UK ‘Remainers’ have come to terms with Brexit. We hope the EU can too.
The announcement of Powell as Biden’s pick to serve a second term as Fed Chair saw short-dated US yields move higher during the past week, though virus news overnight has seen all of this move reverse in thin Thanksgiving markets. With data prints remaining robust and an increased political focus on inflation, we think it is likely that the FOMC will announce an acceleration in its taper schedule at the December meeting.
For now, longer-dated yields remain rangebound as the yield curve flattens. Although Eurodollar futures price a much more hawkish path for rates, relative to the median Fed dots during 2022 and 2023, it appears markets are reluctant to believe that cash rates can breach 2% over the longer term.
However, we doubt that it will be possible for the curve to flatten much more than has been the case to-date and we are confident that a move higher in yields should be led by the 10-year point on the curve. The news of the new Covid variant B.1.1.529 over recent hours could of course change some of this, but at this stage a lack of information makes it hard to analyse or credibly comment too much.
Away from rates markets, it has been interesting to observe how the dollar has been buoyed by rising short-dated yields, whereas equities have been supported by contained developments with respect to longer-dated maturities.
In many respects, this may be a logical outcome since equities are themselves very long duration assets. Therefore, it is the discount rate for future cashflows coming from the long end of the bond market that should have the biggest bearing on stocks. Even amidst talk of an accelerated taper and projections moving towards three Fed hikes in 2022 and 2023, so the yield on 30-year Treasuries is still some 50 basis points lower than its 2021 high back in March.
Seen in this light, it is understandable if equity investors remain sanguine until this changes. That said, if long-dated yields do start to rise, then this could increase the risk of a reversal in stocks and a rotation from growth to value on a sector basis.
Attention in Europe remains more focused on a fourth Covid wave. Based on the UK’s experience, we expect this to plateau soon and hope that policymakers hold their nerve without re-imposing lockdown restrictions, as we have witnessed in Austria. At this point, lockdown feels like a policy error to us and looking at healthcare data, it is observed that levels of hospitalisations across the continent remain much lower than was the case earlier in 2021 – notwithstanding scare stories coming from organisations such as the WHO.
Although we remain sanguine with respect to Covid risks in Europe, we think that recent developments will give the ECB plenty of cover to remain relatively dovish at the December policy meeting, despite elevated inflation pressures.
A EUR40 billion extension in APP purchases is largely expected and the technical outlook for eurozone government fixed income continues to appear supportive through the course of 2022. We doubt eurozone rates will rise materially before the end of 2023 and consequently have a more favourable outlook with respect to euro duration than is the case in the US or UK.
Elsewhere in Europe, a coalition agreement in Germany appears to pave the way for a Scholz government to be announced early next month. Politics in Sweden also caught attention, with the country’s first female prime minister only lasting a few hours in office before a coalition collapse.
European credit spreads have been under some pressure during November, with swap spreads, corporate spreads and sovereign spreads all rising. With supply abating as we move into December, we think that these moves may be reversed over the coming month, as long as the ECB does not deliver a hawkish surprise, which we see as relatively unlikely.
Favourable seasonals in January should also be a constructive factor, yet we think we are starting to see the beginnings of a re-pricing that could come later in 2022, should asset purchases draw to a close by the end of the year ahead.
In emerging markets, it was (perhaps appropriately) Turkey that was very much the focus of attention in Thanksgiving week. Following the recent rate cut by the central bank in the face of rising inflation, the lira has come under heavy pressure on growing evidence of dollarisation in the Turkish economy.
Erdogan has been scrambling for support from his friends in the Middle East in order to prop-up the currency, though he appears to remain very much the architect of many of Turkey’s problems. Macro fundamentals will require more restrictive policy to tame inflation and, until this is acknowledged (possibly by a different government), then we suspect that Turkish assets will remain under pressure.
Meanwhile, concerns on the Russia/Ukraine border continue to escalate, elevating unrest within the region. November has been a tough month in emerging markets with negative country developments, rising geopolitical risk, rising US short rates and a firm dollar all weighing on valuations.
We look for a firm November US labour report to be announced at the end of next week. US job openings remain at record levels and jobless claims have been trending lower, suggesting to us that there is ongoing healing in the US labour market. Consumer sales over the Black Friday/Cyber Monday period will also be closely scrutinised, though in the absence of inventory, we think that the key theme from this year’s holiday sales will be that discounts are far less generous than normal.
As we move into December, it is interesting to note how each of the Fed, ECB and BoE meetings are very much ‘live’ events. Typically, December policy meetings are viewed as non-events, given a desire not to surprise or disrupt markets during a period when liquidity is thin. However, there seems plenty yet to be decided and if we are correct in looking for a firm jobs report followed by a firm inflation report, we think it is inevitable that the Fed will need to raise its 2023 inflation forecasts and this will become a catalyst for accelerating the pace of taper.
In the UK, we also expect robust data for now and in this context, the BoE’s flip-flop in November means that it may be under much more pressure to act next month. In contrast to more hawkish risks in the US and UK, we think that a more dovish outcome could come from the ECB. However, Lagarde has made communication errors in the past and risks around the ECB meeting remain elevated in the run-up to this.
On a more sombre note, it was upsetting to witness the loss of life in the English Channel this week. Migration stresses are an issue on a global basis and are likely to only intensify in the years ahead due to different demographic trends, geopolitical upheaval and the impacts of climate change. Individuals are being displaced in record numbers and it seems there needs to be greater understanding as to how to address this.
In recent weeks, it appears that simmering resentment from the EU, and France in particular, has led French authorities to turn a blind eye to human traffickers who cram men, women and children onto small and dangerous boats in freezing waters so that they can dispatch their unwanted onto the UK. Post-Brexit, there needs to be collaboration and co-operation between the EU and the UK.
The UK may have left the EU, but it remains an important neighbour. It can only be hoped that the recent tragedy serves as a catalyst to knock some heads together so that it is not repeated. Remainers in the UK have come to terms with Brexit and hopefully the EU will do so as well.