Markets Weekly - 6 September 2021
In our latest Markets Weekly podcast, Jai Lakhani, Investment Analyst, takes a closer look at private debt and the importance of manager selection and active management. Meanwhile, with investor risk appetite wavering last week, Henk Potts, Market Strategist, discusses what weaker US jobs data, as well as rising Eurozone inflation, could mean for the economic recovery and investors more broadly.
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Henk Potts (HP): Hello. It’s Monday, 6th September 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. 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, then we’ll discuss the outlook for private credit, and finally I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.
After a strong month of gains in August for equity markets risk sentiment was held back last week by the disappointing US employment report, elevated levels of inflation in Europe and further evidence the Delta variant and supply chain disruption is weakening the economic recovery.
Gold rose to a seven week high on Friday. In Europe the STOXX 600 fell six tenths of 1% at the end of last week, but was flat over the course of the trading week. On Wall Street the S&P 500 retreated from record highs following the job report but still managed to eke out a gain of half of 1% over the course of the week.
The headline grabber, of course, of the week was the huge miss on the US labour report which slightly pushed out the Fed’s tapering timeline. If you look at the headline figures, consensus was for a gain of 732,000. It actually came in at just 235,000 which was below the lowest estimate and the smallest gains in jobs created in seven months.
Wage growth exceeded expectations. In fact, was up six tenths of 1%. That’s primarily due to compositional effect. On the positive side, the unemployment rate fell two tenths of 1%. It was down to 5.2% which is actually the lowest since March 2020 but the participation rate still remained very low.
If you are looking for some mitigating factors, well, the weakness maybe a blip from a Delta variant impact. There was a sharp deceleration in retail and leisure components. If you look at the June and July figures they’re actually revised up by a meaningful 134,000 from the prior estimate. There could also be some seasonal effect in there as well as children were not back at school during the course of August.
However, the weak employment report, coupled with signs of a softening in final demand deteriorating sentiment certainly increases the risk of a pandemic driven deceleration in demand in the United States which in turn may encourage the Fed to delay the tapering announcement so they can assess the incoming data.
So in terms of policy impact, we now expect the Fed to only offer a conditional taper signal at the September meeting with implementation dependent on the path of the pandemic and progress towards full employment now forecast that a Fall announcement will be postponed until the November meeting and tapering to be initiated in December with the risk skewed to a December announcement and a January start if September data disappoints. But once started the speed of the tapering may be faster than previously predicted with the purchase programme concluded by the middle of next year.
In terms of market reaction, actually pretty limited it has to be said. US treasury yield curve steepened. Investors still expect a reduction in purchases this year although the delay is seen as positive for emerging markets where stocks and currencies rose. The dollar index fell for a second straight week. That’s the first back to back decline we’ve seen since April.
Moving on beyond the United States, there are actually signs that growth can rebound despite the Delta variant. If you look at India’s economy it bounced back in the second quarter despite the impact of a second wave.
Asia’s third largest economy, to remind you, slumped by 7.3% last year. That was one of the worst contractions of any major economy. However, there’s been a lower than expected economic loss from the second wave. Government restrictions were less severe than anticipated and monetary and fiscal support was stronger than expected. The rebound in manufacturing, robust rural demand, strong export growth certainly boosted the recovery.
The Ministry of Statistics estimates the economy grew somewhere around 20% in the second quarter. That was up from 1.6% in the first quarter performance of course that has been flattered by those low base effects.
We have raised our growth forecast for this calendar you. We now put it at 8.8%, forecast growth of +8% for the course of 2022 for India as private consumption should start to improve as the economy further reopens and vaccinations pick up.
In terms of policy, we expect interest rates to be held at 4% throughout the course of this year although as activity stabilises and with inflation towards the top end of the range we can expect a relatively quick policy normalisation cycle that still appears to be some way off.
On the data front, eurozone inflation hit the highest level in almost a decade in August as the reopening of the economy and supply shortages pushed consumer prices higher. Consumer prices were 3% higher last month than a year earlier. The surge from 2.2% in July represents the sharpest rise since November 2011.
Of course inflation prints around the world have surged over the course of the summer months from the low base effects of last year creating additional uncertainty for businesses and consumers and ramping up pressure on policymakers. Ultra accommodative monetary policy, additional stimulus packages and rising commodity prices have all added to the short term price pressures.
Supply bottlenecks in areas such as computer chips, shipping costs and labour shortages are also keeping inflation measures higher for longer than central banks had hoped. However, there are plenty of reasons to believe that price pressures will indeed ease going into 2022 as commodity prices stabilise, supply shortages ease and global demand is likely to rebalance away from goods into services.
We do think investors need to be aware of that inflation risk. Of course, in order to preserve the long term purchasing power of wealth investors need to generate a return that’s equal to or indeed preferably higher than inflation. Even moderate price rises can cause meaningful damage to wealth preservation assumptions.
So we think investors need to really think about being invested. Holding cash we should remind you of course does indeed come at a cost in terms of not only the threat of inflation but also foregone returns. So lots of clients thinking about I think how to mitigate that risk using the likes of fixed income and equities.
So that was the global economy and financial markets last week. Let’s move on to private credit. I’m pleased to be joined by our Investment Analyst Jai Lakhani to discuss private credit opportunities in a little bit more detail.
Jai, great to have you with us today. We’ve seen of course spreads tighten in traditional credit markets. Start us off by thinking what does that really mean in terms of portfolios.
Jai Lakhani (JL): Well, good morning, Henk, and thank you for having me. For sure we’ve definitely seen spreads tighten both in investment grades in the high yield context. Both spreads are below their 10 year averages. Really it’s been driven by lower for longer rates keeping government yields anchored and investors seeking carry that have come to these markets.
Just to put it into some context investment grade bond spreads are close to historical lows of around 90 basis points in the US. At the same time the average yield in the US high yield corporate bond index is just below 2%, but you only achieve this yield with taking on duration risk of an average duration nine years.
The question really being asked given this spread tightening is around valuation. Is it now too expensive to invest in credit? Do you get fairly compensated?
Our answer is that you do get fairly compensated with caveats. On the yes side you have the fact that default rates have gone to decade lows. We’ve had the reflation trade and the economic recovery and the fact that when you think about it on a relative basis to government yield there is still carry to be had.
The caveats are the fact that when we look at bank loans and M&A volumes favouring larger businesses and those that have accessed traditional credit markets before has meant the leverage in this market is high.
Michel spoke about this in the May podcast with regards to credit cycles and it means that active management and selection particularly in high yield is of paramount importance. Simply buying at the index level increases exposure to these over levered companies and tight spreads.
HP: So given the potential risks around I guess the credit cycle and companies being over levered are there other avenues that we should be considering?
JL: Sure. So as with any investment environment there are avenues that can be considered. What we’ve seen as a result of banks turning down loans to smaller firms and entrepreneurs is that actually these institutions are fairly stable and offer significant growth opportunities. In fact, many of these firms have more stable balance sheets than your traditional larger organisations. What they need is capital to realise their growth potential. As a result of these factors they’re focused on actually the execution as opposed to the cost of borrowing.
So what does this mean for private credit managers who actually lend more in this space? Well, private credit managers that select the right firms and arrange bespoke solutions they’re likely to be rewarded with noticeably higher yields but for the same given level of risk that you would have taken in public markets.
HP: OK. So when we think about the opportunity with smaller firms and entrepreneurs is there a risk of the unknown certainly given the higher transparency that you would have with larger firms in traditional markets?
JL: This is, of course, the main risk with private credit. What it highlights is the idiosyncratic risk you get when selecting companies to invest in that is unique to private markets alongside the well known risks such as the illiquidity premium and the backstop risk. Unlike banks there are no real bailouts from policymakers so managers need to have that skin in the game as it were.
We would argue, however, actually that the benefits more than offset these risks. When we think about backstop risk this is actually what is stopping banks from loaning to potentially more stable firms and achieving a higher return for doing this. It could actually be argued as a benefit.
When we think about idiosyncratic and illiquidity premium risk, yes, it is a risk but what it highlights is the importance of manager selection. When you think about private managers with the ability to thoroughly evaluate the investments given the backstop risk, perform the due diligence and source stable companies or entrepreneurs and a platform that allows for more tailored lending and bespoke solutions they’re likely to have the most success and really capitalise on this higher yield for the same level of risk.
HP: OK. So to finish up where do we see private credit in terms of investment perspective? What does it mean in terms of portfolios?
JL: Sure. So I think a key point here is that we aren’t saying that private credit should replace traditional credit. Active management and selection in traditional credit is key to avoid the pitfalls and achieving this means a nice diversifier and a source of return or carry alongside equities.
However, what we are saying is that private credit can be added to the ingredients and provides a complementary solution to portfolios provided that due diligence is performed with regards to manager selection.
HP: Well, thank you, Jai, for highlighting both those risks and opportunities in that private credit space, certainly a topic we’ll come back to in the future.
Let’s move on to the week ahead. The focus of course will be on the European Central Bank meeting. The European Central Bank’s revised policy framework allows for a period of inflation running above its 2% target if pressures appear to be transitory. The ECB will release its latest inflation forecast this week, expected to show inflationary pressures will indeed be more pronounced than previously predicted this year but with the pace of price increases easing back in 2022 and 2023.
We forecast that eurozone inflation will peak at 3.4% in November with the risk skewed to the upside but with that below 2% mandated levels by the middle of next year.
In terms of policy outlook, the improving growth profile should allow the Governing Council to indicate the pace of PEPP purchases will be reduced starting in the fourth quarter.
In terms of rates, the European Central Bank I think will be conscious not to repeat the policy mistakes of the past by hiking rates before the recovery is assured. So economists predict that its key interest rate which, remember, has been below zero since June 2014 will remain in negative territory for at least the next couple of years.
With that I’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.
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