but we are less inclined to look for a structurally weak dollar and the end of US growth exceptionalism over the medium to long term.

Democratic constraints in the UK

On a relative basis, we also continue to be struck by the underperformance of the UK. A modest bounce of +1.8% in May GDP, following a -20.3% contraction in April, is much weaker than has been seen in other economies.

Although a more sizeable gain is likely in the June figures, there remains a sense that the country has been slow to return to work. Contradictory messages from policymakers have also created confusion and city centres remain largely deserted, with infection rates stuck at levels materially higher than elsewhere on the Continent.

From a cultural standpoint, it may also be notable that in democracies such as the US and UK, which don’t have a history of authoritarianism or external rule, populations tend to be more cynical with respect to policymakers telling them how to behave. This may be one reason why the UK public to-date has been reluctant to adopt the widespread wearing of face masks.

Although this independence and freedom of thought and expression may bring virtues, which can create some competitive advantage in certain areas of life, when it comes to combatting the spread of a virus, it is easy to see how this can become more of a hindrance.

It will be interesting to see if new laws change this, or simply serve to decimate the high street with even fewer individuals bothering to head into shops or return to offices in the weeks ahead.

Going all-in for earnings

The start of earnings season has led to few major surprises to-date. We would not be shocked to see some ‘kitchen-sinking’ in the current round of releases, with companies happy to announce bad news at a time when this is widely anticipated, in the hope that this means that it will be possible to report quarters of sequential strong growth in the period which follows.

Otherwise, with new corporate bond issuance light, there has been a sense that we are drifting towards summer markets with most investors sitting on positions which are quite close to home, reflecting general uncertainty.

In this context, it has been interesting to observe the rally in US stocks at a time when the VIX indicator of expected volatility remains stubbornly high. Of course, this could be explained by some as evidence of complacency in the market, particularly in the retail investment community.

However, it could also be indicative of many institutional investors remaining sceptical of the rally and potentially being underinvested. Depending if one wants to see a glass half empty or half full, there is no shortage of narratives which can seem to validate one’s opinion.

Flirting with YCC

Core government bond yields continue to trade in narrow ranges for the time being, even as other assets rally. It appears that central banks continue to flirt with yield curve control, along with further asset purchases, as the preferred easing tool of choice for the time being, rather than further cuts in interest rates.

The ECB meeting passed without much further comment. Otherwise, attention in Europe has been focused on the EU leaders summit over the next few days. A final agreement with respect to the recovery fund may not yet be concluded this weekend, with discussions also focusing on the coming budget round.

However, we believe that the broad framework will be agreed in principle, with the finer details to be ratified by the end of July. In anticipation of this, we retain a generally constructive view on eurozone assets, both in the periphery and in investment-grade corporate bonds.

The dance of greed & fear

As we look forwards, we feel that over the next few weeks the newsflow with respect to initial vaccine trials could be skewed towards the positive. The economic data calendar will be relatively quiet and, from a policy perspective, we are likely to see further fiscal easing measures in both Europe and the US. In this context, the backdrop may be benign, unless that pace of infection grows more rapidly, to a point where more extreme lockdown steps need to be taken.

However, if markets continue to rally in July, then we could witness a more difficult backdrop in August. By this time, it is possible that the spread of COVID will have steadily increased and economic data in the US may well record a dip based on measures to slow the spread, currently being enacted during July.

In that context, it is easy to see how we may travel from hope to worry and in financial markets, greed could once again give way to fear. Consequently, we are happy to run moderately long risk positions in investment-grade credit and the euro periphery for the time being, noting again that these are the parts of the market which benefit most directly from central bank support, whilst staying more cautious in other areas of the investment universe. However, we are inclined to continue to look for opportunities to realise gains and flatten risk as the summer progresses.

Inflation contemplations

Another topic we find ourselves paying more attention to is the future trajectory of inflation. In the near term, it seems that there is plenty of scope for prices to fall and for inflation to undershoot targets thanks to low energy costs, reductions in sales taxes and shops eager to clear inventory. However, this recession has not just been one in which we have witnessed a shift in the demand curve. The supply curve has also shifted.

Meanwhile, anecdotally speaking, businesses facing increased COVID-related costs are already looking to pass these costs on to end consumers. As and when economies recover, it is yet possible that we will see a return to higher inflation prints, especially with central banks committed to keeping real interest rates in negative territory for a period of time.

At some future point this could leave the long end of yield curves looking materially over-priced and in the UK, 30-year yields at 0.6% may well look rich, given the rising level of government debt and the country’s general tendency to generate inflation more readily than elsewhere on the Continent.

Bursting the London bubble

As a supplemental point, in a country like the UK, it is interesting to contrast the increased level of business in commuter towns outside of London compared to the general sense of emptiness in the capital. We believe that we are witnessing widespread displacement of demand, with coffee shops in the suburbs seeing queues out of the door, as those in the city tout desperately for business. This is causing some such businesses to cut costs and discount, yet others have actually been able to raise prices and grow margins.

London house prices could similarly fall, but those farther from the capital could easily increase as the relative premium in London prices shrinks materially, with more of the population seeing the benefits of working from home.

Also on the topic of inflation, it certainly seemed surprising how expensive it has become to book new flights, when organising a vacation for next week – even though there seems no shortage of seats available. The lack of last-minute deals seemed surprising, yet the urge to get away, may mean that many are happy to pay the going rate without much complaint.