BlueBay AM: Markets remain in Christmas party mode

December 18, 2020

Mark Dowding, CIO at BlueBay Asset Management, has issued his latest market insights, in which he discusses accommodative policy, ongoing Brexit negotiations and the outlook for 2021. 'Rallying spreads and record highs in US equities keep an upbeat tone in markets as 2020 draws to a close, despite the Covid Grinch damping Christmas cheer as lockdowns resume and infection rates continue to climb.'

A further rise in Covid infections has seen additional restrictions and lockdown measures imposed on both sides of the Atlantic during the past week, with governments and health officials doing their best to pour cold water on any seasonal cheer. A long, tough winter seems to stretch ahead of us in the knowledge that it will take some time before the benefits of vaccinations help to flatten the curve and allow for increased levels of social interaction.

However, this rather sombre tone couldn’t be further from the truth when looking at price action in financial markets. Ongoing policy easing continues to support risk assets, with US stocks making new record highs, credit spreads rallying and Bitcoin breaching USD20,000 for the first time.

As sentiment indicators highlight greed outweighing fear and we see growing evidence of a ‘FOMO’ mindset driving price action, the end of the calendar year marks an interesting point to ask how long the broader market rally will be able to last for.

New year drivers

It strikes us that the two principal market drivers that have been prevalent since the end of October may be set to remain intact for the time being.

Medium-term optimism is supported by hopes that mass vaccinations will enable life to return towards normality in the second half of 2021. With policymakers indicating that they will be deliberately slow to remove accommodation before output gaps have been fully closed, this suggests that there may be a heady period of robust growth and very low interest rates to come, and that this has underpinned allocation flows towards more risk-seeking assets.

Meanwhile, any fear in the short term that Covid infections may worsen, or growth may experience a double dip, seem to be fully countered by the promise of further easing, as and when this may be required.

This effectively conveys the idea that global central banks will operate a ‘put’ under the market in the event of bad news. Since the only avenue to ease monetary policy is via further asset purchases, every time this occurs, it serves to push out the demand curve for financial assets and thereby raises the equilibrium price level.

In this way, recent investor behaviour can be seen as relatively rational in a world where both good news and bad news at large is treated as good news in financial markets.

Themes from 2020

Broadly speaking, this pattern of financial repression and stimulus has been the most important investment theme of 2020, since policymakers effectively vowed to do ‘whatever it takes’ to support economic growth through the Covid crisis.

Divergent trends in the real economy and financial markets have led to discussions of a ‘K’ shaped economic recovery and no doubt the distinction between winners and losers in the past year has been stark. However, history has taught us that such trends cannot persist indefinitely.

In this context, we believe that the key to understanding market direction in the year ahead will be identifying (and hopefully pre-empting) the moment at which the narrative with respect to policy accommodation starts to change.

With the first quarter of the year likely to be challenging with respect to economic data, it seems unlikely there will be a change of tune for at least a few more months. However, as the weather warms, infection rates decline and the rollout of vaccines makes substantial headway, then we could see a surge of optimism in the real economy lead to a moment of self-doubt in financial markets. If economies are healing then it is questionable whether further stimulus will be required.

Although it will seemingly be years until interest rates move higher, the sense that central banks are no longer growing their balance sheets may yet act as a catalyst for markets to start to re-price. In particular, in areas where central-bank buying has caused negative net bond issuance, markets may need to find a new clearing price at which private investors are happy to purchase these securities. In this context, the scope for a retracement may well be governed by the extent to which prices might become over-inflated in the interim.

European divisions

We would also observe that in Europe, there has long been history of the EU responding to crises relatively well and moving to act to enforce solidarity. This is something we have seen over the course of the past year and is likely to persist in the months ahead.

However, once economies look to be getting back on track, we could well see renewed discord between Northern European economies seeking a return toward fiscal discipline in 2022, whereas economies in the South may point to a more expansive fiscal agenda in Washington as evidence that they should be permitted to continue to run large fiscal deficits. This could point to an uptick of intra-euro stress heading towards elections in the year after next.

Meanwhile, in the US itself, the potential wildcard would be if Yellen at the Treasury were to win support for an even more ambitious fiscal boost – as we have highlighted is a possibility in commentaries over the past several weeks.

Clearly, a surprise win for both Democrat candidates at the early January Senate elections in Georgia would throw this into sharp relief even before Biden’s inauguration day. More generally though, we have often experienced in meeting with Washington Senators how the simple promise that there is money that can be spent without a need for this to be repaid through higher taxes, is a very tempting one to put on the table.

Consequently, we are inclined to believe that markets generally underestimate the likelihood that a much more fiscally expansive boom could be possible in the US in the months to come.

In this way, we believe that following a period of disinflation in the real economy, which has brought about inflation in financial asset prices, so it is possible that a move to a more reflationary stance could see inflation ticking higher in the real economy at the expense of a period of disinflation in financial markets.

Market flip-mode

We could see 2021 as a possible mirror image of what we have experienced in the past 12 months. But as always, the key to capitalising on this will lie with timing these shifts. For the time being, we still think there is mileage in recent positions with a constructive tilt towards higher-beta credit and assets in emerging markets, coupled with a short stance on the US dollar.

Newsflow in January is likely to be about as miserable as the weather. Therefore, we could be set for more of the same as we have seen at the end of 2020, with bad news being read as meaning yet more stimulus to come.

In addition, markets often enjoy a seasonal boost at the start of January as investors seek to put cash to work ­– this could help support a further leg to the rally. However, it will be important to keep an eye on valuations and be prepared to sell positions into market strength.

From this point of view, we may see a benign start to the new year, but need to remain vigilant in the knowledge that before the weather gets warmer, it will have been likely necessary to seek shelter in more defensive positioning.

In this context, it would seem possible that more of our risk budget could skew towards short positions in rates markets as we move through the year ahead, with less risk deployed in areas such as credit risk, which has driven the bulk of returns over the past nine months.

Looking ahead

For the last couple of weeks in 2020, we are hopeful that volatility will remain subdued and prevailing trends continue to benefit markets. Ongoing Brexit uncertainty remains a risk, but we continue to believe that a deal is in sight. A growing risk now though, is that this has been left so late in the day, the timetable to ratify this is very short and hence there is plenty of scope for an accident of sorts.

Moreover, as we assess UK prospects into 2021, it looks like the country will endure some further economic underperformance for a period of time and therefore we only see modest short-term upside for the pound, meaning that there is little incentive to maintain a long position there at this time.

In closing, I would extend best wishes for Christmas to all readers of these weekly commentaries. Yes, the Grinch has stolen Christmas, but we must remember that 2020 could have been a whole lot worse (really!). We can now live in the hope that there will be a lot to look forward to later in 2021. All the very best to you all.