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Accept Decline
by  BlueBay Fixed Income teamM.Dowding May 20, 2022

Passionate, insightful, contrarian at times and always a true thought-leader in his field, Mark Dowding shares fresh fixed income insights every Friday. His musings on the week cover macro developments, bond market trends and his latest positioning thoughts, with the odd joke thrown in for good measure. Here is his latest insight.

Risk-off sentiment drove markets over the week, as growth fears continued to build and central banks reinforced the narrative that fighting inflation is a more pressing agenda than supporting economic activity.

With investors coming to the realisation that ‘the Fed is not your friend’, so more of a bear-market mindset appears to be taking hold, in which there is an increasing tendency to sell any rally, replacing the ideology of ‘buying every dip’. This turn in sentiment continues to be felt most keenly in assets with the greatest levels of retail investor participation, though there is also a growing sense of shellshock among some institutional investors we meet with, in the face of accumulating losses on a year-to-date basis.

Longer-dated government bond yields have rallied over the past week or two, as forward-looking recession probabilities have inched upwards. On the whole, investor positioning has been skewed toward short positions with respect to duration.

The sell-off in bond yields was seen as the principal catalyst putting pressure on risk assets during Q1, so it has been increasingly popular to use short-duration trades in order to hedge long positions in risk assets over the past couple of months. However, as concerns tip towards slowing growth versus increasing inflation, so these hedges may be squeezed.

We would observe that at times when markets become stressed, there will often be a tendency to seek out the ‘pain trade’ that will trigger a capitulation. From this point of view, we feel that yields could push lower still in the next week or two. However, we still think that such a move will ultimately prove to be more of a rally in a bear market for rates. Therefore, we would be inclined to close longduration trades and look to position short once more, should yields move materially lower.

Meetings across the policy community continue to reinforce the view that inflation is the dominant theme for central bankers. There seems to be agreement on the narrative that the Fed won’t stop hiking rates until core PCE moves below 3%, and this may not occur for another 12 months or possibly longer. Labour markets appear excessively tight and there is concern that competition for labour is bidding wages higher.

In this context, UK data for the past three months have seen earnings accelerating at a rate of 7% and, as much as central bankers may want to send messages with respect to observing pay restraint, the blunt reality is that many workers are aggrieved at the prospect of taking a material pay cut in real terms for the second year in a row, at a time when many are experiencing personal rates of inflation far above those reported in official CPI data.

With unions similarly mobilising to ask for 11% pay deals, it should be clear to central bankers that the labour market will need to cool in order to alleviate wage pressure from continuing to drive second-round inflation effects and averting an outcome whereby inflation remains stuck at elevated levels.

From this standpoint, it seems clear that although financial conditions have tightened by a lot in 2022 (with the move mirroring what was experienced over the whole of the last ‘aggressive’ Fed cycle in 1994), they were very accommodative to begin with, so further tightening will be required in the weeks and months to come.

The corollary of this is that asset prices may continue to be challenged. Although we may have seen the worst of the price action over the past several months, it may be too early to adopt a more constructive outlook.

Ultimately, we are convinced that the Fed will prevail over inflation and think that a US recession remains unlikely, assigning a probability of around 30% in the next 18 months. Recession risks are much more elevated in the eurozone, and with inflation not peaking until Q3, we see consumption getting squeezed at a time when the outlook for capital spending is impacted by elevated geopolitical uncertainty.

Meanwhile, we are inclined to believe that the UK economy will be seen to have already entered recession at the beginning of this quarter once we look back on data later in the year. To date, the UK government has been raising taxes, even as governments across Europe deliver fiscal easing in the wake of the energy price shock.

We think that Sunak will also start to raise spending soon, but we are inclined to believe that UK policymakers have been slow to understand that the economy has moved into stagflation and seem clueless (rather than helpless) in terms of what to do about this.

We continue to be surprised that the Bank of England (BoE) is abandoning policy orthodoxy with respect to monetary policy, in a hope that inflation will manage to somehow cure itself, without inflation expectations de-anchoring along the way.

It seems like the BoE is overly paranoid about impacting house prices, but ultimately, cheaper shelter costs would advantage the working poor over the medium term, and so it is not clear that those who have purchased second and third homes represent a group that needs protecting in this way. Moreover, the ongoing erosion of the credibility of the BoE represents a growing risk to all UK assets. Indeed, South African Gilts offer investors yields that are 10% higher than UK Gilts, in a country we are inclined to believe has a better central bank and better growth and inflation prospects.

Meanwhile, noise around revoking aspects of the Brexit deal also risks weighing on the outlook for UK assets and the pound, even if a rare second place at last weekend’s Eurovision song contest could be seen as a message that the rest of Europe is not quite as resentful towards the UK as it has been over the last few years, in the wake of the decision to leave the EU.

Credit spreads continue to take their lead from equities and, broadly speaking, market liquidity remains relatively thin. Fund outflows are also weighing on sentiment, with limited engagement from institutional asset allocators just yet, even if there is mounting evidence that public market credit is becoming more attractive relative to private market credit, as valuations in the former improve just as credit deterioration becomes a growing concern for the latter.

This said, new issuance markets remain open and although spreads are moving wider, there is not much to give policymakers pause for thought or concern just yet, even noting their concerns that they don’t have access to good data from private markets and areas where stress may be building more quickly.

In emerging markets, the slowing in China continues to be a cause for concern, but the much more prevalent narrative of late relates to the growing food crisis. Food price inflation is devastating news for a number of developing economies and further reinforces the sense of winners versus losers, in the wake of massive changes to relative terms of trade across countries.

Looking ahead

It remains challenging to adopt more confidence with respect to the outlook. Russia is losing ground in Ukraine, but we remain nervous that Putin will be pushed to double down on his war, given the sunk costs with respect to the mounting death toll.

In China, authorities face a challenge in stabilising the property market, even as they ease policy against a weak economic backdrop as they continue their struggle with zero-Covid.

Elsewhere, global consumers are battling inflation on a number of fronts and, although this may lead to some spending of pandemic-accumulated savings, the reality remains that the macro backdrop is fraught with uncertainty. Meanwhile, with inflation hitting a 40-year high in the UK this week as RPI reached 11.1%, it is worth reflecting that it took Margaret Thatcher and 10 painful years the last time around before inflation was brought back to where the BoE target now sits.

Bailey and colleagues will be hoping they get lucky, although it is widely acknowledged that the longer an inflation overshoot persists, the more that this will become entrenched via inflation expectations. In light of this, further price hikes ahead mean that UK inflation is yet to peak. 1982 seems a long time ago now – the UK was engaged in a war (in the Falklands), which Russia was condemning. Economies were battling recession. A pint of beer cost 50 pence in the UK and US 10-year Treasury yields stood at an impressive 13%. Plus ça change.

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