Views and Analysis

Which direction?

Much like the container ship in the Suez Canal, the financial markets – for the most part – have been fairly immovable of late both in the face of several conflicting themes – hope, better data, a “third wave” of the virus in Europe and a fairly haphazard global campaign of vaccination. The likelihood is that the second quarter will be much more positive for a number of reasons. Andrew Lake explains more.

Much like the queue of traffic behind the container ship, Ever Given, so pent up demand should be unleashed as the summer begins, vaccination programmes accelerate, and economic reopening begins in earnest. On the vaccine front, most US citizens should be vaccinated by the summer. Furthermore, the vaccine supply situation in Europe completely changes for the better over the next couple of months, with big deliveries from both Pfizer and Moderna.

The downfall of hedge fund Archegos Capital has had limited impact on the wider market outside the shares involved in the unwinding of positions. However, it is an illustration of the potential risk that can and probably is being taken at the moment. Gold continues to be under pressure, so its efficacy as an inflation hedge continues to be in question at this point. Let’s see what happens once we begin to see some of the expected inflation begin to come through over the next few months. The US Dollar continues to defy consensus and along with the continued rise in Treasury yields, is a challenge for Emerging Market investors in the short term.

US Stimulus

It would seem that US stimulus checks are going into the real economy. Bloomberg reported that  ‘Credit- and debit-card data from Bank of America for the week ending 20 March showed total spending rose not only 45% from the COVID shutdown period a year ago, but also climbed 23% from two years ago, driven by government stimulus payments. Card spending for stimulus recipients jumped 40% from February’s average, with people buying furniture, electronics and clothing’. It also looks like malls are back in vogue after years of declining footfall as shoppers return in droves. How sustainable this is clearly open to question, but it is encouraging and fits with the narrative of the big boost to activity we all expect as economies fully re-open.

Inflation

The European recovery is several months behind that of the US and the massive stimulus bill that has just been passed in the US, together with the anticipated infrastructure bill, that are disquieting investors. Certainly a stronger US dollar will import inflation to certain Emerging Market countries with fragile currencies and cause issues. However, for the most part, we believe that inflation is a US phenomenon for now.

We believe that inflation is going to rise dramatically in the next few months, especially with regard to year on year comparisons. The fear is an overheating economy driven by stimulus and reopening that could force the US Federal Reserve to act sooner than anticipated. Bloomberg has estimated that excess accumulated savings amount to approximately $1.7 trillion. Even Powell said that “a lot of people can go out for dinner” hence the 6.5% real GDP forecast. All of this we know and anticipate. The big question is whether consumers continue to go out for more dinners than pre-pandemic, buy more cars, more stuff. The likelihood is that once the initial flurry is over, growth and activity will settle down again. Supply chains as evidenced by the shortage in microchips plus the Suez blockage are struggling and may well have an inflationary impact in the short term, as will rising commodity prices. Let’s not forget that the global economy was settling into a below trend situation pre-pandemic and with even larger debt burdens the likelihood is that inflation will settle down, especially as some consumer behaviour will change. The virus is not going to go away, so perhaps savings rates remain somewhat elevated given the ongoing uncertainty. Higher unemployment and structural economic damage is likely to persist for a few more years even in the most optimistic scenarios. We will need to wait and see how the next 6-9 months unfold, but the likelihood is that financial markets will jump one way or another before then, so we will need to be ready for overshoots in either direction.

US Dollar

At the moment, the consensus weak dollar trade looks to be under pressure. As yields in the US rise, so US assets look more attractive as the US economy improves more quickly than its peers and the US dollar rises as well. The US dollar also retains its risk off power during periods of uncertainty. However, as the global environment improves, we believe other currencies more leveraged to a more positive outlook should improve. This outlook will also lessen the need for the US dollar as a safe haven. We also believe the huge current account deficit should also be dollar negative over the longer term.


ESG

The theme of green washing has been very much in focus over recent weeks. It seems as if every company needing to raise capital is issuing a sustainable bond. For some, it is very difficult to see what is actually green or sustainable about the companies coming to market or the use of proceeds of the bonds issued. This is becoming an issue and thorough analysis is required to find the real sustainable opportunities.

Outlook and current portfolio thinking

Duration is now sub three years across the Global High Yield and Global Strategic Bond strategies. This is in anticipation that government bond yields will continue to rise in theUS given the more robust economic outlook. Combined with this is my expectation of a continued rally in recovery bonds, cyclicals and high yield despite the back up in government bond yields. As a result, we continue to be focused on company specific investments in fallen angels and high yield over longer duration investment grade.

I expect some continued volatility over the next few months as we wrestle with higher government bond yields and better economic data. The US Federal Reserve has made it very clear that there will be no withdrawal of stimulus but it remains to be seen how financial markets look at the economic data and whether transitory or permanent inflation is priced in. Better vaccination programmes will drive optimism and so I continue to think the re-opening theme is still very relevant for the next couple of months.

Much like the queue of traffic behind the container ship, Ever Given, so pent up demand should be unleashed as the summer begins, vaccination programmes accelerate, and economic reopening begins in earnest. On the vaccine front, most US citizens should be vaccinated by the summer. Furthermore, the vaccine supply situation in Europe completely changes for the better over the next couple of months, with big deliveries from both Pfizer and Moderna.

The downfall of hedge fund Archegos Capital has had limited impact on the wider market outside the shares involved in the unwinding of positions. However, it is an illustration of the potential risk that can and probably is being taken at the moment. Gold continues to be under pressure, so its efficacy as an inflation hedge continues to be in question at this point. Let’s see what happens once we begin to see some of the expected inflation begin to come through over the next few months. The US Dollar continues to defy consensus and along with the continued rise in Treasury yields, is a challenge for Emerging Market investors in the short term.

 

 

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Andrew Lake

Head of Global Fixed Income