By the time of our next Quarterly Outlook in December 2020, the future president of the United States should be known, we may see a market-friendly line up with the Senate, a UK-EU trade deal, several Covid-19 vaccines successfully passing Phase Three trials and ready for H1 2021 rollout, containment of the virus in those countries where it is currently flaring once again, and an associated reopening of economies ready to celebrate Christmas. Alternatively, we could have bearish newsflow on every single one of the above five questions.
Evidently, future market paths for DM rates, credit spreads, EMFX and the dollar – affecting most of the USD 64 trillion of securities in our benchmark – are conditional on a cluster of upcoming events, each with their own intrinsic uncertainties. So much for the traditional role of fixed income as a bit of central bank watching, economic analysis, Debt Management Office meetings and assessment of valuations! We approach some of these questions, such as the vaccine, with full humility in assessing our own information advantage (or lack of it). Others are a matter of shifting probability distributions, with some error term around them. But helping us navigate the next few packed months is our philosophy, resting on an assessment of asymmetries, potential future distributions and scenarios, positioning analysis, patience, flexibility and a value-based contrarian approach.
The net result is to enter the autumn with a high-quality tilt to our portfolios, near-term caution in credit, a preference for investment grade spread products (sovereign and corporate) under the umbrella of ECB purchases, a small bearish bias in EMFX, and some cross-market and yield curve trades that we think have attractive optionality under various future scenarios. In other words, in parts of the rates markets, we think one can position for more than one outcome in more than one of the various upcoming events and topics, while introducing some positive convexity into portfolios. Yield curve steepening positions in 2s5s in Treasuries and Bunds are one example, with a low cost in risk-off scenarios, in our view, and a greater payoff profile versus benchmarks in risk on.
Either way, we think it will pay to be nimble and flexible over the next three months – just as we were in H1 2020. To us, this is a version of Keynes’ advice to assimilate new information into the existing body of knowledge quickly, and to respond to it (which, to adapt his words slightly, means keeping an open mind, rather than changing it necessarily). Our quality bias demonstrates an overall tone of conservatism – after all, some economies are beginning to show signs of economic relapse into Q4. With partial lockdowns extending across parts of western Europe, there are even concerns of a ‘Cromwellian winter’, where discretionary consumer spending and associated jobs wither. Yet if we are right that the upcoming environment could see higher volatility, that also suggests opportunity in due course, after some of the languid weeks of late summer. We are prepared for the autumn cluster.