BlueBay AM: Goldilocks and the three vaccines

27 november 2020

US equities posted new record highs over the past week, as optimism with respect to the growth trajectory in 2021 continued to overshadow near-term worries regarding the rise of the virus. The number of new daily Covid cases in the US has shown signs of plateauing in a range between 150,000 to 200,000 per day, though there are concerns that gatherings over the Thanksgiving holiday could lead to a further acceleration in the next few weeks. 

Nevertheless, it appears that US GDP will still be positive in Q4 thanks to momentum from the end of Q3, even if a dip is likely before the spring. By contrast, it appears that growth in the eurozone may already be negative in Q4 in the wake of lockdown restrictions, based on weak PMI data in the past week. However, European infection rates are now falling and re-openings are planned during the week ahead, with further easing to be enacted over the Christmas period.

Near-term concern for the real economy is set to keep monetary and fiscal policy ultra-accommodative for the time being and asset purchases by central banks can continue to fuel asset-price inflation. 

At the same time, it would appear that there are now three vaccine candidates nearly ready to go and we expect initial rollouts from Pfizer, Moderna and AstraZeneca in December. Ultimately, mass vaccination should enable a re-normalisation of everyday life.

We also think it’s possible that, once deployment is underway, the focus for policymakers will be to stimulate the return of growth as quickly as possible. In this context, we continue to see US output back at end-2019 levels by the end of 2021, notwithstanding worries relating to the present wave in infections. The eurozone should also be back to where it was at the end of last year by early in 2022, though some countries in Southern Europe may lag within the region. We expect the UK economy to be one of the last to recover, as it digests disruption in the wake of Brexit on top of the damage due to the pandemic.

Credit spreads drive tighter

The confluence of policy support in the near term and economic hope in the medium term has been a powerful current that has seen investors driving credit spreads tighter over the past several weeks. In recent days, we have also observed volatility indices starting to decline. With limited new issuance likely before the end of the calendar year, it seems there has been something of a scramble to put cash to work. 

Sectoral rotation has also continued to be an important theme, with some of the Covid-related issuers amongst the leading performers in credit markets. At an index level, investment-grade spreads are essentially unchanged since last December, though areas of the credit market such as subordinated bank cocos still trade over 60bps cheaper than at the end of 2019. This suggests to us that these trends may have further to run, as confidence in the trajectory for 2021 continues to build.

Higher oil prices in the past week have continued to support emerging markets, with oil-related credits and currencies trading relatively well. EM FX has lagged the recovery since central banks started to ease policy in late March, but has played catch-up more recently.

In the past several days, price action in FX has been more contained with the US dollar trade-weighted index, DXY, holding firm support at 92. However, we anticipate that a break below this level could lead to another leg of dollar weakness, with EM currencies continuing to outperform.

We see this supported by optimism surrounding a more internationalist US president, hopes for improving global growth seeing asset flows into more cyclical assets in overseas markets, and also the sense in the near-term that Covid rates are improving across Europe, just as they get worse in the US.

Accommodation remains the status quo

Core government bond yields continue to trade in a narrow range, supported by the notion of implicit yield-curve control. 

Ordinarily, hopes that vaccines will boost 2021 growth and lead to an end to balance-sheet expansion later next year would see yields start to rise and the yield curve steepen. However, the ECB is expected to add EUR400bn to its bond purchases next month, while the US Federal Reserve may well announce intentions to increase the maturity of the assets it is purchasing. 

These moves can help to hold yields down and promote financial conditions which are as accommodative as possible. In this way, it seems that core government yields may be in a range for the time being. 

Meanwhile, we continue to see spreads in the periphery grinding tighter and there may still be a bit further for this trend to run, even though absolute yields in Spain and Italy have reached record-low levels and may now offer only limited value. Elsewhere, the Brexit saga continues to linger like a bad smell, but it still appears that a compromise remains on the cards.

Looking ahead

We feel that the trends seen in the past few weeks may have further to run and it is possible for markets to operate with a constructive tone until the second half of January. During this period, we have been keen to monetise as much by way of returns as we can, while remaining mindful of the overall risk we are running. 

In the next few weeks, we believe that volatility can fall further, credit spreads can continue to compress and we look for further weakness in the dollar to enable local EM currencies to post a positive finish to the year.

There are now only three weeks of normal trading before markets start to shut down for Christmas. We are hoping that the news events in the next few weeks – comprising ECB easing, a dovish Fed, the start of vaccine deployment and an easing of European lockdown restrictions – may all be slightly risk-supportive on the margin, even if they are already expected. 

We also believe that some strategists may give in to hope and revise default expectations lower in their annual outlooks and may tout the scope for further gains from rotation.

In the past few days, it has felt that markets are operating in ‘Goldilocks’ conditions, with policymakers happy for asset prices to run higher as a side effect of enacting policies to support the real economy.

In 2021, the bears may eventually come for Goldilocks when the tide of policy starts to turn. However, for now, she can be content with three vaccines and doesn’t even need to worry about one being too hot, one being too cold and only one being just right. In reality, it seems (for the moment at least) that all of the jabs will likely do the job.

Let’s hope we don’t get any nasty surprises…it certainly feels like we have had more than enough of them over the past nine months.