Taking stock after a tough 12 months.
The collapse of the Archegos hedge fund and the associated unwinding of its leveraged equity holdings stole most of the attention in financial markets during the past week. In the wake of block trades associated with this, a number of financial institutions have been left nursing losses amounting to several billion dollars.
It might appear that greed was allowed to dominate risk management and robust due diligence, not least with Archegos founder Bill Hwang having prior convictions related to insider trading. However, it seems that this incident is a relatively isolated and contained example. Consequently, there is no need to be concerned that this will lead to broader contagion.
In fact, in discussions with policymakers over recent days, there is a thought that this may serve to tighten up regulation and risk management practices in areas of weakness, whilst serving as a timely reminder that greed can often come before a fall. This is something which may have particular relevance in some quarters within financial markets, where FOMO has at times been the key factor driving prices on an exponential upward path.
The bigger story
If Archegos is more of a storm in a teacup, then discussions around US fiscal policy remain more significant in terms of the medium-term economic ramifications.
On this front, it now appears that the Democrat administration may plan to use the budget reconciliation process to push ahead with plans for a bill on infrastructure spending, meaning that this would not need to rely on any bipartisan support from Republicans in the Senate. It now seems possible that budget reconciliation could be used three times in the current calendar year in order to push through the key plans of the Biden legislative agenda.
On infrastructure specifically, we expect a USD3 trillion package, which will be partly funded by higher taxes. It seems that tax increases could be back-loaded – this is likely to add stimulus to the economy and add to debt levels over the next several years. At the same time, it is planned that these initiatives help jump-start investments in the green economy, as well as achieving a degree of income redistribution in order to support lower income and disadvantaged American households.
The ability to push these ideas through may hinge on support from Democrat Senators, such as Manchin and Sinema, and there is likely to be much discussion, debate and compromise lasting the next several months. However, the direction of travel looks to be relatively clear and in this context the narrative of a ‘new fiscal paradigm’ remains in play, with US policymakers unashamedly pursuing a pro-growth agenda.
Getting set for economic activity
US fiscal policy continues to represent a medium-term threat towards higher bond yields. All things being equal, it seems reasonable to expect that tighter monetary policy is likely to be required in the face of more expansive fiscal policy.
Meanwhile, as we enter the second quarter of 2021, this debate is playing out against the backdrop of a rapidly strengthening US economy, which could expand at a double-digit rate over the course of the next three months. Economic re-openings are anticipated to lead to robust jobs growth in the next few months and with consumers flush with cash, we see pent-up demand spurring activity in the coming weeks.
Economic data points released for March thus far have been hinting towards this, and with Operation Warp Speed making good progress with respect to vaccinations and spring under way, it seems as if the economic narrative is set to be bullish over the next few months.
Against this backdrop, it seems challenging to see Treasury yields rallying very much, even if Q1 has matched the biggest quarterly rise in yields since 1994. A steep yield curve means that currency hedged yields on offer to overseas investors in Japan and Taiwan are the highest they have been for a number of years and there may be demand to support the market coming into the new fiscal year, which is just starting.
However, we believe that it remains appropriate to adopt a moderately defensive stance, looking for yields to rise towards 2% on the 10-year note and using any rally as an opportunity to add to short positions.
We believe that the outperformance of the US economy in the coming quarter gives the dollar scope to continue to outperform.
In Europe, the fiscal policy response is more muted and delays in ratifying the EU fiscal support programme could mean that a material flow of funds is now unlikely until close to the end of this year. The vaccination programme continues to struggle across the Continent, with doubts around the AstraZeneca jab serving to undermine public confidence, even as a third wave of infections continues to grow.
From this perspective, it won’t be surprising for economic data in the region to underwhelm, even as the US booms in the next couple of months. This means that the ECB may continue to push back against higher yields, even if inflation indicators seem to be normalising across the region. With the 10-year Treasury/Bund spread now north of 200bps, we see portfolio flows favouring the US dollar, even if the risks are skewed to a wider current account deficit.
We remain more optimistic that EU policy and vaccinations will catch up later in the year, but for the next few months, it strikes us that there is a window during which the dollar could outperform.
Sentiment has appeared to firm over the past week in credit markets, with investors continuing to hunt for yield. With the quarter-end now behind us, we believe that there could be scope for some further spread compression in the next few weeks and so have been inclined to lift CDS index hedges held against long cash credit positions.
Events around Archegos saw some financials under pressure, with Nomura and Credit Suisse both underperforming. In the case of the latter, there has been some concern that the bank has been slow to quantify and publish its expected losses and Archegos comes on the back of losses over the past several months related to the institution’s exposure to Greensill.
However, we might expect these events to mean that the institution needs to shelve plans to re-purchase its stock and actually raise capital if needed to do so. We don’t see this having any lasting impact on Credit Suisse credit spreads and at the margin, tighter risk management and a more cautious approach moving forward may help underpin credit worthiness, even if this limits the ability to generate shareholder returns.
Turkish assets remained under pressure following last week’s events. Meanwhile, higher Treasury yields and a firmer dollar have also continued to act as headwinds and it may be necessary for these trends to abate in order for EM assets to outperform as a whole.
For the time being, divergence means that it is possible to pick relative winners versus losers and in a number of areas, valuations may now appear cheap. For example, this seems quite notable when looking at long-dated local yields on an inflation-adjusted basis.
This is perhaps all the more striking for the fact that, in many other asset classes, valuations already seem full or expensive by comparison. However, EM countries which are reliant on importing capital may continue to be challenged and with Covid accelerating in a number of countries, there remain both economic and political challenges to overcome.
We have US payrolls this Friday when investors may be away from their desks in much of Europe and elsewhere. The US employment report is always closely watched and following the pattern of the past year, as economic activity recovers, so the pace of job creation could create data shocks and surprises along the way. From a statistical point of view, some months with one million plus added jobs seems quite conceivable to us.
Notwithstanding this, we doubt much will change the narrative we have been discussing as we enter Q2. Firm data may mean risks to government bond yields are on the upside, though after the sharp rise in Q1 it seems like any move higher is likely to be a slower grind, unless inflation surprises materially to the upside. If there is more stability in yields then this could benefit risk assets, though we see relatively limited scope for spreads in credit indices to move materially tighter given that valuations are already full.
In a low interest rate world, it is likely that investors still need to adjust to become content with more modest returns. As Archegos reminds us, greed can often end in tears and investing should not be confused with the pursuit of chasing short-term speculative gains. Consequently, we see more of a landscape where investors should be looking to score ‘singles’ rather than trying to play for a ‘home run’.
The message to the world at Easter is one of hope and after a tough 12 months, it feels there are grounds to be particularly thankful this year. However, just as financial assets delivered eye-watering returns in the period that the global economy has been mired in recession, so there may be a ‘give-back’ to be had in the happier months, which now hopefully lie ahead.