BlueBay AM: March Madness

BlueBay AM: March Madness

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By Mark Dowding, CIO at BlueBay Asset Management

Ample liquidity combined with a year of lockdowns led to an erratic week in financial markets.

Lower Treasury yields in the wake of a benign US CPI report saw risk assets rally during the past week, with US equities back close to historic highs. There is a real sense that the trajectory of inflation will ultimately hold the key to policy rates, bond yields and broader market direction in the months and quarters to come.

Put simply, if inflation remains contained at low levels, then there will be little pressure on the Federal Reserve to raise rates and in such a scenario, robust growth and abundant liquidity may continue to drive markets higher. 

However, if inflation trends upwards, then bond yields and policy rates will rise and this may create a much more challenging market dynamic. 

In assessing the likely trajectory for inflation, it seems very likely that base effects will lift core PCE towards 2.5% at the April release, due in May. Thereafter, inflation doves will look for price pressures to subside. By contrast, those in the more hawkish camp may see any retracement as shallow and short-lived, before prices resume their upward trajectory. 

With abundant liquidity meeting pent-up demand and supply shortages, it strikes us that there may be situations in which we see ‘too much money chasing too few goods’, to paraphrase Milton Friedman. Put in the context of the monetarist equation where MV=PY, there has been little increase in ‘P’, even as ‘M’ has expanded dramatically in the past year, with the velocity of money slowing substantially. But now as growth and animal spirits return, so this may change, if ‘V’ accelerates in the months ahead. 

From this point of view, we are more inclined to look for medium-term risks to inflation on the upside, especially with fiscal policy continuing to play an expansive role and the FOMC happy to react to, rather than pre-empt, changes in price developments.

With the USD1.9 trillion Biden stimulus now ready to be signed into law, it won’t be long before US household are receiving cheques through the post. A large portion of earlier rebates have been saved. 

However, with consumer balance sheets now looking very healthy and economic activity normalising, we would not be surprised if the marginal propensity to consume dominates the inclination to save this time around. Living life under lockdown creates disincentives to spend – for example, who wants to spend on new outfits to dress up when there is nowhere to go? But this is changing as lockdowns dissipate. 

Furthermore, the current round of cheques is more targeted towards lower-income households, where the propensity to spend tends to be greater. Consequently, we see plenty of demand in the months ahead, with the US consumer the driving engine of economic activity.

H2 stimulus

Looking further out, we also expect further fiscal stimulus later in the year, with Democrats now working on a planned USD4 trillion infrastructure package. We expect this to be concluded in the second half of 2021 at around half of this size, with spending spread out over several years. These monies may have less of a direct economic impact than the current package due to their long-term deployment. 

That said, it may be possible for infrastructure spending to achieve a strong multiplier effect on GDP growth, given the dire need for infrastructure spending in many US states. Furthermore, this easing will ensure that concerns of a fiscal cliff in 2022 are mitigated and policy remains supportive over the lifetime of the Biden administration.

Against this backdrop we continue to believe that there is scope for US yields to rise further. By contrast, we think that it will be difficult for any rally in rates to gain too much traction, unless there is a strong flight-to-quality risk on the back of other assets falling. 

Sustained easing in Europe

We see developments across the Atlantic putting some upward pressure on Bund yields. However, eurozone growth around 3.5% in 2021 may be only half of the level in the US. Therefore, it is understandable that the ECB will be keen to prevent a premature tightening of financial conditions and has consequently announced plans to accelerate bond purchases over the course of the coming quarter. 

This move has helped to benefit eurozone sovereign spreads somewhat, with Italy, Greece and Spain outperforming. Nevertheless, we are doubtful that PEPP purchases will seek to bring about materially lower yields or tighter spreads and can be viewed as more of an insurance against higher yields. 

Macro developments

Equity markets experienced some pretty interesting gyrations over the past week, with the NASDAQ index falling heavily at the start of the week, only to post an impressive rebound. 

Reflation and economic re-opening has seen a rotation towards value stocks. However, it is notable that this has not been especially beneficial to more cyclical asset classes, including European stocks and emerging markets. 

In the case of the latter, sentiment remains relatively fragile with EM credit, rates and FX all underperforming since the start of the year. 

Elsewhere, corporate credit spreads have remained much more stable. There has been a steady flow of new issuance, offering investors the opportunity to add exposure and deals have mostly experienced solid demand. 

Next week the Federal Reserve meeting will be interesting in terms of the FOMC language and also its projections on growth, inflation and interest rate expectations in the ‘dot plot’. We sense that the Fed has been much more sanguine than the ECB with respect to rising yields. 

Meanwhile, we can’t help but emphasise the importance of the future trajectory of inflation on asset prices in the months to come. Over the next few weeks, it may be too soon to conclude clearly whether strong growth is leading companies to exert pricing power, or if restraint will prevail. In the interim, we could see some swings back and forth in prices, reflecting shifts in sentiment.

Is abundant liquidity here to stay?

With moves in the Treasury market remaining a key focus, we would note that last year’s Fed suspension of the Supplemental Liquidity Ratio (SLR) is set to expire at the end of this month. The relevance of this measure has been that banks have been purchasing more Treasuries during the past year than would otherwise have been the case. Therefore, if this suspension is not extended, then this could trigger sales of Treasuries from bank portfolios. Estimates put this amount close to USD200bn.

Consequently, many banks have been lobbying in favour of an extension. Yet with the Biden administration disinclined to roll-back part of the policy framework enacted following the GFC, it would seem counter-intuitive to many in policy circles to extend liquidity when banks are simultaneously using liquidity to buy-back their own stock. 

Furthermore, liquidity is generally in abundance and, politically speaking, it is not clear whether some Democrat lawmakers will be happy to see policymakers bowing to Wall Street when the macro conditions today could not be more different than was the case in March 2020.

As we gear up for the ‘March Madness’ that is the annual US College basketball tournament, it is interesting to reflect how abundant liquidity is also creating some March madness in financial assets. 

GameStop was back in the news after shares trebled over a three-day period, only to lose half their value in half an hour of erratic trading on no fundamental news. Retail investors have also been chasing gains on esoteric digital currencies, with ‘Kebab Token’, ‘Pancake Swap’ and ‘Pancake Bunny’ all posting eye-watering gains.

Sometimes you can be forgiven for thinking that the rules of investing that many of us know have gone out of the window in liquidity-soaked markets. Mind you, it may be that this is more about ‘speculation’ and entertainment than investing in its own right. After all, a lot of folk are still stuck at home and a year on from the start of lockdowns, maybe it isn’t surprising that a bit of March madness is impacting us all!