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While statues topple, interest rates remain firmly anchored

A dovish Fed update dampened the week’s mood, with seemingly only the return of sports able to provide some life-after-lockdown cheer.

The liquidity fueled rally in risk assets appeared to run out of steam during the past week, with markets experiencing a reversal from their highs, shortly after the S&P 500 had fully recouped its 2020 year-to-date losses.

Notwithstanding the temptation to fit a narrative to the price action, a simple explanation could be that as markets have moved higher, so we have seen the burden of proof shift away from those who have been adopting a more bearish stance towards those who have been extrapolating that the recent rally in assets will continue. Perhaps, after a record-breaking 50 days for the S&P, this should not come as a major surprise.

Meanwhile, this week’s Federal Reserve meeting appeared to offer little new information beyond what had been previously communicated. Policymakers have been much more circumspect than many market participants in talking up the pace of economic recovery as the impact of Covid-19 and the lockdowns start to fade. Consequently, downbeat economic forecasts should not be much of a surprise – save for those fantasists who, last week, were proclaiming that the ‘V’ shaped recovery had become an ‘I’ shaped recovery in the wake of one statistically quirky payrolls report last Friday.

Yet the corollary of all this is that, in the absence of inflation, the Fed and other central bankers seem set to keep rates at current levels for a very long time. They will also seek to anchor yields (and spreads) through asset purchases and although there may be insufficient new steps to drive markets higher, the liquidity from prior announcements will continue to support markets.

‘In it to win it’ mentality

Over the past few weeks, it has seemed apparent that the rally in risk assets has been driving a renewed ‘FOMO’ mindset amongst investors, as shown by the balance in options markets switching from puts to calls.

Anecdotally, it was also captured pretty nicely this week in the temporary 1500% one-day move in a stock under the Bloomberg ticker of DUO, whose company name happens to be FANGDD Network. It appears that those chasing the rally in FANG stocks didn’t notice that this particular company operated in the real estate sector – but it is symptomatic of a market in which the importance attached to research and analysis has been replaced by a desire to jump on a trend because you can’t afford to be the one who misses out.

Regardless of this, it certainly seems that market technicals are no longer skewed in the way that may have been the case a couple of months ago. Consequently, it is tempting to think that the recent uptrend in some markets could be replaced by more of a move into a trading range, especially if some investors who have recovered earlier losses decide it is time to take some chips off the table during the next couple of months.

Returning to normality

Uncertainty regarding the trajectory of Covid-19 and the easing of lockdowns seems set to persist for some time. Many countries now appear to have brought the outbreak under control, but there remains understandable nervousness with respect to the path to normalise many sectors of the economy.

For example, in the US, restrictions have been eased, even as the rate of infection continues to rise in some states. Questionable handling of the virus, as well as civil unrest and increasing domestic political tension, all continue to weigh on the US dollar, yet we struggle to extrapolate this continuing with much certainty, as it would seem premature to conclude that the US growth advantage over Europe and many other countries has now come to an end.

Elsewhere, the UK now seems to be topping the polls in terms of the country which has most mis-managed the epidemic. Death and infection rates in the UK have been falling more slowly than across the rest of the Continent.

Meanwhile, attempts to bring the economy out of lockdown have been hampered by botched plans to re-open schools and recent messaging that it isn’t safe to be out in public without a face mask now that infections are falling, having given advice to the contrary when the virus was at its peak.

Consequently, when growth estimates for 2020 in countries like the US and Germany are hovering in the region of -6.5%, with Italy and Spain at -10.5%, the UK appears a notable underperformer based on projections in the region of -12%.

Furthermore, we sense a renewed determination to push ahead with Brexit, with a seemingly invincible and reinvigorated Dominic Cummings calling all the shots. We believe that compromise with the EU is unlikely and a hard Brexit at the end of this year would now be our central view. In Downing Street, we sense a mindset that the economic situation in 2020 is going to be so bad anyway, that any bad news on Brexit can be blamed on the virus impact.

Against this backdrop, we expect the Bank of England to deliver additional policy easing in the days and months ahead. However, we believe that the committee will continue to favour asset purchases rather than moving to negative interest rates. That said, we believe that policymakers won’t be unhappy if the pound weakens in order to support the UK’s competitiveness and encourage domestic production; they may look for sterling to tests its lows against the US dollar and euro in the months to come.

Bonds & equities move in tandem

Correlation across financial assets has remained very high over the past several weeks. Corporate credit spreads and emerging markets continue to track moves in equities, yet it is worth observing that, notwithstanding the rally over the past two months, investment-grade spreads remain around 50-60% higher than prevailing levels at the start of 2020, at a time when equities (in the US, at least) have recouped all of their losses.

Given that central banks on both sides of the Atlantic are purchasing investment-grade corporate bonds, we would observe that there may be more room for spreads to rally in this space than elsewhere, should fears relating to supply start to moderate.

Similarly, should sentiment sour, then we would anticipate this segment of the market should see the most support.

Consequently, we retain a moderately constructive view with respect to investment-grade credit, even though we have been progressively paring exposure and selling into strength as markets have rallied in the past several weeks. We also retain a constructive stance with respect to the European periphery, where we have continued switching away from Greek to Italian government bonds.

As we have added BTPs, we have also been content to add some duration risk. Having seen underlying Bund yields rise in recent weeks, we believe that a retracement rally is likely, as it seems premature for reflation trades to lead to a sustained bear steepening in the yield curve at a time when economic newsflow is set to remain challenging and the ECB continues to increase its policy support.

Looking ahead

We continue to express uncertainty with respect to overall market direction. The battle between central bank liquidity and recessionary fundamentals seems likely to continue to play out for the next several months.  In this landscape, we continue to question whether incremental newsflow is more likely to be skewed in a positive or a negative direction.

Between now and the end of June, we don’t anticipate material new policy developments and, consequently, the greatest uncertainty may pertain to the trajectory of Covid-19 and the success of re-opening economies as we emerge from lockdown.

Up to this point, we have seen some signs of hope, but there may be some danger that this breeds complacency in the days ahead. In Europe, success in lifting travel restrictions starting from next week will be particularly important with respect to the economies of Southern Europe, given the relative importance of the tourist sector.

We remain alert to the possibility that a second spike cannot be ruled out.

Meanwhile, should rates of infection in the US and UK start to rise, in countries where the virus is still some way from being successfully contained, any move to reimpose lockdown restrictions could be economically and socially disastrous. Hopefully, this won’t happen. However, a desire to proceed with caution is also being met with the concern that ‘winter worries’ will mean that anything not fully open by October is likely to remain impaired until next spring at the earliest. This may drive forward plans to ease restrictions and accelerate openings, but at the expense of increased risk.

Anyway, for now at least, spirits may be lifted by moves back towards normal life. At a time of elevated anger and resentment being directed towards the establishment, the return of sport is likely to be warmly welcomed, not least as a source of distraction from ‘statue bashing’. That said, football fans have been known to topple a statue or two…