BlueBay AM: A period of calm doesn’t mean there’s room for complacency

16 april 2021

By Mark Dowding, CIO at BlueBay Asset Management

Financial market volatility continued to drop during the past week, as US stocks nudged to fresh record highs. US CPI for March surprised slightly above expectations at 2.6% year-on-year on the headline measure and 1.6% on a core basis. Further increases are anticipated over the next two months, yet this move has been well flagged.

Inflation update

Elsewhere this week, a White House paper commented on temporary price pressures stemming from the reversal of base effects in addition to pent-up demand and supply disruptions. It would seem that investors are inclined to allow policymakers the benefit of the doubt and assume that inflation will drop back below target as we move through the summer. However, we remain inclined to believe that prices will be more sticky. 

Medium-term inflation concerns could come to the fore if inflation heads above 3%, and with input prices, business surveys and anecdotal information all suggesting risks to the upside, so we think that this will be an environment in which it will be difficult for yields to rally very much.

We retain a modest short position in US rates and would be inclined to add to this should yields drop towards 1.5% on the 10-year part of the yield curve.

Meanwhile, stable yields and declining volatility has created a benign environment for risk assets, as discussed in last week’s commentary. April seasonality, driven by lower supply on earnings blackouts, has also seen corporate credit spreads resume their grind tighter, with investor demand focusing on those pockets of the credit market that offer higher yields and scope for compression.

Europe

An acceleration in vaccine deployment has helped support sentiment in the past week, even as the rise in Covid infections appears to top out. Germany, for example, is now administering half a million doses per day, representing a sharp uptick this month.

Clotting concerns with respect to the J&J vaccine, in addition to the AstraZeneca jab, represent a risk to further progress – yet there is a sense that administrative missteps in Q1 have now largely been addressed. Moreover, companies manufacturing the mRNA variant of the vaccine, like Pfizer, have promised to boost deliveries to the EU in recent days.

Subsequently, European bond yields have risen slightly, even as Treasuries have moved in the other direction over the past few days. With growth set to accelerate in Europe, there has been some discussion about whether we are passing the point of maximum pessimism and that higher inflation prints could yet see the ECB start to taper its PEPP purchases at the beginning of 2022, at the same time as the Federal Reserve winds down its own balance sheet expansion.

To us, it still feels premature to be too optimistic on the eurozone outlook – data in Q2 may well disappoint to the downside. However, as fiscal doves seek a more accommodative revision to the EU fiscal compact once fiscal rules are re-established after 2022, it is yet possible that this sees Northern European countries push for a pullback with respect to monetary accommodation.

It will be interesting to assess the dynamics of the ECB under Lagarde as we move towards the end of this year. For now, we feel this analysis is premature and with the US economy racing ahead, we continue to favour the dollar over the coming quarter.

UK

A focus on regional elections in May sees us paying more attention to matters north of the border in Scotland. A majority for pro-independence parties looks likely and if this were to see a referendum and a subsequent move to dissolve the union, this could create fresh uncertainty for UK assets and the pound, mirroring the Brexit vote in 2016. This could be another reason to support a negative view on sterling, with the pace of UK vaccinations also dropping lower than European levels over recent days on supply disruption.

Outlook

Looking forward to the second half of the month, there seems relatively little to drive markets prior to the Federal Reserve meeting on 28 April. To be honest, it is unlikely that FOMC rhetoric will change much at this meeting and so it may not be too surprising if markets remain rangebound until the payrolls report at the start of May. Lower volatility may continue to favour risk assets in general, but notwithstanding a period of calm, we feel this is no excuse for complacency. 

Should spreads rally, then realising gains on credit longs and/or resetting hedges at tighter levels may be an attractive approach, especially with valuations making it difficult for markets to run ahead very far. 

Meanwhile, if Treasury yields fall then adding to shorts at more attractive levels continues to seem the correct approach to us. Eventually, we feel that range trading will be replaced by higher yields and a stronger dollar, even if this may need to wait a few weeks to come about – unlike Boris’ haircut, which he couldn’t wait to have when UK hairdressers re-opened this week.