BlueBay AM: Quiet between the storms

4 februari 2022

By Mark Dowding, CIO, BlueBay Asset Management

Chinese New Year holidays and an absence of data help to provide a – perhaps temporary – sense of calm in markets going into February.

The past week began with some consolidation in price action following a turbulent month in January, which saw hawkish central bank projections weighing on risk assets in the wake of building inflation pressures. Softer data trends resulting from Omicron disruptions appeared to suggest that the upward pressure on rates could abate for a time. 

However, hawkish central bank comments from Europe have renewed the pressure on yields and may threaten risk assets. In that context, it is less clear that there will be much of a quiet period following last month’s storms before the next round of turbulence impacts markets.

This week’s ECB meeting saw Lagarde seek to deliver a relatively dovish message to markets. However, markets were quick to look through opening remarks, as it became clear in her subsequent comments that the Governing Council is now moving in a more hawkish direction. 

Effectively, market participants concluded that a hawkish pivot will come in the wake of forecast revisions at the March meeting, with inflation risks clearly skewed to the upside. 

To date, the ECB has given forward guidance that rates won’t rise until asset purchases cease. However, with markets now expecting a 10bps hike this June, there is the sense that this will also serve to trigger an early end to asset purchases, placing pressure on spreads within the eurozone.

In many respects, Lagarde’s comments lacked much credibility and one may have concluded that this would have been a press conference that the ECB president would have liked to have missed. It is clear that delivering policy is going to be increasingly challenging for the ECB this year. 

However, we ultimately believe that inflation expectations in countries like Germany are more anchored than is the case elsewhere. We are inclined to think that a rate hike in the next six months looks too premature, but that markets will need to understand that policy tightening has become inevitable.

Across the Channel in the UK, the Bank of England hiked rates to 0.5%, as expected, at this week’s MPC. Yet a 5-4 split showed that the Committee was almost persuaded to raise the base rate by 50bps and steps to commence QT via sales of corporate bond holdings also came as a surprise to markets.

We look for further rate hikes and a reversal of QE to occur in the coming months in the wake of overshooting inflation and a tight labour market. Many countries are struggling with the availability of labour supply, notably with respect to lower-paid jobs. With many younger EU citizens, who had previously filled many of these jobs, departing the UK in the face of Brexit and the pandemic, it seems that labour market pressures are more acute in the UK than is the case elsewhere. 

Rising inflation seems likely to feed into wage pressure and although the BoE is fearful of raising rates too far or too fast as rising prices squeeze real incomes, the de-anchoring of inflation expectations may end up giving the central bank little choice.

In this context, we continue to see Gilt yields as remaining too low. UK cash rates are already more than 100bps above the eurozone and we think this spread will diverge further, with inflation expectations in a country like Germany much more anchored, relatively speaking, than we see in the context of the UK. This sees us continuing to favour Bunds relative to Gilts in a world where we think most yields will ratchet higher over the coming year.

The election of incumbent Italian President Mattarella for another term in office saw BTP spreads rally temporarily, on the perception that this reduces political risk and the chance of an early election in the near term. However, the fractious wrangling between parties in the preceding week serves as a reminder that Italian politics remain heavily divided. 

As the election approaches, so this may undermine the authority of Prime Minister Draghi, and it seems probable that he will cease to play a role beyond next year. With the ECB set to pivot in a more hawkish direction into 2023, a political risk premium in Italy may make it hard for Italian spreads to converge much further in the weeks ahead. 

More broadly, we think that the outlook for eurozone spreads may be challenged by the withdrawal of central bank liquidity and increased divergence across the eurozone. This will make life hard for policymakers to reconcile as we move away from the pandemic.

In emerging markets, the Chinese New Year holiday infers a period of quiet. However, with local Covid cases creeping up, we are concerned that this may prompt further lockdowns that could lead to the persistence of supply chain problems. 

Meanwhile, further policy easing may be required to stabilise the property market. Risk appetite has stabilised in the past couple of weeks, but we suspect that underlying property prices are in a structural bear market given their elevated multiples relative to domestic incomes. We understand that the Communist Party is eager to improve housing affordability, but deflating property bubbles is notoriously difficult to expedite without more widespread collateral damage. 

Elsewhere, it has been interesting to see signs of Beijing clamping down on the gambling industry, with moves against some casinos in Macau. It seems that the tide may be turning against the gambling sector more broadly. Suggestions that gambling should be treated as ‘the new tobacco’ are likely to lead to elevated ESG concerns for investors in the sector.

The past week has also seen calmer conditions across risk assets, notwithstanding the moves in European yields. Having risen above 30 towards the end of January, the VIX has been trending lower after sentiment readings suggested that risk appetite had contracted too far. Improved sentiment has also benefitted credit spreads. However, with credit proving much more resilient than stocks during the January sell-off, there seems little conviction to take spreads much tighter. 

At a macro level, there are few signs that the factors causing yields to rise and stocks to struggle will abate anytime soon. However, we would contend that the outlook for growth should infer a promising backdrop for corporate earnings and, in line with prior comments, we continue to retain a longer-term constructive growth outlook, as we think that any policy tightening in 2022 will do relatively little to subdue demand. This should limit the downside on stocks, noting that in general, equities will be looked at as an inflation hedge and may represent much more upside than can be seen in longer-duration fixed income securities. From this point of view, sectors like banks continue to look well set to us, on the notion that they can benefit from higher rates.

In FX, the dollar has surrendered gains over the past week. We think that divergence on rates can support the greenback in the coming weeks, but that we may need to wait until the March FOMC for the next catalyst for the dollar to outperform. 

Elsewhere, Russia risks remain prevalent. Should Putin launch an incursion in the coming days, as is now widely expected, we think that this should benefit the dollar relative to the euro in a flight to quality.

Looking ahead

We think that after today’s payrolls data is out of the way, we could witness a quieter couple of weeks in financial markets in the absence of significant new data releases or central bank comments that might act as a catalyst to drive price action. We believe that January data (which is released in February) may surprise somewhat weaker due to the Omicron effect, but that markets are likely to look through this as a short-lived distortion.

Generally speaking, it appears that the pandemic is now in retreat, as it is accepted that the symptoms of Omicron appear to represent a very different and much less serious disease. Indeed, if we had not witnessed the prior variants of Covid and the world was looking at Omicron on a standalone basis, it seems doubtful to us that we would ever have seen widespread lockdowns, masks and many of the events that have become part of everyday life.

We remain hopeful that the world is on a path to a better place in 2022. Yet, as this will infer the withdrawal of policies that helped to inflate asset prices over the past two years, so it remains appropriate to retain a less constructive structural outlook for the year ahead, in the context of beta returns from long-only benchmarks. 2022 may be a turbulent and stormy year in this context. However, there may be periods of calm and February could represent a moment of quiet between the storms.