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  • 06 August 2021 (7 min read)

The second half of 2021 will be pretty much like the first half. Liquidity is plentiful and that will support asset prices. Short-term changes in sentiment will be driven by COVID news and central bank musing. I suspect as we get ready for Christmas in a few months’ time, yields will still be low and equity markets higher.

Lower again

Bond markets continue to be interesting with US Treasury yields hitting new lows for the year this week at below 1.20% for the benchmark 10-year maturity. Yields have since risen again but the decline in yields since March continues something that is confusing to many market commentators and, if reports are to be believed, has led to some significant losses by investors making the wrong “macro” bet. We have said for some time that the macro story clearly points to higher yields in anticipation of higher future interest rates and in response to the current higher inflation rates. However, this has been dwarfed by technical factors that have driven the demand for safe assets.

Massive buyers

Not to labour the point too much but this demand has come from central banks and from the increase in liquidity in major economies that has led to the banking systems being awash with cash. In the US the Federal Reserve continues to buy $80 billion Treasury securities per month. The European Central Bank, the Bank of Japan and the Bank of England remain significant buyers of bonds and the accumulated impact of that over the years has led them to own huge percentages of the outstanding market value of government bonds.

Deposit driven 

US commercial banks have seen their deposit base surge as a result of economic policy stimulus. Deposits fund asset purchases but commercial and industrial loan growth and mortgage lending has not been able to keep pace. As such banks have been buyers of safe assets as well. The combined buying of Treasuries by the Fed and large domestic commercial banks has totalled close to $900bn so far this year. This has outweighed the net issuance by the US Treasury.

Bear market delayed

The demand for bonds by financial institutions and central banks is not driven by views on getting a total return or whether yields are at right level. As such they are not going to be subject to selling when we get a strong non-farm payroll number or an increase in 2023 inflation forecasts. The selling is at the margin and often driven by short term players and derivative markets. I think that yields can go higher but I can’t bring myself to forecast or expect a major bond bear market in this environment.

High yield most attractive credit asset

With bond market based inflationary expectations remaining consistent with medium-term central bank inflation targets, this low nominal yield environment means that real yields continue to be extremely negative. Forgetting what I said above about institutional investors, when looking at “risk” premiums across asset classes there is nothing to compensate investors for taking interest rate risk. In Europe this week, 30-year bund yields turned negative again. That means real capital losses for buy and hold investors. There is an inflation premium. There is very little credit risk premium with spreads on investment grade bonds very tight. High yield does offer some risk premium over investment grade with the average index spread relative to BBB-rated bonds well above 200 basis points (bps).

Risk premium in equities

Yet the real risk premium is still in equities. We are just completing a very strong Q2 earnings reporting season with reported earnings for the S&P500 surprising 17% to the upside. I regularly track bottom-up aggregated earnings-per-share and they point to a very rosy picture for stocks in general. Earnings are forecast to grow by 12% in the US over the next year, by a similar amount for Europe and by much stronger growth rates for large emerging market economies. This is a good reason to remain positive on equity markets. The earnings-bond yield premium is 3.4% for the US and around 6% for European, UK and emerging market equities.

Tapering but not yet

The earnings outlook for 2022 is not likely to be undermined by what central banks are increasingly talking about – a shift towards reducing monetary stimulus. The Bank of England said this week it would stop re-investing maturing gilts once the base rate had reached 0.5%. There is a consensus view that the Fed will announce a tapering of its Treasury purchases before the end of the year and possibly will expand on that at the Jackson Hole monetary symposium later this month.  Markets don’t expect rate hikes until 2023 and tapering might not shift the dynamics on bond markets for some time.  A 2-3 year view, however, probably requires more caution as monetary conditions should well be tighter then than they are now. But that is not a 2021 H2 story.

Waiting for the hump

Without a sell-off in bonds, long-term return expectations for will remain very low. Capital growth can only really come from stocks and the market is not so wildly priced to require a big sell-off in order to have more realistic long-term expectations. Of course, another hit to economic growth would be a big problem. In the short-term the biggest concern is supply bottlenecks and the impact that is having on prices. Andrew Bailey, governor of the Bank of England, told Bloomberg on Friday morning that central banks can’t do anything about “semi-conductor” shortages but if there were signs of second-round inflation effects the Bank would act. I’m sure the Fed thinks the same. At the moment though there is no clarity on that and won’t be until the “hump” in inflation is behind us.

Buy dips in H2?

What that means as we come back from summer holidays is probably to expect any dips in bonds or equities to be short-lived. There will be a market reaction to the Fed announcing tapering or an equity reaction to further Delta driven increases in infection rates in some economies. But the big picture remains the same. Liquidity and economic recovery are driving financial market returns.

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