Direct From Dowding: September 2024

Okay. Good morning. Good afternoon. Welcome to the seminar that we're hosting today. It's a just a short talk for 30 min where I'll be speaking across global markets.

For those who haven't joined before, I'm Mark Dowding, CIO at BlueBay, and here we are, ¾ of the year way through the year. 30th of September, third quarter is done. And wow, what a lot there's been to talk about, what a lot there is to continue to discuss before we reach the end of the year.

But jumping straight to it. So obviously the big talking point over the last couple of weeks was the Fed and its decision to do 50 basis points at the September FOMC. I think, came as quite a surprise to many economists and market participants on the day itself. It was a very sort of hotly debated thing.

But I think when you look at the decision to do 50 by the Fed. What should we be learning from this? Well, I think for me, one of the real takeaways here is, we've got a Fed that's very focused on wanting to prioritize growth relative to inflation at the current point. In time, perhaps, PAL sees more risks to the soft landing, coming through the risk of the downside in terms of the economy, slowing more than prices, moving higher.

But it's certainly very striking the Fed has moved in this way, and if you look back in the past, I think one of the reasons why the move was quite as shocking as it was to some is if you look at the history of the Fed going back for the last 30 years there have been three occasions where we've actually seen the Fed cut rates by 50 basis points in a similar way back in 2001 in 2008, and in 2020. Now in each of those situations we'd ended up seeing the economy having a big sort of downside sort of shift risks, had really skewed very much to the downside with the bursting of the dot-com bubble in one, with the onset of the global financial crisis in 2008, obviously with Covid back in 2020.

And so, the decision to make a more aggressive and more assertive move by the Federal Reserve, I think, was much more clearly understood at that particular time. It's also worth saying that in each of those occasions we'd actually seen quite a material tightening of financial conditions, largely because of credit spreads moving wider and equity markets coming under a lot of pressure. So in each of the past situations where the Fed had done 50, obviously, we'd seen an adverse set of events really sort of force the Fed into more assertive action.

Though this time around the honest truth of the matter is, the economy, for the time being, anyway, continues to tick along just fine. If you look at the Atlanta Fed, they do their “now cast” for GDP. They're currently projecting 3rd quarter growth at 3.1, which is a bit above trend economic growth.

I'd also sort of note that there are indices such as the surprise index in terms of looking across all economic data. This actually sort of troughed at a low in the summer in July, at a reading of minus 46 at the time it did look like downside risks in the economy may be starting to sort of come to the fore.

But actually, since then, we've actually seen that economic surprise index actually bounce by 40 points. It's nearly up to the 0 line now. And so from that point of view when you look holistically at how the economy is doing there doesn't really seem to be anything to get too concerned about just for the time being. Furthermore, you look at credit spreads. They're close to their tights. Equity markets close to the highs. Financial conditions have been moving easier, not tighter. So again, it does sort of highlight the Fed's decision to do 50 in a historic context coming through that this is a Fed that is effectively doing something really quite dovish in some respects, and certainly from that point of view, a Fed that really seems to be particularly focused about the growth part of its mandate.

Now, I would say that there's been talk about the labour market and what's happening in terms of the labour market. But if I just say a few words here in terms of how we would see the US labour market evolve. Is that what we've seen is we've seen a slowdown in the number of new jobs being added in terms of the payroll growth from a very hot labour market earlier in the year. At that time we saw we'd seen sort of post Covid, a situation where there were almost record job openings. Hunger for labour demand coming through. And we've seen cooling in the labour market. But we think the labour market is cooled towards a level which is pretty consistent with a fairly stable trajectory at the current time.

Certainly what we seem to be seeing is an outcome where the supply of labour is actually growing in the US. Partly thanks to net immigration and sort of now that the workers aren't being absorbed as quickly. That's actually seen the unemployment rate move up a few tenths. But if you look at sort of other important indicators like weekly jobless claims, you will see these are actually running at levels consistent with a very strong labour market. In other words, we're not seeing workers who have got jobs losing their jobs being laid off. It's more a case of sort of net. New entrance to the labour force aren't being absorbed quite as quickly as they once were. So, in a way you see a bit of a positive supply shock here.

But in as much as you're seeing that sort of narrative, I don't think we're in a situation where this is particularly growth negative. Moreover, when unemployment starts to rise, typically, as we've seen in the past, people then start to fear about losing their jobs. And when you start fearing about losing your job, you rain back on your consumption. And so there's more of a feedback loop this time around again. We don't see job losses. We don't really see that. And so from my perspective, I think that the labour market looks okay. It's something that we need to continue to look at, but I don't think there's any particular cause for concern just in the here and now. If anything, I'd actually infer that the recent policy move by the Fed, if anything could actually help push the economy a bit stronger over the course of the next couple of months.

I know we've got the uncertainty of the election just ahead of us. But in as much as you're easing financial conditions in as much as you're giving a further boost to the equity market. Actually, in the short term, you could actually sort of see some of the sentiment indicators continue to move a little bit firmer, and we could actually go into the start of Q4 with the economy continuing to look relatively strong.

And so when we look at the reaction in markets, firstly, I'd say, when it comes to the equity market, it's understandable in my interpretation that the equity market would want to go up on what they perceive as a dovish fed effectively. The Fed's got your back. And, moreover, if you're an equity investor, what really matters to you at the end of the day is what's happening in corporate earnings and you can think of corporate earnings really trending with moves in nominal GDP. And so in as much as a Fed is being a bit more assertive. This is lifting the growth outlook a bit. It's lifting the inflation outlook a bit is good for nominal earnings and therefore beneficial to stocks.

I think the other thing to say is that since the Fed actually did the 50, it might surprise some that actually longer dated bond yields have actually moved up a bit. They haven't gone down, notwithstanding a dovish fed. So why is that? Well, actually, in part here I would say that a more dovish Fed in the short term, effectively reduces the risk of any near term recession. So if you had thought that there was, I don't know a 20-30% chance of a recession in the next Six to Nine months.

The fact that the Fed has been more assertive has actually reduced that recession risk in the short term, and from that perspective that partly explains why yields have gone up a little way in a sense more monetary, easing in the short term might actually mean a little bit less. Later on we'll have to wait and see. But I would note that in some respects the fact that sort of recession risk now seems to be really quite low is a reason why sort of treasuries are struggling to make a lot more headway. Because one of the things that I've inferred in terms of a valuation framework for US fixed income is, I probably think, that neutral rates in the US are probably around about three and a quarter. Yeah, I know that the Fed long run dart currently is at 2.9. It was at 2.5, but on that sort of Fed neutral rate I'd infer that once upon a time, the way the Fed thought about neutral rates was governed by the Taylor rule in a world where growth was at 2 and inflation was at 2. You ended up with neutral rates, or then thinking of around sort of 4 to 4.5%.

Now the Fed came away from the Taylor rule largely because during the 2010s we saw a protracted period where inflation kept undershooting the Fed's target. And so, they kept on revising down this idea of a long run dot. It got as low as two and a half when I've spoken to people with the Fed. I don't think any of them really believe that two and a half was a real neutral rate for the economy. But anyway, now that we're in a world where inflation is a bit above the target, we're seeing that thinking of a long run dot move a bit higher.

My inference would be that actually, you end up with neutral rates in the US, probably looking around three-and-a-quarter. But in that world that if we're right to think that three-and a-quarter is neutral, interest rates, it probably means fair value. Further out, the curve is three and a half, or 375 for the long end of the market, which is not far from where yields are today.

But put another way. I would therefore contend that in order for yields to rally a lot, you really do need to be moving into a situation where growth really is slowing down where you really are moving towards a recession, because in a way, you actually need the market, then to discount that monetary policy is going to go from a situation where, instead of just getting back to neutral, it actually has to move into accommodative territory. And already, if you look at what's priced into markets looking forward on US. Interest rates, markets are already pricing interest rates coming down to 3% by the end of next year.

So in a way, for treasuries to rally. It feels like you do need worse economic news at this particular juncture. And, as said, I'm sceptical that we're going to see that. So, if anything in the short term, we actually think there's a bit of an opportunity to fade. Some of what in our eyes is excessive easing being priced into the Fed curve.

Also the other part of the reaction that's been very strong has been yield curve steepening. Now we've spoken about. Yield curve steepeners in the past we continue to favour the idea of a steeper yield curve in the United States. If you're becoming sort of more dovish in terms of monetary policy that obviously helps the front end of the curve. But the back end obviously, is going to be more impacted by the fact that it could mean that longer term inflation outcomes are a little bit less certain.

Moreover, the fact that we've got this issue on fiscal policy with the US continuing to deliver a 7% fiscal deficit in our eyes continues to be one that demands over time. More risk premium being attached to longer duration assets, particularly because we think that, regardless of who wins the election, we're going to continue to see further easy fiscal policy in the United States. There is no interest in cutting the deficit at this particular point in time on either side of the aisle.

Though, we would note that if we do end up with Trump winning, and we end up with the Republicans taking all three branches, this is likely to be the outcome that is the most inflationary, also the most fiscally stimulative.

And on the back of that we do think that the curve would steepen even more dramatically where we'd see that particular outcome on the election. Of course, the election itself is coming close now. It's only a month and a half away. We still know the wiser in terms of who's going to win. If you look at the polls, if you look at betting sites, if anything, it's kind of got Kamala just about shading it, but it's all within the sort of tolerance of uncertainty at the minute. We don't really know what we do observe, though, is, this is likely to be an outcome in an election that's decided by 100,000 voters or less in just a few swing States.

It's also the situation that most voters in the US who voted Republican in 2016 did so in 20, likely to do again in 24. Similarly for the Democrats, so actually, rather than people actually being persuaded to switch between different parties and candidates. A lot of this could actually come down to turnout on the day.

One last point on the US election, though, is one pattern that we have observed in the last two campaigns is actually, the Democrats actually lost a little bit support during the months of October and November, just in the run up to the vote itself. So, if you were to put a gun to my head on this and force me to make a call one way or another, I still wouldn't be surprised to see trump actually shading this. But then a lot can happen. And who knows what's going to be said or done over the course of the coming Six, Seven weeks that's still left to run on that particular campaign. But for sure it's going to be interesting. It's going down to the wire.

One other thing to say in the US, as well post the Fed, we've put on a trade. We like to look at inflation break-evens. We've actually been allocating a bit to TIPS. We think the break-evens look attractive, a world where the Fed is becoming a bit more stimulative, we think, is a bit more sort of constructive for inflation outcomes, and although last week's PCE reading was obviously benign when we look at sort of Core CPI in the US. You're still trending at 3.2, and we don't think that's going to come down very much. We're still minded to think the inflation outcomes will continue to be a little bit higher than the Fed's long run objective, albeit you're now not that far from the Fed target. So, it's not ever such a burning issue.

Maybe enough said on the US. For now moving across to Europe, the picture in the economies is obviously much weaker. We've had some more disappointing German data today. It feels like Germany - Germany is famous for its net zero policies. The only net zero it's really getting is when it comes to economic growth. Certainly aren't getting on the on the environment. They've got these crazy policies where they've gone away from nuclear, and it means they're burning more coal than ever, which we question the wisdom of. But when it comes to the economy itself, really struggling for growth, and it's not surprising that industry is having a tough time of it.

Energy in Germany is costing Six times as much as it does to many of Germany's competitors in terms of global manufacturing. And so you can really see how industry continues to be hit really badly by this disparity in energy prices on the continent.

That's particularly bad news for manufacturing. So Germany looks weak. France looks weak. France looks like a political mess, not clear whether we're going to get a vote of confidence or not this week in the French Cabinet. It could be that Barnier survives just. But this is a very weak government. We still think that French politics looks like a mess, and we're still quite wary of French assets. And we see this ongoing theme that the problems in terms of economic growth, and in politics are writ large in the countries of Northern Europe. Yesterday we had the win of the Austrian far right. Party politics is moving in a more Populist direction.

And so these are troubled times on the continent, and it's still the case that the countries towards the south it's the countries like Spain, Portugal, Greece, to an extent Italy which are now doing. Relatively speaking, a lot better. In fact, Europe wouldn't have much growth at all if it weren't for some of the southern European economies that are doing well. And it's interesting to think that we did used to have this.

This idea of a European periphery. What was it? Portugal, Ireland, Greece, Spain? A lot of these countries certainly aren't periphery countries anymore. Maybe the new periphery. Maybe it's France and Italy. Perhaps we'll have to see how that plays out. But certainly I'm concerned about France in terms of the trajectory of travel there. But when it comes to the ECB. I think there's a chance that they'll cut rates again in October, or, if not, go for a 50 in December.

You might wonder why the ECB isn't being more sort of explicit in wanting to cut rates more assertively. And here it's worth reflecting on the fact that, notwithstanding the European economy being really quite weak. European unemployment is actually at a 25-year low. So when the ECB looks at it, there's not a lot of slack in the economy. There are risks to wages on the upside.

The ECB has got a mandate which is an inflation mandate. So from its point of view, there's only so much it feels it can really do to actually support the economy. And this fact that unemployment is so low, even though growth is weak, really sort of speaks to the fact that across Europe I would observe that in some respects we've seen a structural tightening the labour market with a lot of society getting quite lazy. People don't want to work in Europe anymore. It's certainly the case in in the UK as well. There seems to be less of a work ethic, people want to spend more time in leisure. And so that's a backdrop which is effectively acting as a bit of a negative supply shock on the labour market side in that degree.

Turning to the UK. Briefly, the UK economy, relatively speaking, is doing better than elsewhere in Europe, partly thanks to the fact that it's a more service orientated economy. So we don't have the same issues that sort of German industry is currently going through with the energy prices. So that's a slightly better element of the story.

But I would say that in the UK we've still got inflation that's too high service inflation is running at 5.5% core inflation is up towards three and a half. And although headline inflation came down towards the 2% target recently, it's now likely to trend back up again. Therefore I think it's going to be difficult for the Bank of England to carry on cutting interest rates, even at a time when other central banks are delivering monetary easing at the same time. When it comes to the UK public finances, there's still a bit of a mess. There certainly isn't really much room for any fiscal easing, and what we're hearing about is a narrative of labour delivering a pretty austere budget come November.

So, from that point of view, we feel that there's less scope for the UK to ease to support growth than we see in the US or in the European countries, for that matter.

Turning next, perhaps to China, China was exciting. Last week we saw a raft of policy announcements, and the backdrop here is obviously China has been really struggling for the last year or two, as the property sector has effectively imploded. Now, a few policy announcements have been made here. One of these has been to make it easier to buy a home and buy a second home. These were sort of moves that if you would have made a few years ago could have really driven growth, we think, in residential investment.

However, at the moment, instead of having a bull market mindset. You've got more of a bear market mindset in the property sector. People are underwater on their property. They're trying to sell. There aren't enough buyers. And so actually changing that psychology in a bear market, I think, is going to take more than was announced last week. So the moves on the property sector. I'm not sure how significant or lasting they're going to be.

I think you're going to end up needing to do more in the same way when it comes to interest rates. There was jubilation over a 20 basis point interest rate cut. Look in China the economy is struggling. I think the interest rate should be at zero already. They've been doing piecemeal cuts of 10 basis points at a time. Maybe they are starting to become a bit more assertive.

But again, other than a short term, bit of a sugar rush, which actually sort of improved sentiment. I'm not sure whether this is again much of a lasting game changer. What was more interesting was the fact that she came out of cycle with some announcements tilted towards the fiscal side. It's if something's done more assertively on the fiscal side that I think that China has got more of a chance of turning around.

But here we're waiting more details in terms of what a fiscal easing is likely to be skewed towards, if it's going towards more investment in bridges or infrastructure, or the army. Obviously there's not much of a fiscal multiplier. It will be hard to get that balled up about that. However, if you end up with steps more focused on consumption, as long as that sort of a boost to the consumer doesn't end up getting saved, then this is a story that could become more interesting.

And for a while we've been telling Beijing. They need to actually move to a more balanced economy with more consumption. You need to run a smaller current account surplus and Beijing has been very wary of actually going down a path where they actually run what they consider to be a more Anglo-Saxon growth model. So they've been quite reticent about that, but it could be that attitudes are starting to change, certainly, for sure.

We've seen a good run up in Chinese asset prices over the course of the past week in the short term. I think there could be more that to come. It's just that we think that in order to become more constructive China on a medium longer-term view. You need to see some of these more structural changes occur. Otherwise this is going to end up being a bit of a short lived flash in the pan.

Otherwise in Japan we've got a new Prime Minister we got Ishiba elected on Friday from the LDP elections. I think that he's going to be continuing policies that we've seen in the past. Although there was some sort of questions about the different sort of agendas of the different sort of candidates, Japan is very consensual. It all comes together.

And I think there'll probably be policy continuity. What that does mean is further policy normalization on the monetary policy side. But that won't occur at the next BOJ meeting, the Quarterly meeting that's occurring in October, because that's when we're going to see elections being called the BOJ certainly won't want to be taking action in and around that. And so I think that a next rate hike in Japan to 50 basis points comes in January.

That being the case in the short term, the fact that we're looking for some stronger US data, the fact that we think that us rate expectations may actually sort of retrace a bit. And the fact that we're going to have to wait for further monetary policy steps in Japan, if anything in the short term could actually speak to a slightly weaker yen, though eventually we think that we will see this rate differential close between the two countries.

We do think the yen is cheap and the yen will rally. And so our mindset is to want to buy the yen. If you see a move now up towards 150, otherwise, when it comes to FX euro dollar, I think, is very much being governed by the elections. If we end up with Trump and his tariffs, 105 could be the level under Kamala you could be heading towards 120. So that's quite a binary event.

There's almost a case to actually buy vol in FX on the outcome of the US election event. Otherwise, I would infer a more dovish Fed. It's been good news for equities. I think it could be good news for emerging markets. It could be good news for risk assets in general.

We think that a lot of investors have been quite cautious in credit this year. They've said that valuations look tight, but a lot of that is actually government bonds have become cheaper relative to interest rate swaps. So, it's a cheapening of government collateral as much as it is a richening of corporate bonds. And from that point of view, we actually think that with net supply in in the corporate space, if anything, static or contracting, and with more investors allocating to fixed income, the technical is quite positive for corporate bonds. And we think that a lot of our peers have probably been underweight in credit beta, and maybe a bit under allocated.

And if there isn't any recession coming in the United States just yet, we see that money being put to work before the end of the year, so we could see another leg tighter, we think, in credit. So, we've actually a week or two back around the Fed. We've been taking off credit hedges extending credit beta becoming a bit more sort of generally optimistic on the world in general.

I'm now going to switch, tack and jump across to some questions. So, 1st question “Given where we are at today should investors focus on spreads or all in yields?”

Well, look, it's an interesting question, right? So I think that as investors, if you're a long-term investor, you're investing for yield right, you're investing for income in fixed income. When it comes to trying to take a market directional view. I think that from my perspective I feel more confident that spreads look a more interesting trade right now than overall yield levels, partly because I think that there's more of a risk that longer dated bond yields could actually come under upward pressure in the United States. As the curve is bending steeper, so for me, the conviction trade is on the curve, the conviction trade is on inflation. The conviction trade is on, spreads more than all in yields on corporate bonds.

Next question “Is the dispersion in spreads across the various cohorts of credit, an opportunity for active managers”?

Well, here, I would say again, yes, there are both at a sector level and an asset class level, some interesting things going on. For example, in financials we've continued to really like European financials all year. European financials, the banks they're just boring. Boring makes for great credit stories. So, we like the senior debt, we like the tier one debt, it's been performing well this year. I think it continues to perform. Banks are in a good space. And I think it's kind of anomalous that financials trade wide relative to industrials.

Otherwise across the asset class space there'll be areas that we really don't like in credit at the moment. I don't like private markets. I don't like private debt. I don't like a lot of those credits, because I feel that in a world that is a bit higher for longer than it has been in the past, where you're running more leverage, that's kind of toxic, and you end up with debt, servicing costs being the thing that eats all your free cash flow, which is why, in the private market space there's such a struggle to actually see much of an IPO pipeline for the time being. And that's why that community is baying for even more aggressive interest rate reduction. So that's an area that we don't like.

Other areas, I think, look interesting in credit. So again, it's about picking your spots. These are inefficient markets, and there'll be places that we like in distressed debt. There'll be places that we like in emerging markets. It is a good time to be an active investor. And again, I'd also assert as investors ourselves. We're the business of delivering Alpha to our clients, that Alpha comes on the back of our skill as investors, and also volatility in our opportunity set, and I don't expect volatility to dry up anytime soon.

“EM debt local currency or hard currency?”

Well, I think that local currency is a space that I do think looks interesting at the moment. I mean, you see, really attractive, real yields. I mean, you've still got yields of 11, 12% in countries like Brazil or Mexico, or a bit less now in South Africa. But these real yields look attractive in countries where we think that inflation is well contained. So, there's cheapness in valuation in EM local.

And again, if we're in an environment where the Fed is being a bit accommodative and risk assets are doing well. We think this is a market where EM FX can probably do okay. But local currency is going to be more volatile than hard currency credit.

“How long do we think the tailwind in EMD continues?”

Well, here, I would say that in many respects EM has been quite unloved as an asset class for a number of years, and so I don't think that we're at the end of a multi-year trade, or anything like that in EM. I think that the one thing to say in the asset class is, there'll always be credits in countries that are moving in the right direction, others that are moving in the wrong direction.

And so sometimes it's difficult having a view on all of the space, just like it's one asset. But generally speaking, we think that in the backdrop of a more of a risk on sort of environment through the end of the year, in my eyes it's looking relatively good for EM right now, absent something new happening, absent a much slower economy in the United States, absent that sort of recession risk kicking in.

“View on commodities and especially oil and the impact on inflation?”

Well, here I would say that commodities have been pretty beaten up on the back of the China news. We saw a massive rally in iron ore overnight. I think iron ore today. This morning was up about 10% when I looked oil is more complex. You would think that oil should be really rallying on the back of what we're seeing tragically in the Middle East and the escalation of risk there. But the reality is that actually, the US. Is such a big exporter in oil today. Actually, that creates a bit of an abundance of supply.

And then within OPEC Saudi is trying to manage that and trying to stop prices from declining, but they're in a difficult situation that they need to raise revenues. And so, if you do see prices moving up, I expect Saudis to pump more. But if prices move to the downside they can't afford prices to drop to 60 or less. So, I'd be sort of looking in oil, probably a bit above 70 bucks, probably not a big driver of inflation one way or another.

“What is our view in inflation linked bonds in Europe?”

So here, we've actually put on a break-even trade in European inflation linked bonds. Again, we think that euro inflation, as elsewhere, can be a little bit sticky, and we, relatively speaking, we like the idea of owning inflation at this particular moment in time. In terms of the EM local inflation links bonds, I don't look so closely at those myself. If anything, some of the trajectories in EM inflation has been actually coming down, partly because central banks are running very hawkish monetary policy. So, I think that's a less clear trade in in my mind.

And then I've got a last question I'm going to finish with which is on gold. “Gold is decoupled from its usual inverse relationship with real yields in the US. Is this a structural change, or something that is just an aberration?”

Well, here I think the reality is, if you look at gold prices, I mean, obviously, it's a commodity that's competing with other commodities, including Bitcoin. These days there will always be secular demand for gold at a time when the dollar has been weaponized as well. Things like gold are actually a more interesting asset to allocate to in asset allocation.

So, in certain jurisdictions, of course, and at a time of global uncertainty and geopolitical uncertainty. Again. Gold is something that you can see taking a bit of a bid. So, I'm no gold specialist myself. I don't really look at the gold price. We don't invest in gold directly in any of the fixed income funds. The only exposure I have to gold is buying jewellery for my wife, I guess, but from that point of view I would sort of infer that I think that there is likely to be ongoing sort of demand for the yellow, shiny metal, and if anything, there's more likelihood for gold prices to trend higher rather than lower over the medium term.

With that I think I'm done. Thanks for staying with. I hope some of that was interesting and useful to you. I hope you're doing well navigating these exciting markets. There's going to be a lot more to talk about in the weeks and months to come. So, if you've enjoyed today, I hope you'll be back on again online in a month's time when we do the next one of these. For now, all the best.