BlueBay AM: Getting rid of the rat

BlueBay AM: Getting rid of the rat

February 5, 2021

Equity
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By Mark Dowding, CIO at BlueBay Asset Management.

Could the Chinese New Year bring with it the end of pestilence?

Following last week’s jump, equity market volatility normalised lower over the past week in the wake of erratic movements in the price of GameStop and other heavily shorted stocks. This has enabled risk appetite to rebound against a backdrop of robust US economic data, falling Covid infections and steady progress with respect to vaccinations. 
 
US business sentiment surveys point to ongoing strength in the economy, with signs in the ISM, jobless claims and ADP reports that the outlook for employment has also improved over the past month, following some softness in December. 
 
Meanwhile, the outlook for policy remains accommodative in the wake of the last Federal Reserve meeting and further fiscal stimulus is on its way. This has helped to underpin reflationary hopes, which have seen long-dated Treasury yields climb to their highest levels in nearly 12 months. 
 
Notwithstanding this, the relatively controlled nature of this move thus far has meant that this has not become troubling to risk assets more broadly. We think that this trend may have further to run and maintain a short stance on US rates, looking for 10-year yields at 1.25% during the course of the next several weeks.
 
Higher yields have seen the US dollar continue to outperform versus developed-market currencies, with the greenback breaking below USD1.20 in the past couple of days. In part, this is also a weak euro story, given how eurozone PMIs and growth prospects appear to lag the US, suggesting a return of US growth exceptionalism. 
 
However, more robust growth prospects and higher US yields do have the capacity to continue to support the dollar and although EM currencies have not been impacted by this much over the past week, we doubt they will be immune should this move have further to run. Meanwhile, sterling has continued its recent outperformance as the Bank of England appears to eschew the idea of negative interest rates in the UK. Brexit trade concerns promise to drag on UK prospects, though a robust and growing lead with respect to vaccine roll-outs has boosted UK sentiment, whereas the EU has been in the spotlight for the mess its bureaucratic institutions seem to be making of this…even possibly demonstrating to the doubters that Brexit may not be such a bad idea after all.
 
In other European news
 
Italian politics have been in focus. Following the collapse of the Conte government, Mario Draghi has stepped into the role of prime minister in Italy, receiving a warm market reception. Signor Draghi certainly comes with bags of credibility following his time at the ECB, although we are a little concerned that his character may be better suited to the role of a president rather than a PM. 
 
During his tenure at the ECB, Draghi had a relatively singular leadership style. However, as a prime minister of a government propped up by multiple parties and factions, there will be a need to build consensus and bring others with him. This may stymy some of what Draghi may want to get done and create an environment where clashes could be inevitable. 
 
Furthermore, it is questionable whether financial markets could hold Draghi in higher respect than they already do today and one could imagine that as an inexperienced politician, he may find it difficult to live up to, or exceed, this reputation. 
 
With 10-year BTPs reaching a spread of 100bps versus Germany, we have consequently seen an opportunity to realise gains on a long-standing long position in Italian bonds. Although our base case sees spreads grinding tighter still, the risk/reward in a long position seems more questionable given that political risks have not disappeared and should this government fail, then a relatively material widening in spreads could be a possibility.
 
Tighter eurozone sovereign spreads and declining equity volatility both benefitted corporate bond spreads over the past week. An easing of supply pressure has created a more favourable supply backdrop, with investors still looking to put cash to work. The outlook in emerging market assets was also helped by firmer commodity prices, as oil moved to a 12-month high above USD55 per barrel. Lower issuance volumes also helped spreads to retrace some of their January weakness. However, US dollar strength remained a headwind with respect to local currency assets. 
 
Notwithstanding this, in examples such as India and Turkey, FX continues to trend stronger, while in South Africa an improved budgetary performance has helped the local rates market.
 
Looking ahead
 
After today’s US payrolls report is out of the way, it strikes us that the macro calendar is relatively quiet. There are few significant data events or central bank meetings to drive prices and we don’t expect major new political developments to grab much attention until the debate over fiscal policy comes to the fore as we move towards March.
 
The Reddit retail crowd seem to have dissipated for the time being and, although Covid mutant variants remain an ongoing risk, there is a growing sense that vaccination are progressing and the battle against the virus is slowly being won. All this suggests that volatility may drop further in the days ahead and if so, the trends over the past week may persist for a time longer, at least.
 
We see higher US rates as creating a bigger question mark to this benign narrative and are wary that a move in US yields beyond 1.25% in the coming week or two could lead investors to turn more defensive. In this context, running a portfolio which is long in risk assets and short in rates has some intrinsic appeal at the moment – albeit we need to be cautious that an exogenous risk-off event could see equity and bond yields re-correlate.
 
Notwithstanding this, we are inclined to believe that central banks won’t want yields to rise too far, too soon, for fear of tightening financial conditions prematurely and that verbal intervention may follow in order to reassure markets, should this occur.
 
Swapping pestilence for stability
 
Quieter markets could also coincide with upcoming Chinese New Year celebrations. We will be seeing the back of the ‘Year of the Rat’ (which might seem appropriate given the backdrop of pestilence we have all endured for the past 12 months) and welcoming a new ‘Year of the Ox’, which certainly has a more steady and dependable ring to it. 
 
Although we look for volatility to return in the months to come, as the policy cycle passes its inflection point, for now we think that a quiet period could be no bad thing indeed.

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