Markets Weekly podcast - 31 August 2021

Henk Potts (HP): Hello. It’s Tuesday, 31st August and 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 for Barclays Private Bank, and each week I’ll be joined by guests to discuss both risks and opportunities for investors.

Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then discuss the outlook for fixed income. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Investors bought on the dips last week after concerns over policy tightening, the regulatory crackdown in China and the disruption caused by the Delta variant eased.

Money flowed back into equities and commodities were pushed higher as markets reacted positively to the Fed’s patient approach, the improving vaccination picture on the back of the formal approval of the Pfizer vaccine in the United States, promises of credit support from the People’s Bank of China and progress on the latest US stimulus bill though geopolitical risk did rattle markets to a certain extent as news of the bombing in Kabul hit the wires.

But it was still an encouraging week for equity markets. The STOXX 600 in Europe was up eight-tenths of 1%. It’s now up 2.3% in August, the seventh straight month of gains, the longest winning streak in eight years. It was also a positive week on Wall Street. The S&P 500 was up 1.5% last week. It’s now up 2.9% in August. Yesterday the index hit its twelfth all-time high of the month.

The Jackson Hole Policy Symposium was billed as the headline grabber of the week as investors awaited clarity on the timing of the tapering of asset purchases. In the end, chair Jerome Powell largely stuck to the main messages that were laid out in the July FOMC meeting minutes. The Fed sees the bar as substantial further progress as having been met on the inflation mandate but not on employment.

That said, the chair noted that clear progress had been made in labour markets and the Committee’s outlook for the US economy is consistent with the start of tapering later this year.

We believe another solid August employment report this Friday will set aside concerns over rising case counts from the Delta variant and lead the Fed to begin tapering purchases in November. This would imply a strong signal about tapering if not a formal announcement at the upcoming September meeting though Jerome Powell reiterated the Fed were in no rush to hike interest rates. Michel will give us more in terms of market positioning shortly on that.

In China the central bank there promised to stabilise the supply of credit and increase the amount of money supporting smaller businesses and the real economy. The vow came after retail sales, industrial production and fixed asset investment fell short of expectations in July. We’ve also seen some weak PMI numbers this morning.

New credit growth weakened to its slowest pace since February 2020 in July. That was due to a slowdown in the shadow banking sector, weaker government bond issuance and the instruction of tighter mortgage policy. The numbers we should remember are also impacted by high base effects from last year.

The statement follows on from a decree from the Politburo in July that banks should slightly increase lending during the course of this year and then accelerate more significantly in early 2022. Analysts are forecasting the central bank will become more accommodative in an effort to support growth in the coming months. We’re expecting another 50 basis point cut in the reserve requirement ratio in the fourth-quarter as the Chinese economy drifts back towards a new trend growth rate of somewhere round about 5.5% in 2022.

In the US the House of Representatives approved a $3.5 trillion budget framework that will provide their financial firepower for a progressive package of reforms, an investment that will cover additional spending in areas such as childcare, education and affordable housing.

There are also incentives for utility companies to meet clean energy goals and funds to help invest in technology that will reduce the impact of climate change and for the electrifying of the federal vehicle fleet.

The bill also proposes raising taxes for wealthy individuals and companies, lifting the highest personal tax rate to 39.6% from 37% and the near doubling of the tax rate paid by higher earners on their investment income.

There are also plans to increase the corporate tax rate, set a minimum tax rate on foreign income as part of the initiative to establish a global tax minimum. Lawmakers are also set to vote on that $1 trillion infrastructure plan before the end of September.

Turning to the impact, the aggressive stimulus package should support immediate and long-term growth prospects. They are designed to help restructure the US economy to meet current and future social, economic and environmental challenges.

We see limited impact from the higher tax rates on profitability and consumption. While the corporate tax rate reform will of course create a short-term headwind for companies, the proposed rate we should remember is still substantially less than the 35% rate it was before Donald Trump’s administration.

Increased taxes could also be offset by the higher growth trajectory that you’d expect. A global minimum tax would help to stop profit shifting and discourage competition amongst countries developing into a race to the bottom. With the personal tax rate increase focused on wealthy households the impact on overall consumption projections we also think should be minor.

However, those opposed to the bill remain concerned about the president’s proposals, arguing that it’s focused not on traditional infrastructure such as roads and bridges and therefore as a result it’s too expensive at a time when US deficits are projected to increase.

If you look at the CBO’s projections, they suggest annual deficit will average $1.2 trillion a year from 2022 to 2031 and exceed its 50-year average of 3.3% of GDP in each of those years. Also by 2031 US debt is forecast to equal 107% of GDP, that would be the highest in the nation’s history.

So that was the global economy and financial markets last week. Let’s move on to consider the outlook for fixed income.

I’m pleased to be joined by Michel Vernier who is Head of Fixed Income Strategy for Barclays Private Bank. Michel, great to have you with us today. As we’ve already mentioned, Jerome Powell, chair of the US Federal Reserve, gave his much anticipated speech at the Jackson Hole Symposium. What is your take on tapering and what does it mean in terms of US rates?

Michel Vernier (MV): Hello, Henk. Yes, the Jackson Hole speech as you said was one of the most anticipated speeches, if not economic event, in the last weeks. And some market participants remembered speeches from former Fed chairs, Alan Greenspan or Ben Bernanke who in the past announced major shifts in direction here in the Jackson Hole Symposium, but in recent years the Fed refrained of using the Symposium.

This time Jerome Powell has put in every effort not to spook markets as seen in 2013 when the Fed started to announce tapering of the then prevailing QE programme. Back then the announcement of the tapering led to 170 basis points move in rates. If we would translate this into today’s levels the 10-year yields would end up at 3%.

So while inflation has been at record highs lately the Fed still considered this trend to be temporary and focused much more on a broad and sustainable job market recovery. The mentioned recovery is on track but not there yet.

Coming back to our thinking with regards to tapering, given what we’ve just said, the Fed will possibly start to make more official announcements in September, perhaps a bit later and that tapering start towards the end of the year.

HP: OK, so let’s have a think about what that potentially means in terms of emerging markets given they seem to be the most affected during the course of that 2013 taper tantrum. What’s your view in terms of the outlook there?

MV: So first of all a quick recap helps to explain this relationship between the US Fed tapering and emerging market assets. There are three major aspects to consider.

So first, use tapering could potentially mean entering into an environment of higher US dollar yields and this in turn would result in higher borrowing costs for EM issuers with higher portions of US-dollar funding.

Secondly, higher US rates would diminish carry opportunities as EM yields lose relative attractiveness against higher US rates. Now this situation could be witnessed when US short rates in 2018 surged to levels which made the EM carry trade less attractive and finally caused volatility among EM, so emerging markets FX currencies but also during the summer of 2013 of course.

Thirdly, higher rates naturally translate into price losses for any US-dollar-denominated bonds and usually emerging market bonds and bond funds have an average higher iteration than US high yield bonds for example where the rate rise impact would be larger.

The above risks are prevalent but we see the risk of large sell-off due to tapering only contained this time. So EM assets have already underperformed recently so investors seem to have positioned more defensively ahead. Secondly, the Fed has mentioned it will make any effort in order to avoid a 2013 scenario.

Back then higher US rates led to repatriation of EM asset flows which led to broad EM losses. This time we think that rather than Fed tapering the economic progress, which is very much linked to the status of the COVID situation and the response in the respective emerging market countries, will be the main driver for emerging market asset performance.

HP: OK, let’s stay with emerging market bonds. Bonds within the Chinese high yield and specifically property markets we’ve been seeing have sold off sharply over the course of recent weeks. Can you talk us through why this was the case and if the selloff has changed our outlook for China?

MV: So we have seen negative news flows from heavyweights in the property segment with missed payments resulting in large sell-offs in the respective names. So many Chinese property developers are operating on very high leverage and are now finding themselves in a very challenging situation. Growth is likely to moderate amid re-emerging uncertainty over COVID in Asia and China. Major cities saw home prices grow at the slowest pace in six months in July, for example, and this is also reflected in lower revenues and sales for these issuers.

In addition, the Chinese government already had introduced various measures to curb growth. For example, the government is trying to manage leverage with the Three Red Lines matrix. So defined debt thresholds have to be met by developers if they want to borrow more for example.

The most recent moves have included holding private equity funds from raising money to invest in residential property developments. China property issues make up a very large proportion of the Chinese high yield bond market which eventually led to the broad market sell-off.

At the same time the move within the investment grade segment was very contained, so higher spreads within the high yield segment offer some buy opportunities but we think volatility is likely to persist over the coming quarters.

HP: So how has the sell-off affected emerging market debt in general? Is there a risk of contagion or indeed do you see this as a buying opportunity?

MV: So as within the Chinese bond market EM, so emerging market, investors clearly distinguish between the broader market and the specific situation within the Chinese property market. The risk of contagion seems limited going forward. With spreads and yields and historic low levels we don’t see large buying opportunities within the emerging market bond complex.

We mentioned often before that emerging market countries may have a rocky road ahead. Many emerging market countries have increased debt load by multiple times as a response of COVID which was necessary. But these high debt loads are not sustainable for all EM countries.

Currency volatility is likely to increase. Some emerging market countries have already started to respond with rate hikes in order to strengthen the respective currency. This however could compromise the domestic recovery potentially. Our stance remains that we would only see limited selective buying opportunities within emerging market bonds while we favour high yield market in the US or Europe for example.

HP: Well, thank you, Michel, for your insights today and highlighting some of the risks and opportunities across the fixed income asset class.

This week the focus will return back to the US labour market with the employment report on Friday. We expect strong labour market conditions despite the Delta variant. We look for nonfarm payrolls to rise a healthy 850,000 in August with private sector private payrolls increasing by 800,000.

Elsewhere we look, the unemployment rates declined by three-tenths of 1% to come in at 5.1%, and average hourly earnings to increase by three-tenths of 1% month to month. And average weekly hours to slow to 34.7.

With that we’d like to thank you once again for joining us. 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.