Thanks to vaccinations, things should be much less scary this time round.
Covid infections accelerated during the past week across Europe, prompting some government moves to impose renewed restrictions on mobility and working from home. However, we doubt these steps will be far-reaching and think it unlikely that a trajectory towards economic recovery will be derailed in the weeks ahead.
The experience in the UK over the past couple of months has seen Covid cases rise materially, only then to plateau with hospitalisation and death rates far below prior waves of infection. Moreover, in the UK, it can be observed that the general attitude to mask wearing has been far less compliant than on the continent, with those of us using public transport observing less than half of users wearing face coverings, even during busy rush hour periods. In this way, the recent acceleration of Covid cases in the EU may appear concerning when viewed on a standalone basis, but it is much less of a worry seen in this context.
We are all learning to live with Covid and it seems that vaccines and recent booster jabs are playing an important role in mitigating the virus. In the context of investors in financial assets, it remains correct to observe a trajectory in which the pandemic is moving into the rear-view mirror.
If there is a more palpable risk to markets as we look towards the end of the year, we are more concerned that this could come from events around Russia/Ukraine. The recent build-up of Russian troops could suggest that confrontation is coming soon and Putin will be aware that there is little that the West can do should he decide to make a move, given Europe’s reliance on Russian gas and a US administration that is likely to have little appetite for action beyond the imposition of additional sanctions.
With the situation in Belarus also destabilised, there is a narrative about Putin looking at the opportunity to re-make the Soviet Union in cementing stronger ties with CIS states. From this standpoint, it is notable that 8th December will mark the 30th anniversary of the end of the former USSR. Perhaps Putin will eye his place in history as the leader who brought everything back together again, though on the whole, our assessment of the Russian president is he’s an individual who doesn’t rush into action.
Moreover, with this speculation only serving to push oil and gas prices higher, it is hardly hurting Russia as things stand today. In that context, Russian assets and the rouble may appear attractive if it weren’t for the looming geopolitical risk.
High European gas prices remain an important theme across the continent. Agreements to end coal usage at COP26 only serve to increase demand for gas in the near term, with additional capacity in nuclear and renewables set to take time to deliver a more decisive shift away from hydrocarbons.
Energy costs are likely to weigh on European consumers in the months ahead. This week’s upside surprise in UK inflation – with the RPI hitting 6% – is likely to be followed by further gains, in our view. In the wake of this, regulated prices, such as train fares or student loan charges, could push above 8% and we see this driving wage demands.
In discussions with trade unions, leaders are not slow to appreciate that their members have seen an effective pay cut over the past year. With inflation set to remain elevated during 2022, so unions have calculated that double-digit pay increases will be required and with labour markets tight, there is every chance that industrial action will follow if governments and employers do not accede to these demands.
For us, this is a stark reminder of how inflation expectations can become de-anchored and second-round effects on inflation can create a more persistent trajectory to higher prices. This is something we think many policymakers have been slow to realise, which is concerning.
In the US, gas prices are not such a concern and moves by Biden to open the Strategic Petroleum Reserve may help to keep a lid on oil prices for now. Nevertheless, inflation is becoming more political and there is a sense of concern within some at the Fed that the FOMC may have fallen behind the curve.
Meanwhile, aggregate demand data in Q4 has looked pretty robust, with healthy retail sales this week and survey data also solid. The queue of ships waiting off the west coast of the US seems to keep growing... Meanwhile, we get the sense from corporations that there is a desire to rebuild depleted inventories. The pandemic is seeing a move away from ‘just-in-time’ production models and globalised supply chains, which also happen to be factors that contributed to lower inflation over the past couple of decades.
In the past week, government bond yields have traded slightly lower, led by the eurozone. Notwithstanding above-consensus job and inflation data in the UK, Gilt yields were little changed – even if this data seemingly highlights that the Bank of England will need to tighten policy soon.
Over the week, currencies provided more of a focus for investor attention, with the US dollar breaking new highs versus the euro and yen in the wake of further stimulus from Japan. We have been inclined to look for dollar strength on the relative outperformance of the US economy and see scope for this to continue into the end of 2021.
Policy tightening is more of a feature in the US and we believe that further robust jobs and inflation data heading into December may lead to FOMC forecast revisions and an acceleration in the pace of taper to end as early as March. Meanwhile in the eurozone, we see the ECB being more dovish and the recent fourth wave gives the governing council every excuse in this respect.
Liquidity fears into the end of the year have seen repo rates dropping and some concerns of collateral squeeze. This has pushed swap spreads wider and has been a factor weighing on cash credit spreads at a time when there remains plenty of supply before the issuance calendar dries up going into December.
With CDS indices not impacted by these moves, a widening in the cash-CDS basis has seen credit underperform over the past few weeks, although we see this as more of a temporary and seasonal phenomenon that should correct in December. Nevertheless, corporate bonds have underperformed, with the same dynamic impacting spreads in sovereign credit.
Next week sees Thanksgiving in the US so it will be a holiday-shortened week in markets. There is often great interest in looking at Black Friday sales data as an indicator of economic health and the strength of the consumer. But this year could be a little different.
It isn’t as clear to us that retailers will want to discount much when they have no real inventory to sell. Discounts may thus be much less generous than in the past and excitement in the shops more subdued.
Meanwhile, we continue to await news regarding Biden’s pick for the Fed chair. Inflation concerns appeared to hurt Brainard’s chances, though were she to be chosen, then this could benefit risk assets and lead to a somewhat weaker dollar and a steeper yield curve. However, we think the absolute level of yields should not be greatly changed – at the longer end of the yield curve, at least.
Further out, we remain confident that US yields should rise materially into the end of the year. A combination of positive data, a more hawkish pivot from the Fed and lower liquidity could contribute to this, especially if the path for the first rate hike moves into the first half of 2022.
Returning to the topic of the fourth wave, it continues to strike us that vaccination offers the answer, not lockdown restrictions. If anything, an acceleration in infections leads to an uptake in jabs and therefore much of this dynamic should be self-correcting.
Generally speaking, one may assess that the morons in the anti-vax crowd should diminish in number, as they face the choice of reassessing their thinking or else end up getting sick. Either way, this wave is much less scary than those that have preceded it.