BlueBay AM: A new Cold War?

March 11, 2022

By Mark Dowding, CIO, BlueBay Asset Management

In the wake of the ongoing Russian onslaught, risk assets traded on the back foot following additional sanctions.

Official measures were compounded by voluntary moves in the private sector. We saw firms pulling out of Russia en-masse at disgust towards Putin and the leadership in the Kremlin, whose war is costing untold lives and human suffering.

This escalation of the economic war saw oil push above USD130 per barrel, before retracing lower thanks to commitments of additional supply coming from the UAE and elsewhere. Meanwhile, a hope that a stalled battlefield advance could lead to a cessation of hostilities also encouraged a temporary mid-week bounce in risk assets.

Sadly, we are inclined to believe that there will be little progress in talks at this stage. As a result, it would appear that the Russian war machine is likely to grind relentlessly forward in the coming weeks, notwithstanding valiant efforts to thwart this. 

We might hope that a popular uprising in Moscow would cause Putin to reconsider, or else be removed from office, yet in all reality this seems very unlikely. Historically speaking, the Russian people have tended to be compliant and accepting of the actions of their leaders, notwithstanding the hardship that may be inflicted upon them.

Against this backdrop, we see commodity prices remaining elevated for an extended period. On the back of recent moves, this may mean a further material leg higher in inflation is yet to come and we would project CPI in the US, EU and UK to hit 9%, 7% and 10% respectively in the coming months.

These moves will subtract from disposable income and cause growth to drop by around 2% in the UK and eurozone and 1% in the US, based on our estimates. However, recession remains unlikely unless oil prices rise substantially more than we have seen up to this point, on the back of further escalation.

Over the medium term, we believe that interest rates and yields will need to rise materially. Indeed, the higher inflation rises and the longer it is elevated, the more we will see inflation expectations de-anchor and second-round effects occur. 

Consequently, this is likely to mean that the path of monetary tightening is largely as we have assumed, but that the peak in the rates cycle will probably need to be higher than earlier envisaged. 

US interest rates rising to 1.5% this year may not do much to tighten conditions and rein in price pressures. As a result, we think that Fed Funds may rise to 3% by the end of 2023 and continue to move higher still in the first half of 2024. 

Nevertheless, in the short term, rate hikes may be fully priced and, given the very uncertain and volatile geopolitical backdrop, it seems less compelling to maintain a strong directional view for the time being. As such, we realised gains on a recent short rates trade that was incepted as rates rallied in the immediate aftermath of the Russian invasion and subsequent sanctions.

In the eurozone, the ECB delivered a more hawkish message than many had been expecting. Playing down growth risks, Lagarde articulated plans to end asset purchases in Q3 and raise rates shortly thereafter. In part, the ECB may consider that its mandate is price stability and therefore it has no choice but to move in a more hawkish direction. Yet a hawkish tone saw eurozone yields underperform during the week and renewed pressure in the periphery impacting spreads.

It is possible that hopes for a ‘Re-Power EU’ fiscal package, as will be championed by Macron to other EU leaders, will help to offset the impact of a tighter monetary stance. However, the mooted size of EUR200 billion seems too small, in our opinion.

Furthermore, EU politics suggests that any agreement around this may take a few weeks to fall into place. Consequently, we think that further pressure on periphery spreads may be likely in the coming days, with markets largely unconvinced that investments from PEPP maturities can act as much of a backstop for spreads.

Risk assets broadly traded weaker over the past week. New credit issuance has required a material spread concession to existing deals, putting pressure on investment grade spreads. Equities have continued to trade with a degree of nervousness, with asset allocators also unnerved to witness bonds and equities sliding in tandem. However, some sovereign credit has shown signs of stabilising after a very soft end to last week.

Generally speaking, it isn’t taking much volume to have a disproportionate impact on prices. Meanwhile, it was confirmed that Russian debt is to be ejected from indices at the end of this month. Prices have now largely been written down to zero and it would seem that Russia is destined to remain in the financial wilderness for a long time to come, unless regime change in Moscow can set the country on an alternative path.

Volatility in FX markets remains more modest. We continue to favour the dollar on a relative basis and found it interesting to witness the slide in the euro in the wake of an ECB meeting, which was more hawkish than most had anticipated. Meanwhile, we also favour commodity-exporting currencies, such as the Aussie dollar and South African rand, relative to energy importers such as India or Turkey.

Looking ahead

We think it will be likely at some point in the next month or so, that the conflict in Ukraine will reach a stalemate. Russia will struggle to impose control in the cities but the Ukrainian population won’t be able to repel the invaders.

At this point, we think we will have moved into a new Cold War context. This will continue to keep risk premia elevated into the medium term, but as the threat to geopolitical stability subsides just a bit, so the focus for financial markets will be back onto the economy and financial fundamentals.

Our assessment is that growth will remain positive thanks to the end of the pandemic, fiscal easing and higher wages stemming from tight labour markets. Runaway inflation is likely to be a dominant concern and it is already interesting to witness what we were phrasing as ‘Bidinflation’ morphing into ‘Putinflation’ as the White House seeks to deflect the blame for runaway price pressures.

Some inflationary pressures will correct on their own as base effects (such as second-hand car price distortions), drop from calculations. However, higher interest rates are going to be needed to bring elevated price pressures back under control before inflation expectations de-anchor too much.

To cite the example of the UK, we are on the way to double-digit inflation at a time when interest rates are at just 0.5%. The Bank of England will have to keep raising rates even if it hurts growth and the housing market. At some point it will be understood that it is better to have a short and shallow recession now than a much deeper one later. Yet such a trade-off is possibly more of a worry for a year or two from now.

In 2022, financial conditions remain stimulative and rates will end the year miles below the level of inflation, hence this is likely to do little to crimp demand.

The road ahead looks to be an increasingly bumpy one for financial markets and volatility could remain elevated. Nevertheless, if we are careful and pick our spots then we should continue to find opportunities both on the long and short side in markets.

Meanwhile, it would be remiss of a Chelsea fan not to comment that the war on Putin and his friends shouldn’t turn into a war to destroy a football club, notwithstanding the desire to dismantle the ‘Roman Empire’. Anyway, we have enjoyed being champions of Europe twice in the past 10 years. Spurs fans know they will never sing that…up the Chels!