BlueBay AM: 'It’s all getting a bit hairy'

11 oktober 2019

By Mark Dowding, CIO at BlueBay AM

Problems become harder to mask as Hong Kong, Turkey and Ecuador cause more geopolitical uncertainty.

As investors wait for the upcoming trade summit between the US and China, sentiment in financial markets has appeared somewhat fragile against a challenging political backdrop.

This week’s imposition of a blacklist on Chinese technology companies and visa bans on officials linked to a crackdown on Muslim minorities is unlikely to help the tone of negotiations, with the risk being a break-down in talks. Should this occur, we would see previously announced tariff extensions coming into effect in the next few weeks.

Markets have broadly expected these additional tariffs to be deferred on the basis of a ‘skinny deal’ linked to increased agricultural imports. However, the risk is that that the US and China are moving in different directions, with Beijing increasingly viewed as a ‘strategic adversary’ in Washington circles.

Rising political uncertainty

Meanwhile, markets have also been somewhat unnerved by the moves towards impeaching President Trump, which has witnessed increasing levels of acrimony across the Republican / Democrat divide.

Rising political uncertainty at a time when data trends have been softer has appeared to sap confidence and so it has not been too surprising to see equity indices trading lower with credit spreads moving wider. Treasury yields have traded lower, with a 25bps FOMC rate cut now widely expected at the end of October.

However, underlying strength in the US domestic economy continues to make it likely that the Fed will want to pause after delivering a cumulative 75bps of cuts, as long as it continues to view current moves through the lens of a mid-cycle adjustment; something which continues to be the case – even if these are not words that Powell will want to use publicly, having been criticised for the use of this phrase earlier in the summer.

Total easing moves of 75bps were seen in both the 1995 cycle and 1998, with rates subsequently moving higher in the years thereafter. Consequently, conventional wisdom runs that if the Fed needs to cut on more than one more occasion, then it will be because of a more definitive slowing in the economy. In this case, rates could well be headed all the way back to 0%. 

We see this latter scenario as unlikely, as we doubt that downside risks will materialise. An escalation in the trade war will be a risk that needs to be watched closely, but if a ceasefire of sorts can be achieved, then we think that sentiment data may then start to improve in the absence of no additional bad new news.

European supply drives some consolidation

The eurozone economy remains very cyclical and so the outcome of trade talks could have a significant bearing on the macro outlook in the region.

For now, the German government continues to eschew the need for fiscal easing – even if it looks like they are holding back an inevitable turning in the tide, which is sure to come. Otherwise there are few signs of weakness in the labour markets in Europe, which would presage the onset of a recession.

Consequently, it seems that there is some sense of stability within an outlook where manufacturing is exceptionally weak but services and domestic demand are relatively healthy. Growth rates remain low and monetary policy is seemingly unable to affect much change on this.

Bund yields seem settled into a range and, over time, we expect spreads in the eurozone periphery to grind tighter.

Although on a one-week view there has been some consolidation due to new supply in Italy and Greece, it is notable that volatility in sovereign spreads is declining – even as it picks-up elsewhere.

With Greek Treasury Bill yields now in negative territory, it has been interesting to observe how Portuguese bonds have squeezed to levels inside of Spain due to a solid technical backdrop. Over time, a similar dynamic could also drive Greek spreads much tighter – especially if further credit upgrades lift Greece back towards investment-grade status.

The Brexit show must go on

UK assets continue to dance to the Brexit tune with chances of a last-minute deal appearing to fade, then coming back to life following Jonson’s meeting with Varadkar.

At this stage, it is still difficult to tell whether a clear breakthrough has been reached – and if Johnson has compromised, whether he will be able to make an agreement, which will pass through the UK Parliament. Indeed, the danger writing about Brexit, is partly that we are entering a stage when new headlines and developments can quickly make analysis turn stale!  However, until now, an extension and a general election had appeared inevitable.

If this were to be the case, then the question is whether Johnson will announce these steps himself, after he returns from the EU summit at the end of next week – so that he can maintain some control over the timetable – or whether he will refuse to do so, causing a rebel alliance to call a confidence vote, install an interim leader and apply for an extension on its own part. 

Were the latter to occur, it is even possible that it may suit such an alliance to hold a second Brexit referendum prior to a general election. This could prove to be politically expedient for many of those involved; especially if they are concerned that the Johnson Tories will campaign (and could win) on a ‘no deal’ Brexit platform, given their need to minimise vote leakage to the Brexit Party. Hence things may come to a head very shortly.

Even if Brexit isn’t resolved at this point – at least it should be easier to understand the path to such a resolution, in contrast to the stalemate of the past 18 months.

At the same time, fiscal policy in the UK continues to be eased ever more rapidly. This has led to concerns to be raised by the independent Institute for Fiscal Studies, with the Conservatives starting to undo much of the austerity of the recent past.

However, we would argue that with bond yields so low and the economic backdrop weak, such a fiscal response is fully justified.

Furthermore, it makes much more sense to be easing fiscal policy than to be cutting rates or delivering further QE at this time. Inflating asset prices will only add to income inequality and it seems globally there is a rising appreciation that monetary policy has run its course.

Our view that fiscal easing will continue, regardless of the party in power in the UK, is part of our rationale for continuing to maintain a short in Gilts relative to other markets, such as the periphery of the eurozone.

Turkey remains fragile

Elsewhere, pressure on risk assets has pushed credit spreads wider. The most noticeable trend has been one of spread decompression, with lower-quality spreads widening by materially more than higher-quality credit, especially in Europe where the grab for yield continues to support high-quality corporate bonds.

In emerging markets, Turkey has traded weaker as troops cross into Syria following the US withdrawal. Risks of an ugly war with the Kurds in Syria has seen Trump threaten to destroy the Turkish economy. However, Erdogan needs to resettle the Syrian refugees who have moved to Turkey in recent years and is therefore intent on creating a buffer zone inside of Syria. Ugly TV pictures could lead to sanctions. With the Turkish economy remaining fragile, this clearly poses an additional downside risk.

Meanwhile, demonstrations continue to blight Hong Kong and in Central America, political unrest has flared up in Ecuador. At the same time, US impeachment proceedings are keeping a media focus on alleged Ukrainian corruption headlines. With worries in the Middle East also not far away, it may seem understandable that with so much seemingly go on, investors remain somewhat fearful.

Looking ahead

It is difficult not to look backwards to this period 12-months ago, when risk assets similarly came under a degree of pressure. This was to herald a challenging quarter, in which US stocks fell by 14%, yields tumbled and credit spreads widened.

However, a repeat in 2019, although possible, seems unlikely in our opinion – even if a conflagration of trade wars and geopolitical turmoil cannot be fully discounted.

These fears may create a headwind, which could make it difficult for risk assets to rally very much, though if the US economy can remain in reasonable health, this may represent an optimistic outcome compared to what is currently discounted.

Unless there is new bad news, it is possible that PMIs are at, or close to, their bottom and if this is the case, then nominal bond yields may struggle to fall much further.

In part, it may be suggested that 10-year US Treasuries have rallied down to 1.5% helped by a rally in European markets and if there is now less scope for Bund yields to go much lower, then this will also constrain demand for US duration, unless US domestic data softens materially.

Turning back to the China-US relationship, it is interesting to observe how much recent coverage of China’s objections, threats and attempts to influence overseas corporations, is attracting attention.

This weeks’ decision by Beijing to cancel coverage of two NBA games in response to basketball’s administrator failing to condemn Houston Rockets’ manager Daryl Morey for comments supporting anti-government protest in Hong Kong, is a further example of what can be viewed as Chinese state interference on an issue of freedom of speech, which is a US constitutional right. 

For some time, US firms have been happy to bend to requests coming out of Beijing, but with this now creating more headlines and negativity at home, it is possible that more will determine that it is expedient to take a stand against Beijing.

Looking at the US and China, it appears that it is getting difficult to gloss over differences on topics such as Hong Kong, with things becoming hairier by the day.