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A game of snakes and ladders

Markets move tentatively forward but must watch their step for obstacles on the path ahead that could trigger a tumble.

Further progress in the fight against Covid-19 has seen markets continue to trade in a constructive fashion over the course of the past week. Rates of death and infection continue to slow and as businesses in Europe begin to re-open, forward-looking PMI surveys have bounced from last month’s lows – even if they remain at very depressed levels.

In China, which exited lockdown several weeks ago, there is some evidence that demand is bouncing back quite healthily, even if restrictions on everyday life persist.

Progress in China has been supported by robust policies and the mandatory adoption of tracking apps, yet it is less clear whether citizens in other countries will be as prepared to sacrifice their privacy and civil liberties in the same way – only time will tell.

However, hopes that the virus is being firmly contained in many countries is leading to a renewed focus on trying to get economic activity moving again.

EU support dilemmas

In Europe, Franco-German proposals on the recovery fund have attracted particular attention during the past few days. Over recent weeks, there has been ongoing wrangling as to how an EU fiscal support package could be deployed, seeking to assist countries and regions which have been worst affected as a result of the coronavirus.

It had appeared that national interests had been dominating regional solidarity at a time of crisis and that this was a concerning development with respect to the medium-term prospects for the monetary union.

Thankfully, the ECB has been in place to support markets and alleviate stress, though the underlying worry has been that in the absence of greater unity, the central bank alone would not be in a position to hold back the tide on an indefinite basis.

Against this backdrop, the Merkel-Macron proposal for an EUR500bn fund, financed by borrowings at an EU budget level, is very interesting. With disbursements slated to take place in the form of grants (as opposed to loans), this would create a template for fiscal transfers to take place on a much more widespread scale than anything seen to-date.

Historically, there have always been grants awarded to less-developed regions within the EU, with these largely targeted at lower-income countries in Eastern Europe over recent years. However, the EU has not had the power to engage in significant borrowing up until this point.

In this context, were this proposal to be adopted, it could represent a material step forward with respect to EU integration.

We can be certain that the ‘frugal’ grouping of countries, including Austria, the Netherlands and the Baltic / Scandinavians in the North, may baulk at these suggestions and will offer counterproposals in the coming week. It is also likely that countries in Eastern Europe will strongly object to being part of an initiative in which they could be intrinsically paying towards supporting regions in countries much wealthier than they are. Protests will also likely be made around the legality of what is being put onto the table.

However, history suggests that there will be a way for EU politics to find a fudge to allay such criticism and a compromise will be found – not least because the alternative could set in motion a series of very unpleasant and unwelcome events.

Consequently, the current Franco-German proposals are likely to be watered down, but with all of the large populous countries in the union supporting these plans – we believe that we are now closer to an agreement; an outcome comprising EUR500bn in a package skewed heavily towards grants seems likely.

Trading on the week

European assets have traded with a positive tone over the past week, with spreads in the periphery and European credit supported by some of these political developments. For now, these may only be baby steps – but inasmuch as it highlights a renewed desire to recommit to the EU project, it should help to alleviate stress in some quarters and thus is consistent with the constructive view that we have been adopting in investment grade-rated assets in the region.

In the days ahead, it will be interesting to observe whether the ECB uses the recent narrowing of spreads as an opportunity to slow its PEPP bond purchases or whether it keeps its foot on the gas, seeking to push spreads tighter in the name of trying to promote accommodative financial conditions across the region.

At a time when bond supply remains exceptionally heavy for the foreseeable future, the central bank is, without doubt, the biggest marginal buyer and potential swing factor in the market.

In our view, we believe that the PEPP will be increased in June and that, ultimately, the best risk/reward in fixed income markets at the current time will be to continue to own those assets which stand to benefit most directly from central bank asset-purchase programmes.

Elsewhere, core government bond yields continue to trade in a relatively tight range, with central banks such as the Federal Reserve (Fed) happy to anchor the yield curve as risk appetite recovers.

In both the US and the UK, there have been an increasing number of questions regarding whether central banks may look to embrace negative interest rates, given how inflation appears to be dropping globally and noting that in a recession the Fed has typically sought to lower the Funds rate by around 500bp.

However, our interaction with both the Fed and the BoE suggests that negative rates remain unlikely for the time being. There is scepticism that negative interest rates do much good from an economic standpoint and concern in some quarters that they could do material harm to the banking sector, money-market funds and to the broader economy.

As such, we see asset purchases remaining the favoured tool to ease monetary conditions further if this is warranted. This could be extended to include the purchase of bank debt, high-yield corporate bonds and equities, were this to be necessary.

Consequently, even as credit quality deteriorates, bond supply balloons and economies struggle to return to health, the idea that the central bank remains the buyer of last resort may create the idea of a central bank ‘put’ under valuations, which may continue to tempt cautious investors to add risk in the coming weeks.

Choppy path ahead

Having said this, it would seem foolish to believe that volatility will not return. Central banks may want to ensure that corporate bond markets remain open to borrowers without necessarily seeking to drive spreads tighter.

Also, the pain threshold for further policy intervention may be closer to the lows seen in March and, with many markets having recovered a long way since, there is plenty of scope for markets to fall before support is found.

In the weeks ahead, there remains the risk of a second wave of infections as lockdowns are eased. 

Unemployment has jumped in many countries but will likely be much, much slower to fall in the months to follow.

Certain sectors of the economy remain completely compromised and certainly in looking at major equity indices, it is striking to see that much of the recent gains are being made by a small number of tech giants, whose businesses may have been helped, not hindered, as a result of Covid-19 and which may be helping the Nasdaq towards a new record high.

Looking ahead

It would strike us that evidence of a second wave of infections requiring a return to lockdown currently represents one of the largest risks to the recent rally in markets. It is to be hoped that this can be avoided, but it’s likely going to prove difficult to predict whether or not this will occur.

Consequently, uncertainty is set to persist. In the meantime, economic newsflow is set to remain very challenging. For now, evidence of falling global inflation will likely mean that central banks will remain inclined to ease policy further, as and when required.

On a longer-term view, should inflation start to move higher once again, this could be where policy making proves much more challenging. Otherwise, at this stage it could be argued that the investment landscape looks a bit like a game of snakes and ladders.

If the end of lockdown can proceed smoothly and the virus is contained, there may be scope for markets to continue to grind slowly higher. Any positive policy surprise – such as steps towards a fiscal union in the Eurozone – could provide a boost up the board. At the same time, there are plenty of snakes in our path and it will require a lot of luck, as much as skill, for countries to avoid some serious set-backs on the path ahead.