It looks like financial repression is here to stay and appears highly likely that interest rates across major global economies may be set to remain anchored at or below 0% for many years to come.
Having initially retraced some of last week’s sell-off, equities weakened again in the aftermath of Wednesday’s US Federal Reserve (Fed) meeting, to end close to flat on the week.
Chair Jay Powell reiterated the Fed’s accommodative stance and it appears that the central bank remains focused on delivering policy in order to support the recovery in growth as much as it is able to do so. Failure to deliver supplemental fiscal easing could lead to the Fed increasing asset purchases at its next meeting if economic data starts to dip.
The thinking seems to be that while monetary policy may be the wrong tool to be using, it is the only tool at the Fed’s disposal. Additional asset purchases may be a driver of further asset price inflation, continuing to drive the disparity between Wall Street and Main Street.
However, for the time being, it appears that financial stability is not near the list of the Fed’s concerns and there is little evidence of asset price inflation driving more widespread price inflation, at a time when unemployment remains elevated and prospects for wages are muted.
Having rallied in a straight line for six months, it nonetheless feels as if the easy money has been made on the trade and if behaviour becomes increasingly speculative and motivated by earning short-term gains, then this may be a smart moment to start looking in a contrary direction.
Euro 20/20 vision
European markets have been relatively quiet over the past week. Concerns related to rising Covid-19 numbers continue to be mitigated by evidence that mortality rates are dropping and there are few signs of the healthcare system becoming overwhelmed.
Some additional measures have been enacted across the continent, limiting large gatherings, but broadly speaking there has been a measured policy response. Meanwhile, Sweden continues to buck the trend, with daily infections declining to zero in the middle of this week, in the country that has eschewed the idea of lockdown since the beginning of the crisis.
A battle for Britain
However, the (in our view) panicky and poorly coordinated approach being taken in the UK seems to stand in stark contrast. Another abject failure with respect to Covid-19 testing capacity and a decision to limit households to a maximum gathering of six individuals seems destined to create more fear and confusion rather than having a materially beneficial impact.
It is striking that UK workers have been much slower to return to their place of work than has been the case for their European counterparts and, although large cities that rely on public transport seem to be most affected worldwide, it is still telling how empty London continues to be.
The UK government consequently seems confused whether it is telling individuals that everything will be fine and they should return to work, or whether they should stay at home and stay safe.
Spreads with respect to corporate bonds and eurozone sovereigns followed equity sentiment over the week, initially grinding tighter before a modest pullback. New issuance remains seasonally heavy, but robust demand has meant that deals are frequently offering little versus secondary‑market bonds, once superficially attractive initial pricing guidance is revised materially tighter on inflated order books.
In many sectors and issuers, spreads are now back to end-2019 levels. While we continue to see pockets of value, more generally speaking, it is hard to adopt a strongly bullish stance, considering that net leverage has increased since the start of 2020, with downgrade-to-upgrade ratios also moving decisively higher.
Supportive monetary policy is set to continue to underpin financial repression, but we believe it continues to appear more attractive to buy dips and sell strength, rather than to chase the market following its recent solid run.
In the UK, evidence that the government may be seeking to compromise on plans to violate international law by violating the EU withdrawal agreement, by declaring it will only do so should the EU be in breach in the first place, could suggest that we may be reaching / passing a point of maximum bearishness with respect to the UK.
Our base case is to expect a compromise between Brussels and Westminster in the course of the coming month, and for a limited trade deal to be agreed, which would come as a relief, following a period during which ‘no-deal’ risk has been rising.
Consequently, we have closed a short position in the UK during the past week, with positive contribution, and believe that the next potential trade may now be to adopt a long position in sterling, if we are able to establish conviction that a moment of compromise is upon us.
Mid-October will be an important deadline with respect to a deal and realistically – even in a messy ‘no-deal’ scenario – we believe that an additional ‘implementation period’ may be needed in order to put in place the required infrastructure at the border. In this case, we are hoping that recent events have been shaped by Dominic Cummings’ approach to negotiation by creating a sense of crisis before pivoting at a later point.
That said, we would still like to see more evidence that the narrative will play out in this fashion before we can ascribe greater confidence to this idea.
No Turkish delight
Emerging markets (EM) have traded relatively well over the past week. Robust data from China has seen the renminbi continue to make gains versus the US dollar. Meanwhile, a relatively dovish Fed has seen other currencies making gains versus the greenback, with EM foreign exchange (FX) outperforming.
Hopes that a Covid-19 vaccine is now only weeks away has also supported sentiment – even if many EM countries may be forced to wait to deploy vaccines with developed countries buying up a lot of the initial supply. Progress on a vaccine may be disproportionately beneficial to those economies most reliant on tourism; in light of this, we have closed a short stance with respect to the Thai baht.
Elsewhere in EM, Turkey remains in the spotlight as the country’s central bank runs out of reserves. In our opinion, a change in policy mix could help stabilise the Turkish Lira, but higher rates and tighter credit conditions will impact growth. More broadly, we would express a cautious view with respect to Turkish banks and also those European institutions with substantial Turkish exposure.
What lies ahead
As we look ahead, it appears that the initial economic improvements as economies have rebounded from the end of lockdown are starting to level off. We feel that the deployment of a vaccine will be needed in order for the most impacted sectors of the economy to recover, with this hopefully seen during the course of 2021.
In the near term, fiscal retrenchment in the US (following the end of prior stimulus programmes) and the UK (with furlough payments ending) appear to create some downside risk as we move into the fourth quarter. This may keep both the Fed and the Bank of England in accommodative mode, while in the eurozone, the European Central Bank also appears dovishly inclined, with inflation continuing to undershoot and worries that euro strength could weigh on the outlook.
As we look back, it strikes us that the sweet spot of cheap valuations, improving macroeconomic data and additional policy stimulus is now behind us. We believe that valuations are much less compelling today and, consequently, it is debateable whether accommodative monetary policy alone can drive asset prices much higher or whether there will be more of a pattern of consolidation.
Vaccine announcements could be the catalyst to lift risk assets further, but these are already widely expected, with a lot of good news seemingly ‘in the price’ with respect to many assets. The US presidential elections and Brexit have the potential to be material risk events before the end of the year and, instinctively, it would be surprising if markets can continue racing upwards unchecked into the end of the year, having done so well in the last six months.
Playing the long game
Looking to buy dips and retaining a sense of patience continue to make most sense to us. At the same time, we feel it is dangerous to become too dogmatic around valuations and it would appear highly likely that interest rates across major global economies may be set to remain anchored at or below 0% for many years to come.
In our opinion, financial repression is here to stay – but it remains dangerous to chase prices or become sucked into owning risk at the wrong price. Maybe prevention isn’t better than cure after all!