As autumn rolls in, perhaps our leaders have a thing or two to learn about insightful and timely decision-making following a haphazard summer. Make space in the classroom, kids…
After the relative calm of summer, US equities began September on a more volatile footing. After hitting fresh all-time highs early in the week, this unravelled as the NASDAQ slumped 5% in one session as market participants started to question the sustainability of current lofty tech valuations.
Core government bond yields also moved lower in sympathy with the pick-up in equity market volatility and as investors digested further comments from central bankers post-Jackson Hole.
From one perspective, markets look rosy, anchored by low borrowing costs, a steady recovery in some of the worst-hit sectors and just in need of some natural consolidation after an extended run.
However, you could equally argue that the data points towards a mixed picture – economic divergence between sectors and countries is increasing and until there is a vaccine, the threat of new local lockdowns lingers. These remain uncertain and unprecedented times as we head into autumn.
Central banks reiterate commitment to recovery
The week saw a host of central bankers speak publicly, adding to comments from Jackson Hole and reinforcing their commitment to keeping financial conditions easy during the recovery phase of the pandemic.
In the US, vice chair Clarida spoke about how the Fed may have been too quick to tighten policy between 2015-2018 and reiterated the new policy stance in terms of not letting low unemployment dictate future Fed actions. Governor Brainard also reiterated the new Fed framework which now adopts flexible average inflation targeting (FAIT), stating there is still plenty of firepower left in the policy toolkit should financial conditions or the inflation outlook worsen.
This tone was also reflected by the Bank of England, with Governor Bailly and MPC member Ramsden highlighting that the bank still has plenty of room to ramp-up QE in existing assets and expand QE into other assets. The dovish guidance has continued to keep a lid on core government yields.
In Europe, there has been some market chatter that the ECB could act sooner rather than later on the back of a strengthening euro and weaker inflation data. There has also been some moderation in PMIs since the last update in economic projections in June, with southern states starting to diverge from northern states. This may limit how far spreads in the periphery can tighten in the interim.
Notwithstanding this, we see some internal resistance to the idea of extending or adding to existing QE programmes in the months ahead and thus see the ECB in a ‘wait and see’ mode with APP net purchases running indefinitely, plus nine months of PEPP net purchases still to run.
Turning to US politics
President Trump continues to eat into Biden’s lead in the polls with some betting markets even showing Trump as the likelier winner in November. Interestingly, the increased likelihood of a close race has seen markets starting to price heightened volatility around election time, with October VIX contracts spiking as the risk of a contested election grows.
Back to this month, US fiscal stimulus talks are set to resume but we are hearing there remains little appetite for negotiation between the White House and Democrats, with Republicans also split among themselves.
We could be in a situation where government funding and fiscal stimulus get rolled into one package at the end of the month, potentially risking a government shutdown, the impact of which could wake up a market which has so far overlooked these negotiations.
Corporate credit markets
Following a summer of strength for corporate spreads, investor focus has now firmly shifted to the pending September ‘back to school’ new-issue calendar, given its seasonal significance of being a heavy month of issuance.
Despite record corporate bond supply year-to-date and the expectation of net supply to be significantly lower into year-end, there is a risk supply could be front-loaded into September given where valuations are and ahead of a potentially more volatile macro landscape into year-end.
While this could lead to some short-term spread indigestion, we remain confident this should not derail our broader constructive thesis on investment-grade credit, given the ongoing global hunt for yield, positive asset class inflows and the asset class being subject to global central bank buying programmes.
At this juncture, we continue to favour taking long risk positions with more of a compression mindset such as BBBs, corporate hybrids and subordinated financials, and running against that convex shorts in synthetic products such as credit indices.
Despite risk assets continuing to steadily climb the wall of worry over the summer months, as we move into the final innings of the year we continue to exercise some caution. There are plenty of potential catalysts for downside volatility, whether that be virus resurgence, data disappointment, US elections, consolidation in overbought US equity markets or a lack of progress on fiscal policy.
Against these negatives, a general sense of risk being under-owned, potential for positive vaccine developments and the global policy backstop likely means any substantial dip gets bought. But with generic valuations having retraced substantially, we believe exercising discipline and patience and looking to take advantage of any volatility will be a fruitful strategy.
On a finishing note, US Labour Day on Monday traditionally marks the end of summer for markets and the prospects for the run into year-end could well be influenced by how progress on government fiscal policy plays out.
Hopefully the decision making of some governments shows signs of immediacy and improvement, because at times in 2020 it has felt like it’s not just the kids that desperately need to go back to school..!