Reasons to be cheerful

January 07, 2022

…as long as your name isn't No-vaxx Djokovic.

Treasury yields have risen at the start of the new year, as Omicron fears appear to give way to optimism that the rapid spread of a much milder variant speeds up the moment at which many societies in the Western hemisphere learn to live with the virus.

In this context, lockdown restrictions are becoming less likely, as the recent wave of infections peaks and healthcare systems weather the storm intact. Upcoming economic data may be impacted by fears relating to the virus during the past month, with large numbers temporarily away from work.

However, as this gives way to renewed confidence in economic prospects, this leaves central banks reflecting on closing output gaps at a time when inflation remains well above policy targets.

As such, we expect to see a number of central banks continuing to move in a more hawkish direction in the coming months. Thus far, the Federal Reserve (Fed) has tiptoed carefully in signalling an end in asset purchases and a pathway to higher rates. Yet with risk assets remaining well supported for the time being, we take a sense that policymakers are becoming more emboldened to up-the-ante in the coming weeks.

Over the past several days, indications that the Fed may soon look to actively reduce its balance sheet, via asset sales, has come as a surprise to some market participants. However, with the yield curve having become anomalously flat in recent weeks, such an approach may make perfect sense.

In addition, inasmuch as excessive liquidity is driving inflation pressure, notably via asset prices, then draining liquidity has some appeal. This is compounded by the fact that wealth gains as a result of asset price inflation have favoured the ultra-wealthy in society.

Conversely, the costs of inflation are being disproportionately felt by lower-income groups, who need to spend a larger portion of their incomes on utility bills and the like, where price inflation has been most severe.

Broadly speaking, we do not believe that policymakers want to push asset prices lower, but they may like to dissipate speculative behaviour in some quarters for fear of ‘bubble’ type behaviour in assets like crypto, NFTs and meme stocks.

Similarly, there seems greater acceptance from policymakers that, after a couple of years of very strong gains, moves in stock prices cannot remain a one-way bet. From this standpoint, we believe that the ‘Powell put’ won’t disappear, but that the Fed is unlikely to flinch unless the S&P posts double-digit percentage losses.

Inflation is also a pressing concern for European policymakers, notwithstanding hopes that recent November CPI prints may represent a peak in the series. Although natural gas prices have declined from their heady heights witnessed during Q4, energy price inflation is likely to continue to push utility bills higher.

Meanwhile, unions are pushing for higher wages and it is interesting to speculate whether the labour union covering workers at the European Central Bank (ECB) will, itself, be pushing for an inflation-target busting pay increase in the coming months.

Consequently, secondary impacts on inflation may slow a return towards the 2% goal, especially when one considers that in an economy such as Spain, PPI inflation stands at 33% year-on-year, with consumer prices some 6.7% higher than 12 months ago. From this perspective, we think the ECB will be moving in a more hawkish direction in the coming months, even if the eurozone is behind the US in the cycle, relatively speaking.

This outlook sees us maintaining a bias to run short duration risk, with relatively elevated levels of conviction. Having been contained over the past nine months, we see most scope for US yields to rise, with UK Gilts also likely to witness comparable moves as the Bank of England also accelerates monetary tightening. European yields should exhibit a lower beta, relatively speaking.

In sovereign credit, a trend higher in US rates could be detrimental to a number of emerging markets. Meanwhile, a more hawkish central bank may see some spread divergence within the eurozone over coming months, even if this should be contained in the absence of negative political developments.

In Asia, we feel that China’s policy to maintain a ‘zero Covid’ approach is destined to fail, in light of Omicron’s elevated transmissibility. Eventually, China (and other Asian countries) will have no choice but to follow the path taken in the West – yet it may take time before this realisation is accepted. In the interim, lockdown risks may continue to rise in China, even as they decline elsewhere. This could lead to additional supply-chain disruption, limiting the speed of normalisation and perpetuating elevated prices.

There is a risk that China worries could induce global growth concerns, but if this were to occur, we think it would be fleeting.

Increasingly, we are witnessing the separation of global supply chains and greater nationalistic motivation as trends that have led the globalisation move into reverse. This is another factor leading us to conclude that secular disinflationary trends may be weakening, allowing for greater growth in prices and incomes in the quarter to come, inferring also that equilibrium interest rates have stopped trending lower over the long-term and may now be trending higher.

The start of the new year has seen solid demand for new corporate credit issuance as investors put cash to work. A widening of spreads in the early part of December made valuations more compelling, and with equities continuing to trade okay, we think that index spreads should remain within a range for the time being. Indeed, the move to higher yields has witnessed rotation within stocks, with more duration-sensitive tech equities coming under pressure just as value sectors, such as banks, outperform. Rising bank equity prices should help subordinated financial credit continue to outperform and this is a trend that we believe has got further to run during the course of 2022.

Notwithstanding this, our overall view on credit this year is more cautious than it has been during much of the past two years. Generally speaking, we struggle to see broad market spreads much tighter in a world of higher rates and we would like to be in a position where we can add to risk on weakness.

Looking ahead

We suspect that a backdrop of more restrictive policy may make this a more challenging year – in the context of absolute returns – for all investors. A withdrawal of liquidity support may also lead to elevated volatility and increased dispersion of performance. We suspect that this will lead to as many opportunities on the short side as the long side. As ever, the challenge in an absolute return strategy will be to utilise skill to capture these moves as they occur.

In many respects, 2022 begins with a sense of optimism after two years of pandemic. As normality returns, we are inclined to think that fundamentals and valuations will play a more important role in determining the path of asset prices than they have during a period characterised by abundant liquidity and market technicals.

From that standpoint, as No-vaxx Djokovic is sent packing from Australia, we wonder whether 2022 will see the complacent and foolish, who have come to rely on short-term gains by jumping on price trends, get their deserved comeuppance, as common sense prevails.

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