BlueBay AM: Will Boris miscalculate as badly as Salvini?

30 aug 2019

By Mark Dowding, CIO at BlueBay AM

Global government bond yields continued to grind lower over the past week, as the grab for duration showed little sign of abating. It seems that negative-yielding bonds are now officially the fastest-growing asset class on the planet, with 10-year German Bund yields posting record lows at -0.73% during the past week, in the wake of the softest IFO business sentiment report from Germany since 2012.

US economics

Across the Atlantic, there was relatively little new news, though economic data remains much more robust, as demonstrated by the Atlanta Fed Q3 GDP Nowcast continuing to track around 2.3%. Former Fed vice chair, Bill Dudley, joined those calling on the FOMC not to capitulate on interest rates, just because of calls from the White House to deliver monetary easing. A sense that the Fed may be enabling Trump to fight his trade war puts Chair Powell and colleagues in a difficult political position, though for now, it seems that a likely 25bps rate cut in September won’t be overly controversial. 

On a medium-term view, we believe that the US economy will continue to perform just fine. US economic benefits from lower rates and easier fiscal policy should offset China trade negatives, with a deal between Washington and Beijing seemingly unlikely at this point. Business investment may soften, though we expect a rising share of investment dollars to be spent in the US.

Consequently, recession risk remains very low in our estimation, as long as there isn’t a further exogenous shock – such as a 20% drop in equity prices, which could negatively impact business and consumer sentiment.

Italian developments

In Europe, Italian politics has provided the focus of attention over the last several days. Investors have cheered the formation of a new Five Star/Democratic Party coalition government on the perception that this will reduce EU break-up risks and put Italy on a path which is less confrontational towards Brussels than had been the case with La Lega driving the agenda.

Suggestions that the 2020 budget would target a deficit below 3.0% added to this investor-friendly perception and with 10-year Italian BTPs rallying below 1.0% yield, there has also been a sense that Italian debt sustainability is being further helped in the positive feedback loop from lower borrowing costs.

With yields more than 2% lower than the levels reached in October last year, the irony is that the incoming government can actually spend more than the outgoing one and still deliver a lower deficit and a reduction in debt-to-GDP metrics.

Many international investors have been eager to avoid Italian debt in the past couple of years, but we would not be surprised to see renewed interest in BTPs in the wake of these developments. It is puzzling, yet true, that there is often the least demand when prices are cheapest (as was the case in Q4 last year) with demand returning only after prices become more expensive.

Taking more of a step back, we would note that politics can continue to be a source of volatility (and opportunity in Italy).

For the time being, La Lega’s Salvini has scored a massive own-goal in breaking the existing coalition and trying to push for elections. Support for La Lega has fallen and Salvini has been chastised – though he is unlikely to stay quiet for too long, with elections in 2020 remaining a distinct possibility.

Boris’ Brexit update

UK politics has also been creating headlines, with Boris Johnson announcing plans to prorogue Parliament by tabling a Queen’s speech on 14 October just days before the Brexit deadline.

MPs return to Westminster next week and will then disband the week after, meaning that those opposed to Johnson’s Brexit plans have very little time to get their act together in order to unite against it. This would seem most likely in the context of a vote of no confidence.

Were this to pass, a mandate to form a new government would fall to the leader of the opposition, though it appears that Jeremy Corbyn lacks support from a broader political consensus. Therefore, the prospects for any government of national unity may hinge on Corbyn swallowing his pride and allowing another candidate to lead as an interim prime minister, with a mandate to apply for a further Brexit extension before calling a general election.

A further obstacle to this outcome lies in the observation that Brussels has hinted at some possibility to renegotiate Theresa May’s withdrawal agreement (WA). If a renegotiation of the WA is in play, then it is hard to see how many Tories can back a ‘no confidence’ vote in Johnson, let alone support a Corbyn interim administration.

If this lowers the probability that Brexit is now delayed, then equally it may have increased the prospect that Johnson does leave with a deal in October – especially if he has scared enough constituents at home and abroad that the only other alternative will be leaving under ‘no deal’.

There is still much to unfold in UK politics and Brexit in the next few weeks. We continue to think that a hard Brexit is an outcome which Johnson himself would like to avoid. For now, we would adopt equal 1/3 probabilities on ‘no deal’, a new Johnson deal and a Brexit extension/cancellation.

Argentina shakes EM

Emerging markets have been rocked by pronouncements from Argentina looking to re-profile its debt as the political and economic crisis engulfing the country continues to worsen. There has been a sense of predictability around these events over the past year, but it has been interesting to observe how many investors have wanted to believe in the Macri turn-around story and have been slow to remember that the country is a serial defaulter, which will ensure that debt holders are subordinated to private investors and those in the official sector, such as the IMF.

Risk reduction in EM has seen other over-owned markets coming under pressure. With ongoing concerns that China is relying more on domestic demand as its economy slows, there has been a re-evaluation of risk premia in several markets. At the same time, we do not see Argentina as systemic and any dislocation in other markets could present a buying opportunity, in our view.

An autumn economic uplift?

Corporate credit spreads have also widened in the past month with lower-quality issuers underperforming in the context of spread decompression. In part, these moves have been linked to moves in equity markets and come at a point in the year just before supply picks up in September, which is often the heaviest month of the year. Wider spreads have also been reflective of the inability of corporate bonds to fully keep pace with strong moves in Treasuries and Bunds.

However, if we are correct in our view that recession risks in the US remain low, it strikes us that we are now pricing an acceleration of default rates in the year ahead, which we think we are unlikely to see. We have added credit exposure in the past month and in Europe, we feel the grab for yield is likely to be a further supportive factor, which is unlikely to die away any time soon.

Looking ahead

We are in uncertain times. August has been a volatile month and it is easy to imagine how the same could be true into September. The focus will be on the upcoming ECB and Federal reserve meetings, though – as we have seen of late – it may well be comments from Trump on Twitter that end up having the biggest impact on markets.

With POTUS dominating policy and the price of many financial assets, we continue to find it attractive running most of our risk in assets less vulnerable to presidential whims.

We remain constructive on the periphery, notwithstanding the recent rally. Gilt yields are too low, in our view, and a compelling short in any scenario, save for a hard Brexit (in which long-dated yields may struggle to sustain a rally anyway).

An understanding of politics and policy has served us well in Italy and we hope the same will be true in the UK in the next few weeks. At the moment, Boris Johnson may be riding high in the polls and his campaign managers will surely feel optimistic that they are out-smarting his rivals. Yet we know that BoJo has been a buffoon in the past and will make mistakes in the future.

Pride comes before a fall and we may not be too surprised to see Johnson cast into the political wilderness along with Salvini. There will be some who will be forgiven in thinking that there would be some poetical justice were the prime minister to lose his Uxbridge seat in the event of an election being called.