BlueBay AM: The greased piglet

July 8, 2022

By Mark Dowding, CIO of BlueBay Asset Management

In the end, there was nobody left to save Boris’ bacon.

Financial markets were broadly range-bound over the past week, albeit with elevated intra-day volatility dominating trading conditions. Fixed income bore much of the brunt, with implied volatility in rates markets and credit spreads both close to their Covid-crisis peaks a few years back.

Moreover, further moves upward in natural gas prices continue to feed recession fears, yet there may be little that policymakers can do about this, save for caving in to Putin and lifting sanctions. This would appear unconscionable, hence governments across Europe are being pushed to deliver increased fiscal support, even as central banks are forced to tighten policy in the face of inflation.

Over the past several weeks, recession fears have pushed yields lower as markets discount a lower peak in interest rates. However, in the context of the US economy, we believe that growth fears may have been exaggerated – this week’s ISM services gauge points towards steady business conditions, comfortably in expansionary territory despite printing lower than last month.

Similarly, JOLTS data also affirmed a (overly) robust labour market, with the ratio of job openings to unemployed workers still at very elevated levels. Payrolls later today will likely provide further extrapolation on labour market conditions. We therefore think that yields are now more likely to rise than continue to fall in the next few weeks.

We might also expect some stabilisation in risk assets following a material re-rating that has pushed credit spreads wider and equity prices lower. In this context, we think that prices are unlikely to keep falling in a straight line.

Recession fears look much more justified in Europe. With the eurozone likely to experience a contraction, we think that it will be hard for the ECB to hike rates as much as is discounted, even as inflation continues to overshoot.

A well-telegraphed 25bp hike is likely later this month, but by the time eurozone interest rates are back to 0%, inflation may have peaked and growth fears could trump inflation in policymakers’ considerations. Therefore, we favour a long-duration bias in the eurozone, while running a short-duration bias in US and UK rates.

Divergence in economic prospects and policy may continue to weigh on the euro. We have held an overweight stance on the US dollar and a move through parity versus the euro now looks likely in the coming weeks.

European credit markets may also continue to be challenged by growth fears. However, we expect policy support for impacted sectors and don't see governments sitting idly by as the industrial sector goes to ruin. From that standpoint, defaults may be more muted than some fear and in investment grade, we think that spreads have more than compensated for the attendant risks when taking a medium-term perspective.

Meanwhile, events in UK politics have continued to fill the headlines in a week shortened by the US Independence Day holiday. More than one-third of PM Johnson's government quit their posts in the wake of the latest round of scandal to rock the administration. Revelations that Johnson referred to a recent appointee (Chris Pincher) as ‘Pincher by name, pincher by nature’, have backfired in the wake of a bum-grabbing sex scandal.

Ultimately, it was the final straw that sent his tenure as PM crashing down, but not without a fight.

Ordinarily, a prime minister would have been expected to quit in the wake of a no-confidence vote and mass resignations. But Boris is no ordinary prime minister.

It would seem that he is more interested in serving his own needs rather than those of the country and having just survived a confidence vote, felt empowered to continue regardless of the lack of support he enjoys within his own party. Even with his resignation, he remains emboldened to continue as a caretaker PM until the autumn while a new leader is selected, eager to push through his economic agenda and make one final stand.

Needless to say, at a time when the UK economy is already on its knees, these developments may continue to add to the negative sentiment and weigh on the outlook for UK financial assets.

 
Looking ahead

It may be that trading conditions reflect more of the same in the next few weeks. Liquidity is relatively poor and unlikely to improve as we move to summer holiday season and so day-to-day market moves may continue to be outsized, even with a lack of overall market direction.

However, with recession fear having dominated price action for the past month, we think that a lot of downside risks have been priced. Therefore, we are more inclined to look for a modest improvement in sentiment over the next few weeks.

Meanwhile, in the UK it was fascinating to see the lengths to which the 'Greased Piglet' (as Johnson has been likened) was prepared to go to to remain in his position.

Indeed, it has felt at times as if he is a cat with nine lives, or unkindly a cockroach impervious to an Armageddon around him. In the end, there was just nobody left to save his bacon – Boris is no longer the greased piglet, more like the suckling pig!