BlueBay AM: Powell puts Goldilocks back into play

Feb 1, 2019

By Mark Dowding, co-Head of Developed Markets at BlueBay Asset Management

A change of Fed direction gives risk assets a lift, although politics remain challenging with the UK crashing closer towards a hard Brexit. Against this backdrop, Greece looks like a surprisingly positive story.

Following a dovish US Federal Reserve (Fed) meeting, at which the FOMC removed its tightening bias and stressed flexibility with respect to balance sheet reduction, risk assets responded positively with government bond yields pushing lower.

Arguably not very much has happened to change the outlook for the US economy since the Fed last met, but it seems that equity market weakness towards the end of last year has certainly caught policymakers’ attention.

Previously, the rhetoric coming from the Powell-led Fed was that it would be less inclined to intervene to support the equity market. This idea now seems to have been cast to one side and the growing sense that there is a Fed put underneath the market could potentially be supportive for stocks in the weeks ahead.

Numbers do the talking (outside of government)

We maintain a constructive view on the US economy and, if anything, the recent easing in financial conditions may stimulate activity further. We continue to expect the Fed to deliver two hikes in 2019, in the second half of the year. Consumer disposable income is growing thanks to employment gains, higher wages and lower taxes. Although consumer sentiment dipped last month as the S&P 500 index fell and the US government shutdown rumbled on, it could rebound pretty swiftly.

We will be monitoring whether higher wages cause inflation to rise, as in the absence of price pressures it is plausible that the Fed will be encouraged to remain patient for an extended period. In the meantime, it seems like the ‘Goldilocks’ conditions of strong growth and accommodative policy are back; this portends well for risk assets.

We remain cautious regarding corporate bonds given ongoing worries related to supply but have been increasing exposure to sovereign credit and emerging markets in the wake of this.

Hard landing alleviation

Chinese PMI data registered a small bounce from its December lows during January. Elsewhere, we viewed steps to open up issuance of Chinese bank AT1 debt with a central bank repo facility and a compulsion on the part of insurance companies to buy bonds. This provided a further incremental policy step towards bolstering economic growth, with banks participating in this scheme obliged to increase lending into the real economy.

Credit spreads in the renminbi bond market rallied substantially in the wake of this move and, in as much as it helps to ease domestic financial conditions and stimulate investment in areas such as infrastructure, this should go some way to alleviate China hard landing fears.

Corporate earnings in the US and Europe continue to highlight softness in Chinese demand, though we believe these may paint a backwards-looking picture of what happened in the past year more than they suggest the trajectory of travel ahead.

Some sectors like autos have performed particularly poorly, and while bears cite more widespread consumer weakness in disappointing earnings from technology companies such as Nvidia, others such as LVMH have painted a more constructive outlook for Chinese demand.

We retain the view that Chinese economic activity should stabilise in the next few months, as Beijing de-emphasises the need to deleverage and acts to support growth.

Short shrift for Britain

In the UK, political developments have continued to underline our fear that, in the absence of a sense of crisis, a hard Brexit could become a rising possibility.

22 months after triggering Article 50, Theresa May has effectively ditched her own plan, having argued passionately that it was the only available alternative – seemingly based on a rather arrogant Conservative Party assessment that they can force the EU to renegotiate the terms of the UK’s departure from the eurozone.

It won’t be surprising, in our assessment, if this is met with short shrift from European partners.

It appears that there is little appetite for a ‘no deal’ outcome within the UK, therefore the EU can afford to hold firm to its principles – in the same way it has successfully dealt with other EU miscreant countries, such as Greece, in the past.

It might be the case that Theresa May is happy to run down the clock and is playing for time. It is also possible that she could pivot back to her original deal at the last minute when it becomes clear that either Article 50 needs to be suspended, her deal needs to pass – or we need to accept the reality of a hard Brexit.

Although we can see the EU extending the 29 March deadline – we have thought this would only be likely were the UK to be offering another Brexit vote or a general election, which could offer a more decisive outcome. Conversely, there seems little for Brussels to gain by simply offering the UK more time to try to renegotiate with Europe. 

At some point in the next few weeks we could see rhetoric on both sides of the Channel start to become more antagonistic, as the prospect for a messy divorce comes into view.

In this context, we feel that financial markets are too complacent of the possibility that we could end up with an outcome very few want – just by the virtue of a shambolic assembly of policymakers, who will seemingly always prioritise personal and political gain above what is in the national interest.

In this context, we continue to run short positions in both the pound and UK Gilts. Even in a scenario where a hard Brexit comes to pass, we think that the safe-haven status of Gilts will prove extremely short lived.

Greece on the rebound?

In the eurozone, fourth-quarter 2018 GDP data confirmed the slowing of the economy in the second half of the year, with Italy tipping into technical recession. However, sentiment in the eurozone periphery was buoyed by strong demand for a new issue in Greece during the past week.

Greece remains an improving credit story and from a political point of view, were we to see a change in government in 2019, it is likely that Syriza would be replaced by an even more market-friendly administration, led by New Democracy.

Greece is already funded through its support programme well into 2020, so has no real need to issue, yet was keen to demonstrate its market access and broadening demand for its debt by placing the issue largely in the hands of longer-term investors. Previous deals have been much more reliant on hedge fund demand.

Speculation with respect to this new issue had been rife in the market since last September so, following Italian-led weakness in the periphery in the fourth quarter of 2018, which saw the transaction placed on hold, Greek bonds had been slow to recover with this lingering in the background.

Consequently, with the sovereign unlikely to return to markets until 2020, we feel that Greece can outperform its peers in the weeks ahead, making the credit one of our strongest conviction calls.  

Snow drifts mask data shifts

We are due plenty of US economic data over the next few days. Despite worries of slowing growth, we would highlight the Atlanta Fed Nowcast of GDP still running well above trend at 2.8%. The government shutdown and the polar vortex are factors that could both distort upcoming data releases, but these effects should soon wash through.

We think that Goldilocks could be here to stay for a little while, although across the Atlantic we are much more concerned that a no-deal Brexit is starting to look like an accident waiting to happen.