BlueBay Asset Management: A shot at happiness

BlueBay Asset Management: A shot at happiness

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Mark Dowding, CIO at BlueBay Asset Management, has issued his latest market insight, in which he focusses on the prospect of a Coronavirus vaccine, the US Senate race, the potential for a Brexit deal and the outlook for 2021. 'Vaccine hopes give us all a boost and improve 2021 holiday prospects, even if the market outlook remains challenging for the year ahead.'

Risk assets received a shot in the arm this week, with Pfizer announcing promising results regarding the Covid vaccine it has been developing. An efficacy rate as high as 90% is well above earlier projections and with phase-3 trials also nearing completion with respect to a number of other vaccine candidates, there has been a surge of hope that vaccine deployment in the months ahead may be able to normalise everyday life towards the middle of 2021. 

We are hopeful that there may be as many as three vaccines being actively deployed before the end of next month. Although it may take a long time to vaccinate enough of the population to drive the virus right down, the ability to target the vaccine at the most vulnerable groups may well give governments the political cover to remove restrictions on economic activity more quickly than many may appreciate.

Vaccine optimism saw a substantial sector rotation within equity markets, with Covid-impacted sectors seeing solid performance just as tech surrendered a portion of its year-to-date gains. An outperformance of cyclical and value names saw high-beta credit spreads gaining relative to higher-quality credit. Emerging markets also performed robustly, building on gains in the wake of last week’s US election. 

The gappy nature of price action appeared to suggest that many investors were not positioned for this trade. This move may have further to run if money on the sidelines is wanting to buy any potential retracement in the days ahead.

 Covid concerns remain

Hopes for a vaccine improving the 2021 outlook are still tempered by ongoing concerns for the building wave of infections being experienced in Europe and the US. Additional lockdown measures are likely to crimp the economic recovery in Q4. This would continue to necessitate a dovish stance from central banks in the coming months as they seek to promote accommodative financial conditions and ensure that fiscal authorities have plenty of room to expand budget deficits, in the knowledge that bond issuance will be more than offset by additional central bank bond purchases.

In the past few days, Covid concerns have picked-up in the US, though in Northern Europe, there are more hopeful signs that infections may be starting to drop from their highest levels. 

In part, we feel that warmer weather in much of the US through October has meant that the recent wave was slower to build there and hence the trajectory may be delayed by several weeks relative to what has been seen on the other side of the Atlantic. However, notwithstanding the latest mutation scare stories coming from Danish mink farms, it could be hoped that in some countries it will still be possible to ease lockdown restrictions ahead of the Christmas holiday season.

We believe that near-term policy accommodation, combined with medium-term hopes relating to a vaccine, may continue to support financial markets into the end of the year.

As investors look towards growth in 2021, there may be a move towards a reflationary bias, meaning that yields are more likely to rise than fall. However, we doubt any rise in yields can travel far before central banks act to squash this – lest they risk a tightening of financial conditions.

Ultimately, we believe that central banks are more preoccupied with what is happening in the real economy than in financial markets. In this sense, we expect there to be some tacit, implied yield-curve control to cap yields – even if this is not a formally stated objective.

US politics

The past week has been characterised by headlines casting Trump as a sore loser and a toddler who won’t go quietly from office and may need to be dragged kicking and screaming from the White House. This creates something of a soap opera, but we don’t see this as a big issue for the economy nor markets, and thankfully there has been little evidence of widespread civil unrest in the wake of the contested election result.

Potentially of greater interest and significance, we have found ourselves wondering whether Biden could secure a Democrat Senate following the two run-off elections in Georgia scheduled on 7 January. This possibility seems to have been overlooked by markets, but both races were close and it may be difficult to predict how Republican intransigence at conceding the White House could energise the base come the forthcoming vote. 

It seems probable to us that the Senate will end up skewed 51-49 in favour of the GoP – but even so, this would mean that Democrats would only need to pick-off one moderate Republican senator in order to create a 50-50 split, with Vice President Harris then acting as the tiebreaker. Although tax rises and major regulatory change remains unlikely, we believe it is possible to see scope for a fiscal package close to USD2 trillion being agreed, which would be above what most commentators think feasible.

Continent waits on ECB update

In Europe, financial markets await the upcoming ECB meeting in December, with Lagarde seeming to signal an increase in PEPP and LTROs and no changes to interest rates for the time being. Spreads in the periphery continue to grind tighter and it is possible to see some further gains in the coming weeks. However, much of the spread compression is now behind us and increasingly it appears that assets such as BTPs are more of a carry trade than a position which can deliver material capital gains. 

The same may also be said to be true in investment-grade credit, with spreads at an index level practically unchanged relative to where they were at the start of the year. Conversely, there appears more value in higher-beta credit. In sectors such as subordinated financials, we expect a rally to run further with bank equity supported by a likely end to the dividend ban and the rotation into value stocks. 

From a credit perspective, we have thought that banks would be much less impacted by the Covid recession than in the aftermath of the financial crisis in 2008, thanks to tighter regulation and much more conservative balance-sheet management. We also believe that the premium between tier 2 and tier 1 securities remains much too wide and there is scope for cocos to continue to rally in the weeks ahead.

The UK

Brexit negotiations have largely gone quiet in the past couple weeks, which has typically been taken as a constructive sign. As time drags on, it is becoming increasingly clear that a transition implementation period will be required to deliver change, with the economy remaining totally unprepared in the event of a ‘No Deal’ Brexit. 

We continue to expect a deal to get done and remain long the pound, though the extent of a rally on an announcement may prove to be relatively modest given projected UK economic underperformance relative to its peers.

Elsewhere in FX

We have maintained a positive stance with respect to the Russian rouble and this week added a position in the Indian rupee on the view that the high-yielding laggards of 2020 are set to play catch-up in the next couple of weeks. We have realised gains in Czech koruna and reduced exposure in the Norwegian krone following positive performance. 

Generally speaking, divergent trends mean that we are seeing increased opportunities to take risk in FX for the time being, in contrast to rates markets, where central banks’ liquidity provisions are seen capping yields and limiting opportunities for the time being. 

Elsewhere in emerging markets, a notable rally in Turkish assets was seen in the wake of governmental changes and comments from President Erdogan seeming to admit that a return to policy orthodoxy is required.

Looking ahead

We believe that many investors have been somewhat under-invested to capture some of the recent moves, as demonstrated in market price action. 

In October, we had observed how implied volatility was very elevated around the period of the US election and this suggested that there was fear and uncertainty with respect to the outcome, which was probably keeping some investors in cash, waiting to buy the dip. 

However, with a dip not materialising in the wake of last week’s vote and attention now switching towards the vaccine and an improved outlook for 2021, we expect further re-positioning of portfolios to take place in the next couple of weeks before market liquidity starts to dry up as we move into December. 

We sense that asset allocators are looking to position towards a reflationary theme at the start of 2021 and, with accommodative policy supporting this, there is scope for assets which have underperformed in 2020, such as bank stocks, to continue to outperform in the next few weeks.

Where we may feel more cautious is when we look a little further ahead

In our view, central bank balance sheet expansion may persist until H2 2021 in the US and until the end of next year in the eurozone. However, we expect to start putting the pandemic behind us in due course and we are nervous that, as and when investors feel the high point in policy accommodation has been passed and the tide is about to turn, that the outlook for markets could become much more challenging. 

We have grown accustomed to a world of abundant liquidity, but this won’t last forever. When the tide does go out, it will expose many issuers operating at much higher levels of debt and leverage than was the case in the past. More broadly, we think that some ‘zombie issuers’, which have been supported by the liquidity wave, will end up needing to face the prospect of credit downgrades and restructuring in what could be an elongated credit cycle with defaults remaining elevated over a 3-4 year period.

In this context, we feel that the current environment is one where it is attractive to continue to try to extract returns from taking a long-risk position, but it will probably be necessary to shift to a much more defensive position as we move through 2021.

All this said, 2020 isn’t over just yet. There have been plenty of surprises in the past 10 months and who knows what lies around the corner. It certainly isn’t a time for complacency, yet we have often observed that markets can perform best in those moments when rising optimism for the future meets accommodative policy in the present. 

Still, one is left to wonder if the US election outcome could have been any different if only Pfizer had announced its result one week earlier…but perhaps of more significance, at least things are looking more hopeful on the holiday front for 2021.