February has been impressive for a number of things (so far). Vaccine distribution being one, increased fears of more aggressive variants being two, surprisingly robust economic data and Q4 results being three and four, and a continuation of the rally being five.
The sell-off at the end of January really was very transitory and, despite increased talk about bubbles everywhere, the overall market sentiment has remained resilient. The new issue pipeline has been smaller than expected, which has helped the technical picture, and every new issue has been over-subscribed, usually the result of reverse enquiry and being aggressively priced.
High yield spreads have dropped below 4 per cent for the first time and any issue with a good coupon has been snapped up. Even Carnival Cruises issued another deal, upsized by $1bn, which was at the higher price range. The company now has liquidity into 2023.
Are we in a bubble?
US equity markets hit all-time highs, with volatility falling again, WTI (Western Texas Intermediate) oil close to $60 per barrel, and increased expectations of another massive stimulus package from the new US administration.
Not only is the word ‘bubble’ appearing more often in news reports, so too is the dreaded word ‘inflation’. Not perhaps scary in itself, but certainly when linked to tapering or rising interest rates. Even speculation around this would be enough to temper some of the animal spirits we are seeing at play.
Treasuries have reacted and we saw the 30-year close at 2 per cent on Friday 12 February, with the 10 year at 1.20 per cent – both recent highs. There is also a lot of data coming next week – Empire State Manufacturing, jobless claims, flash PMIs (purchasing managers index) and home builders index so we may be in for further Treasury pressure if the numbers are solid*.
Too early to worry about inflation
I think that it is too early to be even having a debate around inflation and rising interest rates in the US or anywhere else for that matter. The likelihood is that we begin to see a phased re-opening of society in most of the developed world over the next several weeks as vaccine distribution gains pace.
The economic boost we are all expecting – driven by very high savings rates – will be somewhat offset by high debt levels, unemployment, and therefore limited wage pressure. This list is not exclusive.
As I have said before, the debate will gain more traction once we head into the second half of 2021 and we begin to look to increasing societal normalisation. Do not forget, interest rates do not have to do anything for government bonds to react and it is likely that there will be upward pressure on yield curves – led by the US – irrespective of what US Federal Reserve policy actually is.
Yield curve management will mitigate this, as there is no desire for government bond yields to go to high or for curves to steepen too much. There will also be natural buyers coming in at some point, again limiting the upward trajectory. At present, the inflation story is very much still in vogue.
US dollar and the impact on emerging markets
The dollar continues to be fairly resilient in the short term, so we will have to wait to see whether the downward trajectory continues as the months unfold. For emerging markets, we have yet to see any significant effect from rising Treasury yields. We are likely to see a tightening of spreads before that happens. The average risk premium on emerging market local currency is 306bps**, so significantly above levels that precipitated volatility in 2009 and 2018. The real concern for emerging market investors would still seem to be unsustainable debt levels in some of the weaker sovereign bonds.
Outlook
It still feels like financial markets are over extended and a pullback would not be a surprise. Having said that, with more quantitative easing, vaccine rollouts and the likelihood of a real boost to growth as economies re-open, perhaps valuations in the short term are irrelevant.
Things always revert to the mean eventually, the big risk remains a significant delay to the economic re-opening and recovery we are all expecting, however unlikely that might seem now. We continue to be disciplined and I remain positive on fallen angels and good quality companies that will do well as economies normalise.
Andrew Lake is head of fixed income at Mirabaud Asset Management. The views expressed above are his own and should not be taken as investment advice.
*Source: Mirabaud Asset Management as at 12 February 2021
**Source: Bloomberg, 12 February 2021