Markets Weekly podcast - 7 Dec 2020
What can we expect from the ECB’s emergency bond program? In this week’s episode of the Markets Weekly podcast, Henk Potts Market Strategist for EMEA at Barclays Private Bank is joined by Michel Vernier, Head of Fixed Income, Barclays Private Bank, for a fixed income special. They give their insights on the ECB’s next move and give their views on where fixed income opportunities lie.
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Welcome to your Markets Weekly podcast. US stocks climbed to an all-time high, as progress was made on a bipartisan US stimulus package last week. Energy banks and insurers have been outperforming, while the more defensive personal and household goods, health stocks and food and beverage have lagged behind. European equities also rose for a fifth straight week.
Henk Potts (HP): Welcome to the Barclays Private Bank markets weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.
My name is Henk Potts, Market Strategist with Barclays Private Bank, and each week I'll be joined by guests to discuss both risks and opportunities for investors.
This recording will last around about 15 minutes, be broken down into three component parts. Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week.
We’ll then move on to our focus section where we will spend a few minutes discussing a specific investment theme. This week I'm pleased to say our special guest is Michel Vernier, he's Head of Fixed Income at Barclays Private Bank.
We will discuss the impact of dovish central bank action on bond markets, the relationship between bonds and equities, and of course bond’s role within a diversified portfolio. Finally, I'll conclude by previewing the major events and data releases that are likely to shape the week ahead.
Let's start by reflecting on markets last week. Equity markets began December as they finished a record breaking November, on a positive tone.
Risk sentiment was driven by revival of US stimulus talks, robust Chinese economic data, an OPEC+ (Organization of the Petroleum Exporting Countries) agreement to partially delay production increases, however as we know of course it's really been progress on vaccines that's been moving markets, as candidates apply for and get expedited approval.
Pfizer BioNTech vaccine has been approved in the UK, to be rolled out this week. Three vaccines are expected to be approved more widely by year end, for a second wave of approvals in early 2021.
It now appears that the US and Europe could achieve population immunity by the third quarter of next year and that's helping to solidify expectations of a sustainable economic recovery through 2021. Barclays has increased its global growth forecast for next year to 5.6%.
Sentiment, as I say, was also boosted by signs that progress on an additional US stimulus package is being made.
The gap between the two sides appears to be shrinking. A bipartisan group of senators has proposed a $908bn plan in an effort to break the impasse and it would include money for small business aid, unemployment benefits and support for state and local governments.
In terms of timing, it is still possible to get agreement this year but most likely to be approved early next year. In terms of the impact, well could be good news for sentiment, unlikely to dramatically change the immediate growth trajectory of the US economy.
In terms of market performance last week, US stocks climbed to an all-time high, all four major indexes closing at record levels for the first time since January 2018. The S&P 500 rose 1.7%, is now up 14% year to date.
In Europe, equities were a little bit more subdued but did rise for a fifth straight week. STOXX 600 was up 0.2% over the course the trading week, led by the energy sector.
Over the course of the past month energy, banks, and insurers have certainly been outperforming while the more defensive personal and household goods, health stocks, and food and beverage have lagged behind.
The risk on backdrop has reduced demand for safe haven assets. Gold registered its largest monthly decline in four years, in November, although this should be viewed through the lens of course of the strong performance this year.
Gold is still up 21% year to date. Dollar has been under pressure, that posts its biggest weekly decline in five last week, and is languishing near 2.5 year lows. In commodities Brent is trading above the $49 a barrel mark, this is after OPEC+ alliance agreed to slowly reduce output cuts, next year.
The producers will release a further 500,000 barrels per day from January but that's well below the 2 million barrels per day that’s been pencilled in, but it is another step towards normalised levels. The decision comes as demand continues to bounce back.
Demand for petrol and diesel has recovered, to around about 90% of normal levels although demand for jet fuel still lagging behind, in fact it's only running around 50% of pre-pandemic rates.
We do know it has been an uneven recovery, demand in Asia has certainly been strong but Europe and the United States we’ve seen demand, far more lacklustre, but supply has also been picking up.
Production levels in Libya have been rising, US production has been increasing following hurricane disruption.
In terms of Barclays forecast, we think Brent will average $53 a barrel next year, edging up towards $60 a barrel in the fourth quarter if indeed that strong recovery does play out.
The US employment report for November illustrated the rise in coronavirus cases is weighing on activity and impacting the labour market recovery.
With payroll employment slowing sharply from prior months, particularly in the retail and leisure and hospitality sectors, headline numbers, well the US economy created just 245,000 jobs last month, way less than the market was looking for.
Economists were looking for a figure closer to 550,000 and substantially slower than the October 610,000. The unemployment rate actually dropped, it fell 0.2%, came in at 6.7%. That was primarily driven by a lower participation rates.
In terms of the impact of the report, the numbers show, as I say, the recovery momentum is slowing. Although there have been solid gains in hours worked and income over the course of the quarter.
Despite the downturn in December, the US economy is still on track for growth around about 6% in the fourth quarter, then anticipating a flat first quarter 2021.
But I think the report will add to pressure on Congress for a more aggressive fiscal response, and perhaps you could argue to a lesser extent, the Fed to lengthen the duration, as its monthly Treasury purchases.
This week of course, the focus will be on the European Central Bank. Eurozone consumer prices continue to fall in November, increasing pressure on the central bank to ramp up its stimulus efforts at this week's meeting.
The inflation rate came in below expectations at -0.3%. Core inflation remained at a record low, -0.2%. Prices have been pushed lower by the ongoing weakness we've seen in energy, coupled with some moderation in food inflation and temporary tax cuts.
If you look to the inflation outlook, well eurozone inflation is likely to remain subdued over the course of the next couple of years with weakness in labour markets and household disposable income, along with higher savings rates anchoring core inflation at depressed levels.
We think inflation should trend up in 2021 due to technical factors and as base effects start to recede, but we expect CPI to average just 0.9% next year and remain well below that 2% target level through 2022.
What can we expect from the European Central Bank? Well of course European rates are already deep in negative territory. The Central Bank has limited room to manoeuvre. As such we would expect the deposit rate to remain at - 0.5% for the next two years.
The Bank's governing council focusing on providing liquidity support. That said of course we know that the European central bank has already fired a big bazooka, the total of announced purchases currently standing at €1.3tn, which is much larger than was seen in the euro crisis earlier last decade.
That said, a rapidly deteriorating health situation, faltering recovery and that subdued inflation outlook does mean the European Central Bank will have to take additional measures.
We anticipate they're going to extend the bond buying programme by €500bn, commit to reinvestment until mid-2023, as refinancing operations has undeniably help liquidity and financing conditions, the targeted long term refinancing operations rate could be cut further to try and encourage bank lending to the real economy if needed.
So that's how financial markets finished at the end of last week, and a little bit about what we can expect this week.
Let’s now move on to the outlook for fixed income. Michel, good to have you with us today.
The European Central bank, as we mentioned, meets on Thursday. What impact could the extension of stimulus by the ECB have on fixed income markets?
Michel Vernier (MV): MV: Yeah, so as you mentioned Henk, market expectation is that the ECB will increase its current €1.35tn bond buying programme by another €500bn and that the programme will be extended by at least another six months.
So, meanwhile the ECB is unlikely to cut the deposit rate, as you mentioned, given this is already at -0.5%. So we see further accommodation as expected, the long end of the curve may react with even lower yields, but we would caution that the market is already positioned.
First of all German government bonds are at -0.58% and last week was the first time that the one week Euribor was lower than the one day Euribor. So the market is already positioned.
On the other hand, should these high expectations not be met by ECB action, rates could see higher volatility going into the end of this week. However, we don't see a scenario whereby the ECB will take the risk that rates will increase substantially at any part of the curve, given it would be harmful for EU recovery.
HP: Recently the correlation between bonds and equities, as we know, has increased again. Why is this such a concern for investors?
MV: Yes, so the correlation between bonds and equities has surged this year in various measures. Higher correlation is a concerning situation given that bonds should ideally have little or even negative correlation in order to achieve better diversification effects in blended portfolios.
We had a look at such portfolios, so from 1992 until 2019 a blended portfolio of 60% equities and 40% bonds not only delivered an attractive annual return of 8.5%, this compares to 9.8% annual return by the S&P 500, so only 1.3% more.
But the price volatility of a blended portfolio was only 8.8% against 14.4%, with a pure equity portfolio. So an increase of correlation potentially means that such blended portfolios offer less diversification and higher volatility going forward.
HP: Can the historic relationship between bonds and equities provide some guidance for the future? How do you view that?
MV: As with most things past returns and price behaviour is not a guarantee for future dynamics, but they provide a good guidance. We looked at these correlations a bit more closely and we observed two very interesting points.
First, the correlation between equities and bonds have varied substantially from year to year since 1972 between -50% to as high as 60%, so a temporary increase does not necessarily suggest that the thesis of broken diversification effects, are suddenly obsolete.
Second when looking at performance of equities and bonds in each year back to 1973 until now.
We had plenty of different scenarios including higher yield levels over 10%, lower yield levels below 1%, we had market crash, bond crash. Interestingly positive correlations appeared quite often when both equities returned positive and bond returns were positive.
Investors made money in these years with both asset classes. Positive correlations in these years should not be a cause for concern.
But what investors really need is negative correlation when it matters, so during equity bear markets. Except in 1994, in all occasions the bond market has delivered positive performance and with that counteracting against losses from the equity market.
So when it matters whether low or high yielding environments, the bond market proved the much needed diversification benefits.
HP: My final question for you Michel today. Given ultra-low yields and increasing diversification effects of bonds, do we still need bonds within a balanced portfolio?
MV: It is correct that ultra-low yields, if persistent, won’t help as yields can only go so low. But as it was always the case, markets are not following a one-way road. There will be setbacks over the course, of the next quarters and things rarely play out like expected.
That means not only the direction is set in stone but volatility is likely to increase again. In such an environment, we think that combining timing and time in the market seems like the appropriate strategy. How we think this could be played out looking into 2021.
The rate market is likely to anticipate the role of vaccines globally and may start to anticipate a broader recovery.
Higher rate volatility and potential spikes could be expected. US 10-year rate for example has potential to reach 1.5%, but at 2% the air is getting thin giving low inflation prospects, a determined fed and prevailing uncertainties about the recovery.
Opportunities to lock in high yields preferably using investment grade bonds which offer additional yield premium seem like a sensible strategy. AA or single A rated bonds, at over 2 or even 2.5% would appear an attractive proposition in dollars for the safe haven portion of a bond portfolio.
Timing and time in the market works also perfectly in the higher yielding segment of the bond market. Why? Simply because spreads as opposed to rates appear to be more mean reverting, so higher volatility can open up even greater opportunities in this area.
We do see that a large part looks expensive, given spread are at ultra-low levels in emerging markets and high yield and it seemed to be priced for a blue sky recovery scenario, but it's just mentioned historically recoveries have been uneven and accompanied by setbacks.
Volatility should be expected and investors should be prepared to enter in the right credits and segments of the bond market. I always like the analogy of the grizzly bear waiting for the salmons to pass. The grizzly is an expert and knows that the opportunity will arise and is already positioned at the right spot.
HP: Well thank you Michel for giving us your insights today and highlighting the opportunities for investors in the fixed income space, a topic I know that will come back to in coming weeks.
Let's move onto the week ahead. Along with the European Central Bank, Thursday's UK October GDP estimate data will give a good indicator on the progress of the recovery of the UK economy in the run up to the second national lockdown.
Monthly GDP remember grew 1.1% in September but is still down 8.4% year on year. The effects of the pandemic still weigh heavily, of course on UK activity, expect those to shine through in terms of the figures.
Against a backdrop of suppressed economic activity inflation rates remained generally subdued.
The US November year-on-year, core consumer price index (CPI) on Thursday will likely continue to show disinflationary pressures, with month-on-month growth flat in October.
Chinese CPI has also been muted with a 0.3% month-on-month contraction in October and year on year growth of just 0.5%. We expect Tuesday's data to follow a similar trend.
Trade, of course an important component of the Chinese economy, has experienced a significant recovery since the damage of the pandemic.
Exports from China jumped 11.4% year-on-year in October following a 9.9% gain a month earlier. We expect to see this export strength sustained in the fourth quarter as China continues to gain from global export market share.
With that, we would like to of course thank you once again for joining us. We hope that you found this podcast interesting, informative, and it’s given you some thoughts around positioning in the fixed income space.
We will of course be back next week with our latest instalment, but for now may I wish you every success in the trading week ahead.
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