BlueBay AM: Summer of solidarity

July 24, 2020

Global risk assets continued their climb higher over the past week, buoyed by positive momentum on policy, corporate earnings and vaccine developments. Europe took centre stage as leaders announced an agreement on the next multi-financial framework (MFF) and recovery fund after a marathon EU council summit.

On the recovery element of the package, the headline figure of EUR750bn was maintained, EUR390 of which would be disbursed in the form of grants over the coming years.

This was slightly lower than the initial proposal of EUR500bn, but it was expected that negotiations would be fraught and eventually lead to some ‘middle ground’, given opposition from frugal nations. In the end, the compromise left both sides satisfied: Germany, France, Italy and Spain managed to keep the key elements of the ambitious proposals (such as the Recovery and Resilience Facility), and the frugals managed to gain the necessary concessions on grants, rebates and governance to appease their domestic audience. On the finer details of the agreement, there were also numerous positives.

The deal agreed will see an increase in resource commitments front-loaded into the first two years. The EU budget aside from the recovery programme also increased significantly (compensating for the lower size in grants) – this is worth highlighting because the budget after Brexit should have been substantially lower.

On the programme financing side, this will be conducted through a combination of EU debt issuance and the introduction of new green/digital taxes (non-recycled plastic bags waste, a carbon-adjustment mechanism and digital levy).

European markets reacted positively on the news, with periphery and corporate spreads gapping tighter. However, you could argue the agreement itself wasn’t a major surprise as negotiations were expected to be long-winded and it was just a case of timing and ironing out the details. This has been in the works ever since Merkel and Macron put forward the initial proposals of the recovery fund in a virtual press conference in May – the unity and scale of ambition between the EU’s two big hitters meant there was no going back.

Ultimately, this is a bold statement of solidarity from all EU members and opens up possibilities for further economic integration down the line.

US labour market tussles against the R-rate

Whilst the stars have aligned for the eurozone, the same can’t quite be said for the US.

On the corona front, rising cases in various states have been accompanied by further local shutdowns, which continue to pose a threat to any prospect of a V-shaped recovery.

For this reason, we continue to look for data divergence in the coming weeks to materialise with the US showing a dip in July data when published in August. Despite US infection rates climbing, the reality of the matter is that the all-important reproduction (R) number is slowly falling closer to 1 (much lower than March) and pointing to a peak in cases soon.

Critically, the death rate is also slowing significantly, with widespread testing one of the key factors for why the death rate has remained so stagnant.

To us, the bigger risk to the US recovery stems from the uncertainty about the labour market, which we think is highly unlikely to return to levels we have seen pre-crisis anytime soon. For this reason, we believe it is even more critical for US Congress to negotiate a new economic relief package over the coming weeks to support the economy.

Whilst the initial Democrat and Republican proposals diverged regarding sizing and details, we are confident compromises will be made and a relief package eventually calibrated.

However, with market expectations of a USD1 trillion package as base case, we think there could be some room for disappointment in terms of scale. Fresh Sino-U.S. tensions also weighed on sentiment in the past week, as the US ordered China’s Houston consulate to close to protect American intellectual property.

For now, we view recent escalations more as further tit-for-tat behaviour rather than substantive action, but equally we do not expect this rhetoric to go away any time soon into the upcoming US election.

We continue to believe Trump remains vocal in emphasising national interests to appease his domestic supporter base. That being said, however, he will not want to jeopardise the phase-one deal as a mark of one of his key trade wins in his first term and which is crucial for risk sentiment in US equity markets.

Second-quarter silver linings

Corporate earnings season also continued to rev-up over the past week, with 2Q results generally showing better-than-expected EPS growth, albeit versus depressed consensus estimates.

Given that the second quarter captured the full impact of lockdowns, the silver lining for many corporates has been the fact that the low bar of market expectations has been easier to beat, especially as analyst expectations trailed macroeconomic data surprises in the last few weeks of the quarter.

Despite these beats, the key for markets continues to be in the forward guidance as a potential bottom-up indicator of the timing and pace of any broader economic recovery.

Investor sentiment was also boosted by positive vaccine developments as three vaccine hopefuls demonstrated robust immune responses in early-stage human trials.

More importantly and for the broader market, it should be taken positively that all three vaccines demonstrated adequate safety, a good degree of efficacy and are targeting emergency use authorisation in the autumn. After all, vaccinating populations to ‘herd immunity’ levels will require more than just one candidate.

Against this positive vaccine backdrop however, society will still need to continue to accept and live with the coronavirus as part of the norm, with any second-wave restrictions taking place more at a community than national level, so as to minimise any adverse economic impacts.

Looking ahead

Financial markets finely feel balanced to us here in the second half of 2020, with risks rising but overall risk positioning still very low. On one hand, the naysayers will point to persistent fears of a second wave of infections, upcoming US elections, rising US-China tensions, an uneven global recovery backdrop and low summer liquidity conditions as a reason for caution.

On the flipside, unprecedented policy action (both monetary and fiscal), positive vaccine developments and a general sense of light investor positioning are all supportive factors for risk assets.

Our strongest conviction continues to be in policy proxies, such as investment grade and sovereign credit, given these areas are being directly targeted by central banks and benefit from bond scarcity.

In the next few weeks as we embark upon the quiet of summer and as volatility subsides, it is plausible to us that risk assets can continue their grind higher, but as valuations become less compelling, our mindset is to monetise profits and reduce the extent of our long positioning in anticipation of volatility potentially picking up after the summer lull.

What is without doubt, however, as witnessed this week in Europe (and throughout 2020), is the solidarity, ambition and resolve that politicians and policymakers have shown in their common goal of overcoming the unprecedented destruction inflicted by the COVID-19 crisis.

Whilst the economic power of monetary/fiscal policy actions year-to-date have also been unprecedented, the message of global solidarity and unity to overcome a common crisis almost eclipses this.

For Europe, the summer of 2020 will go down in history as a pivotal moment, a rubicon having been crossed with the agreement of the EU’s first-ever genuine counter-cyclical fiscal tool. The very notion of EU fiscal transfer would have seemed unthinkable prior to the pandemic, but as with any crisis there needs to come a response.

Over the past week, European member states have demonstrated solidarity and a desire to rise above the crisis, cementing the fact that the European project is in fact a community of common values with a common destiny.