BlueBay: Loss of momentum

BlueBay: Loss of momentum

Vooruitzichten
Vooruitzicht.jpg

Mark Dowding, CIO at BlueBay Asset Management, has issued his latest market commentary, in which he focusses on US Treasury Yields, the UK vaccine rollout and the European market.

Fixed income markets take a brief pause but show no sign of a reversal, creating potential positioning opportunities for those with cash on the sidelines.

The past week has been characterised by a loss of momentum in financial markets, following on the back of a couple of months of healthy returns. A worsening of the pandemic in recent weeks appears set to weigh on data in Q1.

Although sentiment has been supported by the prospect of further fiscal policy stimulus, this has led to Treasury yields pushing higher in line with medium-term inflation expectations.

Weigh on risk assets

Over the past few days, there has been a sense that this move in US yields has begun to weigh on risk assets, thus pointing to a possible tightening in financial conditions. Consequently, we have not been surprised to observe speakers from the Federal Reserve start to push back against the idea that it will allow yields to rise too far in the near term, reaffirming its commitment to accommodative policies in order to support the economy during a difficult period.

We expect US Treasury yields to be more rangebound over the next month or two. A worsening of Covid data may lead to further restrictions on economic activity in the early days of the Biden administration and, although we expect that this will be countered by additional Federal spending, we believe that disappointing data may keep reflationary hopes in check for the time being.

This has seen us realise gains on a short position in US Treasuries over the past week, with near-term prospects for yields more evenly skewed. We still believe that yields are likely to end the year materially higher than what is discounted in the forward curve, which prices the 10-year note around 1.35% at the end of the year. However, in the near term, we think that this move has gone far enough.

If US yields can be contained in a range, then we believe that other risk assets should continue to perform reasonably well. A reach for yield can see spreads grind tighter and an ongoing compression across credit curves.

With the Vix indicator still at elevated levels, these moves could also be supported by a decline in volatility if macro risks are able to fade somewhat into the background. In this context, we would view Trump’s second impeachment as merely symbolic at this point, given that the outgoing POTUS only has a maximum of five days left in office anyway. Indeed, the absence of tweets is almost deafening in itself and a pointer to the fact that the days ahead could be much quieter than those we are leaving behind.

Political risks resurface

In Europe, the dominant focus of recent days has been the rollout of vaccinations, which is progressing at a pretty modest pace across the EU. Elsewhere, Italian political risks have resurfaced with Renzi pulling his party’s support from the ruling Conte coalition.

We doubt that this will lead to early elections (which neither Conte nor Renzi would want) and believe that a compromise can be found or a new technocratic government installed. However, were Italy to head to the polls anytime soon, this could represent material event risk given the lead that the combination of populists at La Lega and Fratelli d’Italia enjoy in the polls.

Earlier in the week, we closed half of our position in Italy BTPs, cognisant of this possibility. We believe that eurozone spreads should trend tighter in the first half of 2021 on the back of relentless demand for bonds from the ECB. However, we believe that it is appropriate to reduce risk and look to add if short-term volatility offers a more attractive buying opportunity.

Across the Channel

Life under lockdown continues to weigh on UK prospects. We would also observe that the full fallout from Brexit is yet to be felt in terms of FDI flows and ongoing disruption, which is likely to create trade friction.

However, the rollout of the Oxford vaccine has meant that the UK is building a clear lead on its EU peers with respect to vaccination. As the percentage of the population who have either had the virus, or had the vaccine, continues to climb – so it is possible to think that herd immunity could come to the UK more rapidly than elsewhere.

This narrative has been supportive with respect to the pound over the past week, with sterling also helped by a somewhat stronger US dollar.

More broadly in FX markets, we detect a sense that the 2020 trend to a weaker dollar may have run its course. Yield differentials appear to be supporting the greenback as Treasury yields climb – as we expect they will continue to later in 2021.

We also would not be surprised to see renewed US growth exceptionalism later this year, especially if EU policymakers act to rein-in expansive fiscal policy in 2022, even as Yellen at the Treasury espouses ongoing accommodation until the output gap is closed. Current account differentials may favour the euro over the medium to long term.

Should investors search for value outside the US equity market, this could also create flows that should continue to see a weaker dollar. However, when we aggregate these factors we are sceptical that we should see a big US dollar trend in 2021 – as we did in 2020 – and that in FX, clearer opportunities may exist in more relative-value positions.

In this context, we have realised gains from a long position in the Norway krone over the past week, but added to long exposure in Turkey, Mexico and Brazil. Against this, we hold shorts in Chile and South Africa.

Looking ahead

Fixed income indices have mostly posted flat-to-negative returns in the first half of January, largely thanks to higher US yields and a reversal of the trend to dollar weakness. Equities and credit spreads have been relatively well supported and we believe that as long as US yields don’t break materially higher, then this should continue to be the case.

In that context, we would see some moves in areas like EM (which has underperformed over the past couple of weeks) as offering opportunities to add to risk on a selective basis.

If markets come under pressure, we continue to look for policy support to turn sentiment, and with investors focused on the medium-term trend towards reflation, this may limit how deep any correction can be. Indeed, we would note that the past week can be seen more as a pause than a reversal in many of the markets we follow.

This may reflect that there remains plenty of cash still on the sidelines that can be put to work. Although this market narrative appears a consensual one, overall positioning behind this view remains relatively modest in our assessment.

Moreover, at a time of year when the weather is dull, the days are short and we are locked inside our homes, boring is becoming the new normal. But in credit markets in particular, boring need not be a bad thing.

This suggests that the overarching investment thesis looking for accommodative policies to support markets in the first half of the year remains intact. This could turn if, as we have suggested, policy ceases adding stimulus in H2 and this could be a time to position much more defensively.

However, back in the real world, the idea that summer is coming will be well received indeed.