BlueBay AM: Not a lot of meat but plenty to digest

10 september 2021

By Mark Dowding, CIO at BlueBay Asset Management

Talk of tapering continues on both sides of the Atlantic, with rising inflation concerns globally. Meanwhile, in the US, Democrats will be looking to pass their USD3.5 trillion spending plan. However, with consensus within the party not a given, it’s as yet unclear what the final package will look like.

The past week has embodied something of a back to school feel. Deal flow picked up after the summer break and many workers returned to office premises for the first time in 18 months, as societies continue to make progress along the path to post-Covid normalisation.

This week’s ECB meeting saw President Christine Lagarde announce a reduction in bond purchases under the PEPP, in line with comments from her colleague Phillip R. Lane at the end of last month. Lagarde was eager to emphasise that this was a recalibration, not a taper, but this choice of words is pretty much semantic it would seem.

With the ECB raising its economic projections for 2022 and beyond, it appears that the high-water mark in policy accommodation has been passed and it will be interesting to hear how the ECB may plan to wind down the PEPP at the next quarterly policy meeting in December.

Looking ahead, the EU economy is set to benefit from the deployment of the Next Generation EU funds, with fiscal stimulus supporting growth, even as monetary policy takes a back seat. Consequently, the outlook in the region remains broadly constructive.

US

Across the Atlantic, the taper debate with respect to the US continues to be a point of discussion. Some recent economic data, including the August jobs report, have been soft, in the wake of spillover from the spread of the Delta variant.

However, robust readings from the Job Opening and Labour Turnover Survey show strong ongoing demand from firms to hire workers. With weekly jobless claims moving to a new post-pandemic low, it seems that the underlying trend in the economy remains upbeat.

Elsewhere, supply chain disruptions continue to be a talking point. Based on conversations we have been having with corporate leaders, it strikes us that these effects will last long into 2022. In that context, robust demand is meeting a shortfall in supply. In the wake of this disequilibrium, this continues to put upward pressure on prices.

Next week sees the release of the monthly US consumer price index (CPI) report and we continue to look for risks to the upside. In recent months, higher inflation has seen yields fall on fears that this would see premature tightening from the US Federal Reserve (Fed). Yet, the Fed seems in no hurry to rush the withdrawal of stimulus just yet.

This means that the longer inflation overshoots, the more this should see wages and forward inflationary expectations move higher. This may well see yields higher in the coming weeks, with the curve steepening if the Fed remains happy to sit behind the curve and more prone to flattening, should its rhetoric turn more proactive.

UK

Inflation concerns are also a building worry in the UK. Here, the effects lifting inflation elsewhere around the globe are being exacerbated by additional supply chain disruptions with respect to Brexit.

From transport costs to surging energy costs, we are concerned that UK inflation may jump materially in the next few months, which seems to be pushing the debate within the Bank of England (BoE) in a more hawkish direction.

The UK government has announced a tax rise to help fund the NHS and social care on a forward-looking basis, which could impact growth prospects. Traditionally, the Conservative Party has stood on a manifesto of low taxation, so it is interesting to observe the Tories breaking past pledges and shifting away from their historic base.

Ironically, it can be questioned whether such a tax rise is really needed at all. There is a perception in Whitehall and at the BoE that public debt levels have risen too much in the course of the pandemic, and need to be brought under control.

However, if BoE holdings of Gilts are stripped out of these debt figures, then it can be observed that net debt in the UK is at a very manageable level, particularly when one considers the long duration and low debt servicing costs in a world of ultra-low rates. It is also interesting to observe the UK tightening policy even as lawmakers in the US continue to debate additional fiscal easing.

Markets

In a US holiday-shortened week, markets were largely rangebound. A pick-up in corporate new issuance met robust demand from investors, meaning that new-issuance premiums are pretty modest. With spreads remaining relatively tight, this has meant that we have felt little enthusiasm to participate in these deals.

More broadly speaking, it is striking to note that 85% of the US high-yield market now trades at a yield lower than the US inflation rate. Negative real yields on junk bonds hardly sounds appetising, yet with default rates set to remain low, it is not clear that there will be much of a re-rating any time soon.

In emerging markets, Romania came under pressure as the ruling coalition comes under pressure. With long-dated euro bonds trading at 3.5%, we see plenty of value in Romania compared to other markets and believe that the political noise will subside in the weeks to come.

Looking ahead

Looking ahead, next week’s US CPI data could set the tone for the rest of the month. A benign report should support risk assets, and open the door to fresh equity gains and spread compression. However, if we witness an upside surprise, as we suspect, we think this will lead to upward pressure on Treasury yields and global rates more broadly.

This could impact spreads and, if investors have participated too heavily in new issues at tight valuations, could lead to a short-term correction. In this context, it may make sense to be cautious into next week’s data and look to add risk after the event, with the data calendar quieter in the second half of the month.

Away from this, we continue to focus on plans for the USD3.5 trillion infrastructure package Joe Biden is trying to sell to his party. As this will need to pass via the reconciliation process without Republican support, this means that the Biden administration needs all of the Democrat senators on board.

With mid-terms looming, more fiscally cautious moderates are likely to want to tone down the ambitions of the progressives in the party. Consequently, we might guess that a package of USD2.5 trillion may prove a more realistic total and we look for more than half of this total to be funded through tax increases.

This will limit the net fiscal positive from this bill. However, at a time when the US economy is bouncing back strongly, asset prices are booming and countries overseas are starting to tighten policy, it isn’t clear that the US economy actually needs a big additional push. Inflation is already well above the Fed’s target and is set to stay there for some time to come.

Anyway, it will be interesting to see how the Biden administration spins this bill. If much of the meat is taken out of it, will they be able to convince the public that it is a compelling offering in the way McDonald’s is seeking to position its own vegan Pretty Little Thing??