Blue Bay AM: All's well that ends well (we hope)

Blue Bay AM: All's well that ends well (we hope)

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Mark Dowding, CIO at BlueBay Asset Management, has issued his latest markets commentary, in which he focuses on the final stretch of the Brexit negotiations, next week’s Federal Reserve meeting and risk assets. 'As the UK vaccination programme gets underway, markets remain buoyant and we see signs of risk-asset appetite continuing into 2021, despite uncertainty regarding Fed policy moves and Brexit negotiations.'

The recent upward run in markets appeared to suffer a slight loss of momentum during the past week. However, this did not trigger much consolidation, with US stocks printing another record high in the past few days.

In the short term, it seems that investors have wanted to get greater clarity with respect to US fiscal stimulus, vaccine deployment and Brexit talks, before chasing prices higher.

At its monetary policy meeting, the ECB announced a nine-month, EUR500bn extension of its PEPP bond-buying programme, meaning that balance sheet expansion will last at least until 2022. This was broadly in the middle of market expectations which had built up during the past several weeks, therefore there was relatively little reaction to this.

Eyes now turn to the Federal Reserve

In the US, Powell is also expected to tread a dovish path. However, it seems that prospects for fiscal delivery are likely to be far more significant with respect to the economy and financial markets as we move into 2021. Breakeven inflation rates on inflation-linked bonds have increased since the election but remain below 2% for the time being.

With nominal yields effectively anchored by the Fed, this has seen real yields decline somewhat in the past few weeks – though we are more inclined to believe that any further tilt towards a more reflationary path is more likely to lift nominal yields going forward.
Consequently, it may be interesting to look at adding to short-duration positions in US Treasuries once next week’s monetary policy meeting is out of the way.

Shock potential

There was plenty of excitement that the first Covid vaccinations have commenced in the UK this week, even if this was slightly tempered by news of a couple of recipients experiencing mild anaphylactic shock. In some respects, this served as a reminder that the whole world is pretty much dependent on these vaccines working and so any negative newsflow could be a trigger for broader concern.

The recent decline in Covid infections in Europe seems to have stalled in the wake of restrictions easing over the past week or two. US case numbers have also trended somewhat higher but remain well below some of the dire forecasts of what may have happened in the wake of Thanksgiving socialising.

Nevertheless, from a financial markets perspective, any bad news or data disappointments only seem to cement the case for further policy stimulus and, consequently, are not having a material impact on asset prices.

Brexit countdown intensifies

Meanwhile, the deadline for Brexit trade talks was extended for what must be the umpteenth time following this week’s visit by Johnson to Brussels. It is now concerning that time is quickly running out and although a ‘Deal’ remains our base case, an increase in uncertainty and rising risks of an accidental ‘No Deal’ have led us to reduce conviction with respect to the bullish view that we had previously maintained on the pound.

Were ‘No Deal’ to occur, we believe that this would be highly disruptive to supply chains and would lead to blockages at UK ports and shortages in a range of imported goods. Food and medicine supplies would be an area of concern and the timing of such disruption during the middle of a pandemic could hardly be worse. This scenario would also be detrimental to eurozone prospects, even if the situation would not be nearly as acute.

In this light, it is hoped that policymakers can find a way past their egos and act in a manner which will benefit the many, not just the few. Notwithstanding this, worries relating to such a scenario might ordinarily be expected to weigh on broader market sentiment.

Yet, the economic impact coming from this outcome is likely to still pale into significance compared to what has been seen as a result of the coronavirus. Moreover, if downside risks just translate to more central bank asset purchases, it is hard to see this shaking the prevailing sense of complacency.

Spread tightening potential

Corporate credit spreads widened slightly during the past week, with some retracement following several robust weeks of price action. However, we don’t see this as much more than short-term consolidation and with supply seasonally light, we still believe that investors will look to put cash to work before the end of the year. For now, we think that sovereign and corporate spreads can grind tighter – especially if volatility continues to trend downwards.

We would become more concerned if we thought that reflationary trends could point to the moment when central bank policy might change direction, but this seems unlikely for another 12 months – potentially longer.

With central banks increasing asset purchases in the near term, financial repression seems to infer that money will have to continue to flow towards more risk-seeking assets and this should continue to push spreads tighter and compress credit curves.

Looking ahead

We continue to think the paradigm of policy support in the near term, coupled with economic hope in the medium term, can continue to support risk assets into 2021, when seasonal flows tend to be supportive for spreads in the first half of January.

We doubt that markets will do too much in the wake of next week’s Federal Reserve meeting, but once this is out of the way, we will be looking at whether we should add conviction with respect to a short-duration stance on the thought that yields could tick higher at the start of 2021.

We would also observe that higher Treasury yields could emerge as one of the bigger risks to the rally in financial assets in general and so traditional correlations between yields and risk assets could become inverted.

This said, we doubt central banks will permit yields to move too far, with the overriding focus for all of the global central banking community being the real economy, rather than what is happening in financial assets.

Elsewhere, some analysis with respect to vaccine efficacy and where it is targeted could mean that a country such as the UK may be in a position to ease lockdown restrictions more rapidly than currently projected. Most of those hospitalised are in the elderly cohort of the population. Additionally, there seems a material uptick in immunity within as little as 10 days of the first vaccine dose.

Consequently, if sufficient numbers of those most at risk of hospitalisation are at the front of the vaccine queue, one can model how the UK could start lifting lockdown restrictions as soon as February on declining fears that the healthcare system could become overwhelmed – even if in the near term there is a growing concern that further lockdowns may be needed to prevent a third wave.

This would certainly be good news and after such a dreadful bad-news year in 2020, one can only hope that we are all due some better luck in 2021. With the aptly named 81-year-old William Shakespeare being the first man to receive the vaccine, let’s hope that ‘All’s well that ends well’.