BlueBay AM: Second wave malaise

25 september 2020

Local lockdowns and a general tightening of restrictions in the hospitality sector have been implemented across a number of European countries. In the UK, this has seen a material U-turn in messaging, with the government, which was seeking to get workers back to the office and into restaurants just a month ago, now seeking to encourage a stay-at-home culture to last until next spring. This reversal has seen the UK announce further fiscal stimulus in order to avert a catastrophic rise in unemployment, mirroring packages announced by other EU capitals over the past several weeks.

Conversely, prospects for additional US fiscal stimulus appear dead in the water for the time being against a backdrop of political hostility and disagreement. It seems as if it will be necessary to wait until after the November election before policy action is announced.

However, with a new government not in place until early in the new year, there have been building concerns that household incomes will be materially impacted by a fiscal cliff with a number of benefits now having expired.

Potential for additional asset purchases

Federal Reserve speakers have highlighted the need for fiscal policy to support the economic backdrop. The reality is that there is a limit to what the FOMC can do to ease policy, with interest rates already at zero and the yield curve anchored at ultra-low levels.

If economic indicators turn down in the next several weeks, it is likely that the Fed may add to its asset purchase programmes in November and may extend the maturity of the assets it is purchasing. This could help to stabilise asset prices, but the truth is that this may do relatively little to strengthen the economic backdrop.

More generally speaking, the Fed can try to sound dovish and can seek to encourage inflation but there is relatively little it can do to bring this about, unless it were to adopt a more radical policy approach, with QE heading in the direction of helicopter money as a last resort. Consequently, investors who have been adding risk over the past few months (assuming that asset prices were a one-way bet), may find that buying the dip will always be a winning investment strategy up until the day it doesn’t work anymore, forcing capitulation in the wake of building losses.

That is not to say that markets will necessarily continue to slide – but risks are building and from a central banking point of view, it is also difficult for the Fed to jump in and support markets too quickly with the election now just a few weeks away, due to the risk of being accused of caving to political pressure.

Ultimately, we are confident that a substantial US fiscal easing will be enacted through 2021, regardless of who wins the election. We also remain confident in the delivery of a vaccine, but are sceptical there will be material deployment before the new year. Therefore, it is difficult to become too bearish in the medium term, but for now it is entirely plausible that the recent retracement has much further to run – such was the extent of the run-up in financial asset prices over the summer.

In terms of a vaccine announcement, we could imagine some headlines during November and it is tempting to think Trump may claim the delivery of a vaccine before the election, almost regardless of whether it has been fully approved or not. When this comes, markets could see a quick rally but we aren’t sure whether this initial optimism will be sustained, as the reality around logistics and take-up of a new vaccine make it unlikely that social distancing measures can be withdrawn too quickly.

However, much may also depend on the trajectory of the virus. For example, it is striking that mortality rates remain a very long way below levels witnessed in the spring. It is perfectly conceivable that as the virus becomes less potent, some of the fear which is prevalent today may prove to have been over-exaggerated.

Extension consensus could prove tricky in Europe

Meanwhile, in the Eurozone recent PMI data appear to show the economy starting to stall after the initial recovery in demand during the summer months.

In many respects, this should not be too surprising and it remains clear that there are many sectors of the economy, such as hospitality and travel, which are very significantly impacted by the ongoing Covid crisis. This is seen leading to calls for the ECB to extend the PEPP programme until late 2021 at its December meeting.

We are not sure that achieving consensus on this will be completely straight forward. It seems clear that Germany and other Northern European countries are faring much better than peers in the south and, with the PEPP already scheduled to run to the end of June next year, there is hope that the pandemic should be largely behind us by that point.

Meanwhile, with sovereign spreads in the Eurozone close to their tights for the year, it is hard to argue that there will be too much urgency for the ECB to act too early. It is possible that division on the governing council sees a decision on PEPP delayed towards its March meeting and this could come to weigh on sentiment in the periphery.

Consequently, we believe that having witnessed a sweet spot during which monetary policy, fiscal policy and national and EU political developments have all helped spreads. It may now be the right time to realise gains and adopt a neutral stance – waiting for opportunities to re-enter on weakness, should these arise.

Asset class update

Corporate bond supply has been seasonally heavy during September but is typically quieter during the final quarter of the year. With central banks continuing to buy investment grade (IG)-related corporate bonds, spreads have been well supported in this space, even as spreads in lower-quality bonds have repriced wider on the back of moves in equity markets.

We retain a modestly constructive view on IG spreads in general, though have sought to take more relative value risk at an issuer level, rather than relying on market direction. Where we have added new issue exposure, we have consequently been hedging this using CDS indices, given that cash bonds continue to offer much more value than synthetics and on the basis that market techincals should remain relatively supportive for cash corporate bonds.

Elsewhere, we have been more cautious with respect to EM credit after seeing spreads rally a long way during the middle of the year. We continue to expect increased divergence and heterogeneity between EM countries, reflecting the underlying fundamentals and the differing policy choices being pursued.

From an FX perspective, the dollar has strengthened as risk appetite pulls back. PMI data also showed some divergence in prospective economic performance, with the US looking set to renew its outperformance relative to the Eurozone.

Elsewhere, robust data continues to favour the renminbi and, generally speaking, Asian currencies. EMFX as an asset class has quickly surrendered its gains from earlier in the month, with the FX component of the local market EM bond index back to double-digit losses on a year-to-date basis.

In the UK, sterling has been able to shrug off some of the negativity related to renewed lockdown measures, thanks to hopes that EU trade agreement negotiations are starting to see some traction.

We are hopeful that an agreement may be reached by the middle of October, given growing fears of a gridlock in trade in the event of ‘no deal’ delivering a hammer blow to an economy which is on its knees because of Covid. We continue to see scope for sterling to rally on this, albeit the magnitude of any upside may be tempered given the UK growth backdrop.

Broadly speaking, adopting a patient wait-and-see approach in the past month has been broadly vindicated and for now we continue to express a desire to maintain discipline, buying into weakness and selling on strength. Should credit spreads come under more pressure, unwinding hedges may be appropriate, though we don’t think we need to rush this.

Looking ahead

It is clear that the past few months have seen market techincals dominate over valuations and fundamentals. The presence of US retail investors driving-up stock prices has made these technicals difficult to predict and understand with much certainty. For now, it seems entirely plausible for stocks to rally or fall by 10% in the space of the coming week without very much ‘new news’ at all.

Ultimately, we believe that policy support and a better outlook in 2021 will mean that the current market correction does not extend too far. However, worries of a mini-March as the weather turns cold could easily spook retail traders, should their recent profits begin to disappear.

Most asset allocators seem to have moved overweight in equities and credit within fixed income and although it is hard to imagine this changing too quickly, it is also hard to discern how motivated money on the side-lines will be to buy on weakness, given valuations are far from as compelling as they were earlier in the year.

If markets do go down, it certainly won’t be the fault of central banks, yet they will easily be handed the blame, in the hope they can be coerced into action. The truth is that economies won’t be able to get back to end-2019 levels until late next year at the earliest.

As this reality is understood, it will also be accepted that there is a limit to how far financial markets are able to out-run the economic recovery. Second-wave malaise is therefore a fear as we head into Q4, but happier times will come as long as we can be patient and wait for them.  After all, I’m sure we can trust our leaders to navigate us through these challenging times…