Soft landing at risk from escalating war and bracing for the end of ECB’s bond purchase programme

Published on 5 February 2024

Dan Farrell, senior portfolio manager at Northern Trust Asset Management, warns that hopes of a soft-landing are at risk from being disrupted by the escalating war in the Middle East and advises desks to prepare for some major liquidity events coming up this year.

Following on from a bumper week for data and central bank interest rate decisions, from the Federal Reserve and the Bank of England, Farrell discusses how markets are cautiously optimistic that rates have peaked but says that geopolitical tensions could still hinder the battle against inflation.

The senior portfolio manager also unpacks the asset manager’s current outlook for 2024; where he’s taking on risk and how he advises desks to approach the upcoming week. In this episode, he takes a look at some of the upcoming liquidity events set to impact markets including the end of the European Central Bank’s (ECB’s) Asset Purchase Programme (APP) in March, where it will kick off the process of shrinking securities balance sheet.

North America: Weekly Review and Outlook

  • Last week saw high volatility across equities after the Federal Reserve’s interest rate decision but overall January has been a good month for liquidity. Record-breaking volumes in United States Investment grade (IG) and bid-ask spreads have gradually tightened since the start of the year.
  • This week’s data: ISM Services on February 5 and Canada’s Unemployment Rate on February 9. Earnings e.g. Alibaba and Walt Disney.
  • This week in primary equities: 6 IPOs expected to price at $1.1 billion in aggregate. The biggest being American Healthcare at $756 million.

Europe and the UK: Weekly Review and Outlook

  • Last week equities volumes surged due to sell-off spikes and liquidity gradually worsened. Euro IG saw record-breaking volumes and bid-ask speedily tightened over the last 5 weeks.
  • This week’s data: EU Producer Prices on February 5 and EU Retail Sales on February 6. Earnings e.g. Nordea Bank, Vodafone.
  • This week in primary equities: One IPO from Air Astana Joint Stock Company to price on LSEG this week. Reported media, says hopes to raise $300 million.

Transcript of interview

Jo Gallagher: Welcome to Trader TV This Week – your insight into how trading desks can prepare for the week ahead. I’m Jo Gallagher and today I’m joined by Dan Farrell at Northern Trust Asset Management to discuss the main topics and events leading this week.

Dan, welcome to the show.

Dan Farrell: Thanks, Jo. Pleasure to be here.

Jo Gallagher: Before we begin, let’s take a quick look at last week’s activity and what’s coming up.

In North America last week’s US equities column saw little change week on week, but markets did experience a lot of volatility following a hawkish statement from the Fed and a decision to hold interest rates. January overall, however, was a good one for liquidity in U.S. equities and bid-ask spreads, and much tighter than those seen for the same week for the last five years. The U.S. fixed income market saw substantial activity last week, with U.S. investment grade on Wednesday hitting the highest daily volume on record for more than three years. Levels were just above the high seen during the November rally. Liquidity has gradually improved over the last five weeks, and bid-ask spreads on average are the tightest they’ve been since early October.

Coming up, we’ll have a late week in terms of economic data in the US, but we can expect the latest ISM services numbers out on Monday, initial jobless claims on Thursday and Canada’s unemployment rate on Friday. Markets can expect a busy week for earnings, however, with results expected from a whole host of companies such as Toyota, UBS Group, Alibaba and Walt Disney. Also coming up, traders will be looking out for the publication of short interest reports on Friday.

In primary equities, there are six IPOs expected to price up $1.1 billion in aggregate proceeds. The largest expected deal should be American Healthcare, which is seeking to raise $756 million out of the REIT sector.

In Europe and the U.K. last week was a busy one for European equities, as markets saw spells of downward pressure on stocks and the highest daily traded volumes on record since the end of January last year. High activity comes off the back of an eventful week for central bank decisions and the Bank of England, hinting at future interest rate cuts. Liquidity has gradually worsened week on week amid spikes in selling activity, with the weekly average bid-ask spread shown to be the widest they have been for the year to date. It was a big week for European bonds last week, with Wednesday’s Euro investment grade volumes hitting record highs not seen since January 2022. Liquidity in Euro IG saw marginal difference week on week, but bid-ask spreads have continued to tighten since the beginning of the year.

It will be a quiet week for data in Europe, but we can expect EU producer prices on Monday and EU retail sales on Tuesday. We can also expect to hear Q4 earnings such as Nordea Bank, Vodafone and L’Oreal in primary equities. Europe is finally seeing a well needed boost to the sluggish IPO market. We can expect one public offering from Ariston, a joint stock company, to price on the London Stock Exchange this week, with some media reports claiming it is seeking to raise $300 million.

Dan, lots to unpack there. We’ve just come out of a very busy week. Give me an idea of how Northern Trust is positioning off the back of that and how would you be advising trading desks to approach this week?

Dan Farrell: The review of last week is one of cautious optimism from the central banks that actually the data that they’re seeing has been making good progress, but actually they need to see further evidence before they make any policy changes. We are seeing language changes occurring that they now believe that they have reached the peak rates. But now the question is, how long do they keep those rates at these elevated levels for to ensure that they do truly win the battle against inflation? This has been something we believe will take longer, and where we differ to the market and the magnitude and the starting point of those rate cuts will just take time for the central banks to become comfortable from an inflation perspective. Now, in terms of our positioning, we are neutral to positioning. We favor the shorter end of some of the front end contracts and securities, but we don’t believe the rate cuts priced in are going to actually come to fruition. Now, in terms of the data ahead, it’s actually a light week after a bumper amount of data out from this week we just had.

Jo Gallagher: Given your risk on outlook, where are you taking on risk and why?

Dan Farrell: So we believe that actually we’re going to see a soft landing in the US, in Europe and the UK this year. And with that, inflation is going to continue to fall down closer to the 2% targets mandated by those central banks. And growth will be lower to historical trends, but it will still be positive in the US. We believe that rate is going to be anywhere between one one and half percent growth.

Now, where do we see that our biggest overweight is and where we are taking risk? Well, that’s in high yield. We see that actually high yield offers the most attractive returns for investors at the moment. And that’s given the all in yield of the underlying securities, but also when we look at the structural makeup of the high yield market, the quality within high yield is at its all time high. Double B-minus and single B-minus securities now makes up almost 90% of the high yield universe. And that to us, means that it’s actually a lower default risk than what we’ve seen occur historically. Now, even if we do see that slower growth, we still see from analysis that we’ve undertaken a 3 to 4% default rate in the high yield market in 2024.

Jo Gallagher: How concerned are you about an escalation of the conflict in the Middle East, and what could that mean for markets and how you adjust your investment portfolio?

Dan Farrell: The biggest concern for us is the delay and the costs of freight transport throughout the region. Now, since November last year, we’ve seen a 350% increase in freight costs, and that’s a huge increase. But one thing we’ve got to remember that is much, much lower than we saw during the pandemic. And that was because the pandemic had both a supply and a demand shock. It’s really down to energy markets and the transport of oil and liquefied natural gas through the Suez Canal, and that means that it could have inflationary pressures if we were to see this continue. But the good news is that we don’t see this actually being too material at this current stage. Now, obviously, if we were to see an escalation in the conflict in the region, that soft landing scenario could become a risk and deviate the central banks from their current course of action. In this situation, when we think about how we position the portfolios, government securities would become more prevalent, particularly those with safer assets in US treasuries and German bunds.

Jo Gallagher: What are some of the liquidity events that Trading Desk need to be thinking about over the coming weeks and months?

Dan Farrell: I think the biggest event that we’ve seen year to date has been the excess demand from investors for long duration government bonds. In October 2023, investors were concerned about higher rates for longer. Now that they are seeing that actually we’re going to be moving towards more of a neutral rate in 2024. They’re looking to lock in these longer duration securities for longer. So we see the demand in the coming weeks will continue to outstrip the supply. Now the biggest liquidity event that we could see coming up in the months to come will be that when the ECB stops becoming the major buyer of government securities in the eurozone and actually starts to reduce its balance sheet. Now the market knows the pace that the ECB is going to do this. And we haven’t seen any spillover effects. If the pace of that taper does change, well what does that do to the peripheral spreads? What would that do to Italian BTP spreads over German bunds? And these are the risk events that we’re looking at.

Jo Gallagher: Thank you, Dan, for your insight, and of course to you for watching. This has been Trader TV This Week.

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