BlueBay AM: Shaping up for a Merry Christmas

December 4, 2020

Mark Dowding, CIO at BlueBay Asset Management, has issued his latest markets insight, in which he focusses on the appointment of Janet Yellen, positive updates on a Coronavirus vaccination and time running out for the Brexit negotiations. 'Shaping up for a Merry Christmas. But will it be a more challenging new year?'

Reflationary themes continued to support markets over the past week. In the absence of major new newsflow, declining volatility has benefited risk assets, lifting US equities to a new record high.

Positive sentiment has seen government bond yields rise somewhat, though the prevailing wisdom remains that central banks will seek to anchor yields as they aim to deliver accommodative financial conditions and create space for fiscal authorities to ease policy and support growth.

Former influence

Against this backdrop, it is interesting to reflect on the role that former Federal Reserve (Fed) Chair Janet Yellen may play at the US Treasury within the incoming Biden Administration. Yellen has a reputation for prudence and is content to lead a relatively modest lifestyle.

In that context, it is potentially quite striking that she may endorse the notion that fiscal policy has scope to remain stimulative over the next several years, with policy easing linked to economic targets. This line of thinking has already gained traction in Australia and has been a growing narrative at the Brookings Institute, where both Yellen and her predecessor at the Fed, Ben Bernanke, have been based over the past several years.

There is a sense that with inflation having trended lower, there is room for an expansive approach seeking to target maximum output. It is possible that this could support Democrat desires to embrace a type of ‘New Deal’. In this way, it may be possible to boost spending without the need to raise taxes, and with a spokesperson with the gravity of Yellen seen supporting this, it is possible that this will hold sway over at least a couple of Republican senators.

Ultimately, with rates as low as they are, interest burdens are very limited and therefore there is little to fear by way of worries with respect to debt sustainability. Of course, were the Dems to surprise and win both seats in Georgia on 5 January, then this narrative may come to the fore even more quickly.

It seems that such an approach would also receive support from the Fed at the current point in time and therefore markets may be underestimating the degree of policy easing that may take place in the years ahead. Over time, this would seem likely to lead to higher yields and a steeper curve.

It is also notable that financial asset price inflation has taken place at a time of broader disinflation in the real economy. Were a more reflationary path to evolve, this may create a much more challenging landscape for financial markets and with Lael Brainard likely to succeed Powell later next year, she may inherit the Chair at a relatively challenging moment in time.

In this sense, we believe that although the landscape remains benign for the time being, it may prove more troubling for market beta as we progress through 2021.

Vaccine news provides a boost

Elsewhere, the UK became the first western country to authorise the deployment of the Pfizer vaccine this week, with deployment set to commence in the next couple of days. Hope with respect to the vaccine continues to buoy prospects for 2021.

The confluence of policy accommodation in the near term, and hope in the medium term, continues to drive financial repression. Credit markets have also been helped by relatively low levels of supply and prospects for reduced net new issuance, after many corporates pre-funded their needs earlier this year. Investment-grade index spreads now stand at identical levels to where they started the year and those looking back in years to come may end up thinking that not very much happened in 2020 – which couldn’t be further from the truth.

For now, we continue to look for spreads to narrow, with technicals seemingly supportive with demand appearing to outstrip supply. However, we believe that it is important to pay attention to valuations and we will look to realise gains in cases where we are reaching our spread targets.

EM local finds a sweet spot

In FX markets, rising risk appetite has seen a trend weaker in the US dollar over the past few weeks, with the DXY dollar index breaking below 92. It appears to us that this trend may have further to run and we have often observed that December can be a month when trending moves in FX markets are more prevalent than is the case at other times of the year.

The euro has outperformed during the recent move, breaching 1.20 and prospectively targeting the highs at 1.25, which it reached in early 2018. Flows into European equities have helped to drive positive euro sentiment, as investors rotate into markets that have lagged the rally seen in the US. At this stage we doubt that the ECB will act to stop euro appreciation, though unwanted FX strength could be a catalyst for a further cut in the deposit rate were this to persist.

That said, with monetary policy already at, or close to, its reversal rate, it isn’t clear that Lagarde or her colleagues can do very much beyond adding to asset purchases at their upcoming meeting.

Emerging markets have also benefited from the reflationary theme, with local markets enjoying a sweet spot as the dollar also trends weaker. Firm Chinese data continue to benefit commodity price. This is helping prospects across exporters.

Covid trends in many emerging markets also remain much subdued at a time when the number of new daily US cases has topped 200,000 in the wake of colder weather and the Thanksgiving holiday.

From a credit perspective, EM index spreads remain materially wider than where they stood at the start of the year, though this is more specific to the higher yielding part of the universe. This mirrors the picture within corporate credit markets, where high yield index spreads remain wider on the year, with much of this relative cheapness located in issuers and sectors which have been more materially impacted by Covid in the past several months.

No-deal nervousness

Elsewhere, Brexit negotiations continue to drag on. It is becoming disappointing that a compromise has not yet been agreed and this must raise the possibility that there is a ‘No Deal’ outcome. However, we continue to believe that compromise is the most likely outcome and that a deal may be imminent.

However, the timeline to ratify any proposals is now getting short and there is a risk that an accident occurs. This could be dangerous if either side believes that its ability to negotiate will be strengthened in the wake of a hiatus at the start of the new year.

Subsequently, we continue to maintain a constructive view on the pound for the time being, but may look to exit this in the week ahead in the absence of greater clarity.

Looking ahead

Today’s payrolls report will be one of the last significant data events prior to the end of the year. The recent ISM survey suggested that the improvement in the jobs market may have stalled in the wake of rising Covid infections, though unless the number released is far from consensus expectations, it seems unlikely to us that this should materially change sentiment within markets.

Meanwhile, next week’s ECB meeting is also eagerly anticipated, yet with ECB speakers giving a consistent message that an addition to the PEPP plus some measures on LTRO are to be expected, it feels as if many of the policy steps have effectively been pre-announced.

In this way, when looking at what may cause volatility to rise and markets to retrace, it seems that a much greater spike in Covid rates could be the most likely candidate.

2021: The year of the Scotch egg?

US infection rates appear to have risen in recent days, yet not to the extent that some had envisaged in the wake of 50 million individuals travelling to meet with family over the Thanksgiving holiday. As long as there is an ongoing flattening of the infection curve, it seems more likely that the focus will now be on the approval and rollout of a vaccine in the US and EU in the days ahead. For the time being, this may continue to underpin hopes into 2021.

It strikes us that the liquidity fueled rally may still have a bit further to run, even though it is increasingly apparent that returns being made today are likely to mean it is going to be a more challenging landscape in 2021. Certainly, a turning of the tide may mean that more focus is on relative value and issuer selection, rather than the top-down-driven beta moves that have characterised the past several months.

Looking at how far markets have travelled this year, it feels like investors have been eating a ‘substantial meal’ in 2020, to quote the phrase that has been coined by British pub drinkers over the past week. Maybe 2021 will resemble more of a ‘Scotch egg’?