BlueBay AM: UK stag on the run

October 1, 2021

By Mark Dowding, CIO at BlueBay Asset Management

Inflation looks less transitory than expectations, while supply disruptions in the UK are putting pressure on prices.

A building sense that inflation is proving a bit more permanent and a bit less transitory saw global yields continue to rise somewhat over the past week.

Central bankers continue to look for price pressure to ease as supply disruptions abate, but it appears increasingly unlikely that this will occur before the middle of 2022. In the interim, there is a risk that inflation expectations begin to shift higher.

Wages have been moving upwards due to skills shortages in a number of sectors, even if the broader labour market is yet to fully heal. Meanwhile, accommodative fiscal policy and negative real interest rates continue to support demand.

US

In the US economy, we believe the outlook remains constructive over the next few months. With the timeline for the Federal Reserve’s taper now largely in place, we think the focus for the market will move to whether the Federal Open Market Committee decides to raise interest rates in 2022. If so, could this be more than one hike?

In assessing the recent move in the Treasury market, we believe that part of the recent rise in yields is a correction of an undershoot that we saw earlier in quarters two and three.

Market technicals have been bullish thanks to ongoing central-bank purchases. However, as these start to dry up, it appears reasonable to look for yields to rise. After all, quantitative easing was announced with the explicit intent of pushing yields lower in order to deliver accommodative monetary policy to support demand.

Therefore, it stands to reason that once this is removed, so equilibrium yields should be higher than prevailing levels in the absence of this downward distortion. That said, we would be surprised to see markets correct too quickly.

Should yields rise too quickly, then a correction in risk assets may act as a stabiliser on any flight to quality. A deeper risk sell-off appears unlikely to us while yields remain lower than the levels seen earlier in the first quarter of this year.

UK

Higher Treasury yields have pulled global yields higher in sympathy. In the UK, this shift has also been accompanied by a rise in ‘stagflationary’ fears.

UK energy costs continue to jump, with the country something of a hostage to the aggressive move upwards in spot gas prices. Unlike the energy-independent US, the UK is very reliant on energy imports – of gas in particular.

The reopening of economies, coupled with a drive towards reduced carbon emissions, has witnessed strong demand for gas, even before the northern hemisphere moves into its winter months of peak demand.

The upshot of this appears an inevitable jump in consumer fuel bills. Meanwhile, chronic supply‑chain issues are continuing to lead to severe shortages across the UK economy. The past week has seen hour-long queues for petrol, in scenes reminiscent of those sometimes seen in developing countries, with the army called in to help meet the shortfall in tanker drivers.

Labour shortages in a number of sectors have prompted eye-watering pay increases. Empty shelves in shops also stand as a demonstration of UK vulnerability, as Brexit disruptions amplify the Covid supply shock witnessed around the globe.

As a result of these UK developments, we now project CPI inflation to move towards 6% in the months ahead. We also expect slowing growth, as higher bills act as a tax on consumers.

This prompts concerns with respect to the curse of stagflation, with policymakers in Westminster and the Bank of England (BoE) seemingly at a loss as to how they should be reacting to this.

A failure to raise rates may see inflationary expectations move higher. However, moving rates beyond 1% could easily trigger something of a collapse in the UK housing market and push the economy into recession. In this way, policymakers are trapped between a rock and a hard place.

For now, the BoE has given a hawkish narrative with respect to rates, which has led UK yields to underperform. Yet, it has been interesting to see sterling also come under pressure in foreign-exchange (FX) markets, as investors reflect that hiking rates when growth is slowing will rarely benefit a currency.

FX

Elsewhere in FX markets, the US dollar has been solid over the past week, breaking out of its trading range for the past 12 months on the downside. Although stagflation is a threat in an economy such as the UK, the outlook for robust growth and a strong consumer means that the same risks do not seem to exist across the Atlantic.

Dollar strength and softer metals prices weighed on a number of emerging currencies, on prospects for cooling growth in China.

Meanwhile, Chinese FX and rates were broadly stable over the week. Noise around Evergrande has died into the background, notwithstanding the non-payment of its bond coupons, which has pushed the entity towards formal default and debt restructuring.

Markets

Higher global yields have started to weigh on risk assets in the past week, with equities finishing the third quarter on a softer note. With equities – notably tech stocks with high price-to-earnings ratios acting as long-duration assets – a higher discount rate has the potential to de-rail the equity bull market.

However, it may be the speed of any move in rates that is as important as the level of yields, as it pertains towards sentiment for equities and other risk assets. Consequently, a range consolidation could help stabilise markets in the next couple of weeks.

In credit markets, spreads were somewhat softer in sympathy, with higher‑yielding names underperforming on a relative basis. However, volatility in credit markets remains very subdued, with investment-grade spreads tighter on the month, as higher yields were partly absorbed in spreads.

Looking ahead

Looking ahead, markets go into the final quarter interestingly poised. We think that firm data will see US yields continue to rise in the next few months.

Moreover, it would not be too surprising if volatility in rates markets were to lead to volatility elsewhere in financial assets in the months to come as central banks begin to step away from policies that have delivered a form of yield-curve and spread-curve control, even if this wasn’t their stated intention.

In risk assets, the battle between the bulls and the bears may become less one‑sided than it has seemed for the past 18 months. Could it be that the emergence of a stag is the event that could really turn markets on their head?

Reflecting on this, it caught our attention to hear how residents near Liverpool were surprised at the sight of a wild white stag running through their streets earlier this week.

Sadly, this beautiful creature met with a rather unhappy end when police shot the animal – presumably to give them something more useful to do than arresting the protestors blocking the country’s motorway network.

However, one wonders if policymakers will be able to subdue stagflation fears nearly so easily. In the UK, the stag could be ready to run, as the country flirts with a return to the 1970s…