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The market’s mask slips

Risk events appear to be coming to a crescendo but we see scope for a moderately constructive bias.

Risk appetite took a turn for the worse this week as climbing rates of Covid infections across Europe and parts of North America led to the greater curtailment of economic activity as lockdown measures were re-imposed.

Core government bond yields were broadly lower while equity markets suffered their worst week since June as volatility spiked higher. Markets stabilised towards the end of the week but with the US election now just a few days away, investors remain firmly on their toes.

In Europe, the focus has been on the rapid re-emergence of Covid cases and their potential economic impact, particularly on the front-facing service industry. Italy and Spain announced new curfews this past weekend, while France and Germany followed by enacting time-limited ‘light-lockdowns’.

It all feels a bit déjà vu

There are no guarantee the latest restrictions will be enough in order to flatten the Covid curve again. In terms of economic impact, last week’s PMIs had already started to show weakness seeping into the services component of the index and it will be interesting to observe the extent to which the latest restrictions knock these numbers in the coming months.

The actions ultimately point towards more fiscal action domestically, as governments look to stem a fall in Q4 output. Ultimately, notwithstanding the increase in budget deficits, European countries remain well supported by policymakers via the upcoming recovery fund and easy monetary conditions.

In the face of added uncertainty in the eurozone, the ECB did its best to sound a dovish tone, signalling its willingness to maintain its very accommodative stance through the duration of the pandemic. This was in line with market expectations, with an increase in PEPP purchases on the cards in December, probably in the region of an extra EUR500bn.

Broader risk aversion meant periphery spreads moved wider over the week before stabilising, but we remain constructive, albeit selective, looking to add on weakness while being vigilant of any broader risk aversion. In this context, a surprise upgrade in Italy’s outlook from S&P provided some comfort that rating agencies are looking through the rise in debt levels in these times of crisis.

Rising election fever

In the US, the election is now only a few days away and campaigning across swing states is drawing to a close. Trump’s final push has narrowed the gap in national and state polling somewhat, but Biden remains the firm favourite.

From a market perspective, the main downside risk is significant turmoil around a contested outcome, but we take the view that this is a relatively low-probability event.

On the flipside, a clean sweep for the Democrats – winning the Presidency, the Senate and holding the House – will likely lead to a larger fiscal boost down the line, while if Trump were to pull off another amazing comeback, continued deregulation and lower taxes would be the focus.

In the UK, Brexit news has simmered since talks resumed last week, a sign that we are in the intense phase of negotiations as we move towards a trade deal. We remain long the pound.

Credit looks past equity volatility

Despite equity markets trading in a volatile fashion over the past week, corporate credit markets have been more orderly. Investment grade corporate cash spreads closed the week only fractionally wider as underlying technicals remain robust given a light primary calendar (as many corporates remain in black out) and given ongoing central-bank buying of the asset class.

Cash/CDS basis has also performed well over the past week and has suited our portfolio construction as our cash longs have outperformed the broader market weakness, whereas our CDS index shorts have underperformed (tracking the move in equities).

As credit indices have moved wider over the past week and close to the wides of the recent range, we have monetised some of these hedges and progressively moved longer risk in corporate credit.

Looking ahead

Anticipated risk events appear to be coming to a crescendo in the macro landscape. The US election, the extent of further lockdown measures, Brexit negotiations and vaccine news all present both upside and downside risks over the coming weeks and it is understandable that investors may want to proceed with caution.

However, we continue to think that a moderately constructive bias, leaving scope to add risk into any future dips, appears to be warranted as we look beyond these events and focus on the scope for further policy accommodation.

Perhaps we have all been too complacent with respect to a second wave. After all, if masks really are that effective, then why can’t a pair of pants stop a simple fart?