BlueBay AM: Markets remain chilled...

30 april 2021

...just like the weather as the UK embarks on an outdoor social life

By Mark Dowding, CIO at BlueBay Asset Management

April has witnessed relatively calm conditions in financial markets and there was little new from this week’s Federal Reserve meeting to change this backdrop. 

Under the current policy framework, the FOMC has communicated that it will be lagging developments in economic data, rather than seeking to pre-empt outcomes. Consequently, it strikes us that there is little relevant information coming from Powell and colleagues for the time being. The principal focus for policymakers is to ensure a recovery in the labour market, as economies rebound from the Covid-induced disruption over the past year. 

Next Friday’s US payrolls report will provide the next update on progress in this respect and, based on an analysis of weekly jobless claims, we would not be surprised to see well over one million jobs added during April as the economy continues to re-open. 

We believe that this should translate into a material drop in the unemployment rate and suggests that the US economy can return to full employment by the end of 2021 on the back of a vigorous economic rebound, which is well ahead of assumed progress in official forecasts.

Data upsides

Positive US economic data is largely discounted in markets. However, we still see scope for upside surprises relative to consensus projections and believe that the April inflation print, which will be released later in May, will also top estimates. Consequently, we believe that the coming months could see a resumption of an upward trend in yields after a retracement in April and we continue to favour short positions with respect to duration. 

We would speculate that the dovish consensus within the FOMC may start to fracture in the coming weeks with more hawkish speakers seeking to trigger a debate on tapering the Fed’s QE purchases. We suspect that this may lead to more intense discussion at the Jackson Hole meetings at the end of the summer, potentially paving the way for the Fed to announce a taper when it revises forecasts at its September meeting. 

We think that tapering itself may commence at the end of this year. Subsequently, a first move-up in interest rates may follow at the end of 2022. 

These projections are based on an upbeat view of the economy with the output gap closing more rapidly than is currently anticipated and for inflation outcomes to also be modestly higher than currently expected. In this context, we see this as broadly consistent with 10-year yields around 2.25% by the end of 2021.

It has also been interesting to observe that US equities continue to record new highs in the wake of stable conditions and upbeat corporate earnings. 

Notwithstanding President Biden outlining progressive-leaning plans for bigger government, higher taxes and greater income redistribution, it seems that stocks have been largely unperturbed. In the period prior to the US elections, there had been a fear that a policy shift in such a liberal direction would be badly received in financial markets, but it seems as if markets are now happy to take this in their stride. 

One wonders whether that may embolden the liberals within the Democrat Party to continue to push this agenda. We would also reflect that, historically, periods when Dems have controlled all branches of the policy executive and have pursued policies running in this direction have tended to be negative for financial asset prices.

Europe

Improving sentiment in Europe has seen Bund yields drift to a 12-month high, even if the ECB continues to absorb all net new issuance. A more ambitious fiscal plan in Italy weighed somewhat on BTPs this week, but inasmuch as this may help lift medium-term growth expectations, we believe that the Draghi administration is largely doing the right thing and that other governments in the EU may also move in this direction.

In the eurozone, disbursements from the recovery fund are expected to grow over the next 2-3 years and we see the ECB winding down its PEPP purchases during 2022. However, the back-loaded nature of stimulus relative to the front-loaded approach that has been adopted in the US may mean that the EU economy continues to lag well behind the states over the next six months or so. 

On this basis, we think it is unlikely to see further underperformance from Bunds relative to Treasuries, as has been the case in April.

Credit update

Declining volatility and upbeat equity markets have continued to support credit markets in recent weeks. However, abundant supply and full valuations mean that movements in spreads are more of a slow grind at this stage. 

At an index level over the past month, US high yield spreads have rallied by 12bps to 341bps over Treasuries, whereas US investment-grade spreads have only rallied by 2bps to 89bps. In Europe, investment-grade spreads have rallied by 6bps to 84bps over the month to-date. 

We retain a modest long-beta stance within corporate credit and continue to favour compression trades, looking for greater proportionate performance from lower-quality names than their higher-quality peers. 

Emerging markets

Meanwhile, April has been a positive month for emerging markets (EM) with indices returning around 2% thanks to lower Treasury yields and a softer dollar. We continue to see value in some EM names but remain very selective on the basis that a resumption of a move upwards in US yields could see the dollar firm and headwinds in the EM asset class return. 

From an FX perspective, a rally in risk assets has seen the dollar continue to slide weaker over the past week. Thematically, we continue to favour FX from a number of Asia exports, including Korea, Taiwan and Thailand.

Looking ahead

We continue to reiterate that economic data holds the key to market direction. Over the past few weeks it has felt like the macro landscape has experienced few surprises to challenge market assumptions and drive price action. 

Ultimately, we believe that it will be strong US data that delivers this catalyst. For example, in the coming month, we would speculate whether the narrative pertaining to the transitory nature of price increases starts to be questioned. It is possible that no single data print in itself will be sufficient to drive markets, but an accumulation of data and accompanying comments could lead to a shift in investor sentiment.

For the time being, we are left waiting for the data. We see increased scope of an equity market reversal from the highs during May and are happy to retain overall beta at relatively modest levels. At the same time, we don’t want to over-pay for portfolio hedges during a period when markets have been tracking sideways.

Over the past few weeks, it feels like most markets have been pretty chilled out, with little new to challenge the status quo from a macro perspective. In terms of chilled, similarly in the UK, we have witnessed several weeks of sunny but unseasonably cold weather, with April 2021 the coldest April in over 60 years. This has proven unfortunate timing when this month has been a period when we are only permitted to socialise outdoors – it’s clear why the UK has never really had a true al-fresco culture! 

Yet just as we know that the weather here will finally warm up, we also know that periods of calm in financial markets will end with a period of renewed volatility. We will be looking towards the data events of May to provide clues that we are moving into a new macro regime.