BlueBay AM: Having fun until the Game Stop(s)

BlueBay AM: Having fun until the Game Stop(s)

January 29, 2021

Equity
Beursvloer (02)

By Mark Dowding, CIO at BlueBay Asset Management.

As retail investors bump up small caps, Covid infection rates stabilise and the IMF revises up its 2021 growth forecast.

Markets have traded with a risk-off tone over the past week. On the face of it, it might be tempting to point a finger at negative news with respect to the virus, disappointment at economic data or the outcome of the Federal Reserve meeting; however, it is questionable that this is the case.
   
This week’s FOMC meeting saw Powell tread a relatively dovish line, carefully avoiding any taper talk, whereas ECB comments flagged the idea of additional policy easing through lower interest rates on fears that a strong currency could be harming growth prospects. 
    
US data remains relatively upbeat and although there are some concerns with respect to the first quarter, it was noteworthy to see the IMF revise upwards its 2021 growth forecasts – largely on the back of greater US strength. 
    
Meanwhile, Covid infection rates in many countries were relatively stable; in the US and UK it appears that solid progress is being made with respect to the programme of vaccinations. In the EU, the programme is lagging – largely it seems because of bureaucratic bungling, which meant that the EU has been slow to place vaccine orders and approve drugs for use. 
   
More virulent Covid variants have also seen an intensification of lockdown measures in Europe, feeding the sense of malaise, yet price action in markets over the past several days seems to be impacted by completely different forces altogether.
   
Price action phenomenon
   
Notably, it seems that a retracement in equities is in some part due to a reduction in hedge fund leverage as investors assess the impact of price action in stocks such as GameStop over the past several weeks.
   
This phenomenon has seen large groups of retail investors buying struggling small-cap stocks, which hedge fund investors have been shorting. Rather than following the traditional rules of investing, it might appear that the intent has been to drive prices higher in the hope that short positions will be squeezed, creating large hedge fund losses in the process and corresponding gains for the little guys at their expense. 
   
Hedge funds may cry foul at these robin-hood inspired tactics, but recent success on the part of these investors seems destined to lead those exposed to unlimited losses (by being short of ‘right-tailed’ risk) to question the viability of their investment strategies. Thus, a need to reduce leverage and close out shorts has had a wider market impact in recent days – even if it is hard to see significant implications for markets in totality. After all, there always have been and always will be bubbles in financial markets and people who are eager to get rich quick – there is nothing new here. 
 
If such behaviour comes to characterise wider market behaviour leading risk premia to disappear, then this could pose a greater threat to financial stability, which central banks may need to react to. However, with indicators such as the second Vix contract pricing forward volatility greater than 30, it would seem that there is healthy scepticism in markets and an instinctive desire to protect downside, which runs counter to any notion that greed is suddenly out of control.
 
Moving in the right direction
 
Recent market moves have seen Treasury yields dip lower in recent days. With 10-year notes falling to 1%, we have re-incepted a short-duration stance, looking for yields to move higher in the weeks and months to come. Ultimately, we believe that the US economy is moving in the right direction and although the Fed will likely contain any move up in yields in the middle of the pandemic, as conditions improve in coming months, we can envisage seeing 10-year Treasury yields above 1.5% later in the year. 
 
In addition, we are inclined to think that any risk-off sentiment which could pull yields lower will ultimately be met by more stimulus, which would subsequently reverse the trend. Hence, we would be inclined to add to a US short in rates should yields rally further.
 
Conversely, we continue to see European yields trading in a narrow range for some months to come as the region continues to underperform.
 
Credit market update
 
The past month has seen relatively heavy issuance in both corporate and sovereign bonds. Notwithstanding investors putting cash to work and healthy participation in the primary market, supply has weighed on spreads with corporate indices unchanged over the month and somewhat wider in emerging markets overall. 
 
Ultimately, we think the biggest risk to spreads could occur when central banks decide to desist from policies of accommodation, causing yields to rise. However, we think that a more substantive move higher in US yields is only likely in a few months’ time – as post-pandemic normalisation meets fiscal stimulus over the warmer summer months.
 
From this perspective, we are also inclined to think that a short rates position can act as a portfolio hedge to long credit risk. The danger to this would be an exogenous risk-off outcome – such as vaccines proving unsuccessful in the general population and this feeding a generic loss of confidence. However, this thankfully seems like a remote tail risk for now and even if it were to occur, we are inclined to think policymakers will be quick to act, lest the real economy suffer even more.
 
Elsewhere, dollar strength in FX markets has accompanied the risk-off tone in recent days. We have a broadly neutral view on the dollar in 2021 after witnessing trend depreciation in the greenback in 2020. 
 
A return of US growth exceptionalism and rising rate differentials could be dollar-supportive later in the year, as and when US yields rise further. However, in the near term we would be surprised to see any lasting dollar strength on a move down in US yields.
 
For now, we are more inclined to add FX risk versus the dollar, even as we add to short rates positions. That said, we continue to favour more of a relative-value mindset in FX for the time being.
 
Looking ahead
 
With central bank meetings behind us and major political events out of the way for the time being, it is tempting to think that we could witness a quiet month ahead and calm conditions. However, events in equity markets in the past few days serve to show how there may continue to be catalysts that drive volatility in the days ahead.
 
We can only think dispersion will grow further as and when central banks move towards tapering their accommodation later in the year. It also reinforces how technical forces can completely dominate over fundamentals and valuations, for a time at least. In many respects, GameStop would appear to represent a failed business that has lost money in four out of the past five years, yet by Thursday morning this week, its stock price has inflated by 30x its level from just three weeks ago.
 
Thankfully in fixed income, we don’t need to worry about right-tailed distributions and unlimited losses on our shorts as – in the worst case – a bond will pay back at par.
 
However, it might appear that long/short equity investors may need to rethink their investment process to take account of recent developments. Yet the power of technicals is plain for all to see and understanding the interaction between those seeking to buy and to sell will continue to be an important consideration. 
 
As for GameStop, there are likely be many who cry foul at practices of collusion and market manipulation. However, with central banks widely perceived as having spent the past decade bailing-out banks and making wealthy investors rich at the expense of the little guy, it would be a brave policymaker who wants to intervene at this point. 
 
Ultimately, it may be better to let this bubble – as with all others – run its natural course and hopefully serve as a warning to others in times to come. 
 
When the fun stops, the game will stop

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