BlueBay AM: Volatility lowers as investors watch inflation dynamics

BlueBay AM: Volatility lowers as investors watch inflation dynamics

Aandelenkoersen

By Mark Dowding, CIO at BlueBay Asset Management

Robust US economic data was greeted with some cheer in markets during the past week, with equities climbing to new record highs. Meanwhile, Treasury yields managed to rally somewhat on the basis that a lot of good news has now been discounted. After a very substantial rise in rates in Q1, this has led some to conclude that the outlook for the quarter ahead should be far more benign by comparison.

Over recent weeks we have highlighted that a next leg upwards in yields may need to wait for firmer inflation data to materialise. With some investors seeing value in Treasuries based on forward valuations, it is not too surprising that the bear market in US rates seems to have lost some momentum of late. 

Consequently, the path has been clear for risk assets to perform well, with stocks making gains and credit spreads rallying at the start of the quarter, notwithstanding lingering concerns with respect to full valuations. 

Meanwhile, the dollar has been on the back foot during the past week, reversing some of the gains it made during March, as a more constructive tone in the US feeds into other markets.

Data round-up

In terms of the economic data itself, the US economy added close to one million jobs last month and if it is able to sustain this trend (as we believe likely), then levels of employment should be back at end-2019 levels by the end of this year. 

Anecdotal reports of labour shortages may help the broader U6 definition of the unemployment rate to fall quite rapidly during the spring and summer as the economy re-opens, with the pace of the US vaccine rollout meaning that it is likely that remaining restrictions with respect to economic activity are lifted by the end of Q2. 

Inflation

Pent-up demand is showing in bullish consumer and business sentiment surveys and it wouldn’t surprise us to see businesses in some of the Covid-impacted sectors of the economy seek to raise prices in order to claw back lost revenue or to counter increased operating costs. For example, we have seen restaurants in California and elsewhere applying a ‘Covid surcharge’ onto customer bills – a practice which could potentially become commonplace. 

This suggests to us that risks to inflation remain on the upside and after a jump due to base effects in the next couple of months, we think that price pressures could remain somewhat elevated in the months ahead. 

As a result, we currently think that US core inflation could end 2021 closer to 3% than 2%. If this is the case, then we think yields will resume their move higher with 10-year rates moving above 2% in the second half of the year.

In many respects, we believe that getting the call correct on inflation is of paramount importance this year. Arguably, if US inflation returns below 2% after a spring spike, this will lead to questions over whether inflation will ever return in the years to come. This could create a backdrop for stable yields and further gains with respect to the valuation of risk assets. 

In such a scenario, it is hard to see the Fed in a rush to raise rates until 2024, even if the economy continues to perform strongly. However, we think that this is unlikely. Secular trends that have pushed inflation lower in the past decade or so are now abating or have already turned. First, a falling dependency ratio thanks to a rising working population has led to increased savings and lower rates of inflation in the past two decades, but this ratio is now set to move higher as the population greys. Second, globalisation has seen disinflationary trends push goods prices lower. However, we have already passed peak globalisation and we think that the pandemic will lead to a renewed focus on national interests and supply chains (as shown in the danger of relying on overseas vaccine manufacture). 

Although technological advancement remains a deflationary force, it occurs to us that the secular pressures holding prices lower are waning at a time when cyclical pressure on inflation seems to be picking up. Friedman always noted that inflation was the result of too much money chasing too few goods and, in the US, pent-up demand is meeting a shortage of supply. 

The lack of supply of semiconductors is just a recent example of this. Consequently, it strikes us that in 2021, inflation risks are skewed higher rather than lower, with policymakers seemingly happy to support this outcome.

If we are correct on inflation, then it seems unlikely that US Treasuries will be able to rally very far and if yields dip towards 1.5% on 10-year notes, then this may create an opportunity to add to short positions. 

Furthermore, we continue to believe that the scale of the US economic outperformance creates a window for dollar strength in the next few months. The vaccine roll-out in Europe is being hampered by doubts relating to the AstraZeneca jab and it seems that the next few months could prove a frustrating wait for further progress to be made in administering jabs and bringing infection counts lower. Even in the UK, it seems that an ultra-cautious government is reluctant to normalise activity too quickly, even if the vaccination programme is far ahead of the Continent. Arguably, the UK may be wasting some of its ‘vaccine advantage’ in its slow journey out of lockdown. 

Meanwhile, ongoing uncertainty with respect to overseas travel and the need to maintain social distancing measures beyond June is making it difficult for businesses to plan ahead with much clarity or certainty. From this point of view, we continue to believe that there may be too much bullishness priced into the valuation of the pound after its outperformance versus other currencies during Q1. For the UK, the second quarter is likely to look better than the first, but as things stand, it still seems that output won’t be much better than flat during the first six months of 2021.

Emerging markets

During the past week, a more benign backdrop in US rates and a softer dollar have both been beneficial with respect to performance of EM assets. This may persist for a time, but we remain cautious that a renewed move higher in Treasury yields or the dollar could see a return of the headwinds seen in Q1. 

That said, valuations in parts of EM are more attractive than can be seen elsewhere. However, at a country level there is a divergence in performance meaning that there may be more opportunity in continuing to assess the merits of prospective longs versus shorts. 

A third Covid wave is now badly impairing activity in a number of EM economies. Those such as Brazil, which have been determined to avoid lockdown, may yet be pushed in that inevitable direction as rates of infections and deaths continue to spiral higher. In Russia, we see rising sanctions risks and are watching developments on the border of Ukraine with some nervousness. In Turkey, we see scope for underperformance with the central bank set to start cutting interest rates in opposition to market orthodoxy. Elsewhere, there is upcoming elections risk in Ecuador and Peru.

From this point of view, it remains challenging to have a broad-based view on market beta in EM, given the scope for country, sector and issuer-level divergence.

Corporate credit

Elsewhere, in corporate credit markets, declining volatility indicators have been a further support during the past several days. The VIX indicator has dropped below 18 for the first time in over a year and may be poised to continue to trend lower. Investor demand for credit – be it investment grade, high yield or structured – appears to remain solid, with positioning surveys showing that many investors have considerable room to add exposure. 

Heavy new issuance remains a barrier to tighter spreads in some parts of the credit market, but at an overall index level, we think that spreads can continue to grind tighter with an ongoing spread compression between lower-quality and higher-quality names. 

Anecdotal evidence of this has been shown in strong ETF demand for trackers, such as FALN, which follows a grouping of fallen angels whose bonds have suffered during the pandemic. In this context, it seems that the consensus is that liquidity will remain abundant as growth picks up and that default rates remain set to be very low by historical standards.

Looking ahead

We believe that much will ride on inflation outcomes over the next few months. Next week sees the release of the March CPI report in the US, but it is fair to say that markets are already expecting a material rise relative to February. It may be necessary to await data a little later in the quarter before the inflation dynamic becomes somewhat clearer. In the near term, we continue to gather as much anecdotal evidence as possible of emerging price trends and are positioned such that we can add risk to short rates trades if we do see yields dip further. 

Meanwhile, we are eager to record gains from long exposures in corporate and sovereign credit, with a view to re-setting index hedges if spreads move materially tighter.

For now, a trend towards lower volatility in the short term could make April a relatively quiet month. Indeed, next week’s highlight (in the UK) may be being allowed to sit outside a pub in the cold and rain for the first time in four months. Bring it on…