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Investment Institute
Viewpoint CIO

Phase over?

  • 19 February 2021 (5 min read)

Policy support and post-COVID growth expectations have been the key drivers of equity market performance for months. That support may be fading as markets come to terms with the next phase of the recovery. In the US that means adjusting to a shift in inflationary expectations and what that implies for the Fed. It also means that, on the recovery side, we are “arriving” – at least in the US. The coming GDP growth numbers will be impressive, but the slope of the expectations curve has been steep and may start to flatten. Combined with higher yields, equities may take some time to adjust. The narrative points to some potential increase in volatility and perhaps less impressive returns for a while. 

Less power in those engines 

For months my bullish view on risky assets has been based on the importance of two engines of support for investor sentiment. The first has been the policy setting. The second has been the expectation of progress on vaccines, economic re-opening and stronger growth. I get the sense that both are becoming less powerful in sustaining the kind of returns we have seen from equities over the last year. Not that I am turning bearish, but it may be that a certain phase is over and markets are struggling to adapt to what comes next.

Recovery to expansion 

I don’t expect the policy support for the global economy to weaken any time soon. However, there are genuine questions to be asked about the implications of the size of the fiscal boost that the US economy is going to receive and whether the US Federal Reserve (Fed), in particular, can sustain its current commitments on policy in the face of increased inflationary expectations. The stimulus proposed by the Biden Administration is working its way through Congress, but it is likely to end up being way north of $1trn although the full $1.9trn might not all get through. Whatever, it is going to be a significant boost to US GDP in 2021 and 2022. The current Bloomberg consensus forecast for 2021 real US GDP growth is 4.8% but that masks a range of forecasts (our own is above 6%). Coming out of a pandemic with a much higher savings rate than normal and a huge fiscal boost makes such numbers feasible. What this means, of course, is that the US will close its output gap much more quickly than other countries. We should see the unemployment rate fall from its current official level of 6.3% over coming quarters. The growth impulses from the additional spending to come on infrastructure should extend higher than trend growth for some time.

Yields adjust 

The bond market is responding to this. It’s rational. Strong growth and closing the output gap raises the potential for inflation. Higher growth expectations and increased Federal borrowing can increase real interest rates. This is what is happening right now – in the last week or so the real yield on Treasury bonds has started to pick-up. It is still very negative (-0.875%) but higher than it was at the beginning of the year (-1.11%). Break-even inflation rates had already risen. So nominal 10-year Treasury yields breached the 1.30% level this week and the momentum towards higher yields strengthened with investors reducing their duration exposure.

Policy outlook 

Higher yields means a steeper curve and the gap between 2-year yields and 10-year yields is now 120bps compared to being slightly negative in Q3 2019. The curve slope is back to almost the mid-point of its range of the last 30 years. Normally the curve steepens when the Fed is cutting interest rates (and flattens when the Fed is tightening). At the moment there is no pricing in of any change in Fed interest rate policy so the adjustment in longer-dated yields appears to be a reflection of market uncertainty about what happens in the next phase of the US cycle – higher inflation – when the Fed’s normal reaction function to higher inflation has been “altered” by the average inflation target policy framework. That has not been tested in reality yet. Is the market betting that the Fed will lose its nerve once inflation does pick up? Jay Powell’s term as Chair of the Board of Governors expires a year from now. Is there some uncertainty as to whether the current policy will persist beyond that, even if it has not really had time to be properly executed?

But way too early to change stance 

We are into a new phase following the COVID-19 devastation to the global economy. In the US the recovery will be strong and the need for the level of monetary policy support that has been in place over the last year might be less. However, so far the Fed has not shown any inclination to step away. The “real” unemployment rate is probably higher than 6.3%. There is evidence of increased poverty  and other structural inequalities in the US. The Fed has even suggested that there is a mis-match between what is implied by financial market valuations and the real state of the economy. I suspect that the Fed will be more vocal in squashing market expectations of any change in asset purchases or the timeline for increases in interest rates. There should be a peak in yields at some point. At this stage, however, it looks likely that the peak will come in the 1.5%-2.0% range.

Expectations being met 

The other pillar supporting equity markets is the growth outlook. For the US this is strong, for other parts of the world, less so. There are active discussions amongst economists about the differences in fiscal policy between the US and Europe and they normally end with a weaker outlook for European growth. That normally also leads to the conclusion that the European Central Bank (ECB) will stay on hold for a lot longer than the Fed. Acknowledging that the US is more important for global investor sentiment, the strong outlook there is still supportive. However, we might be seeing an example of “travelling and arriving”. Equity market sentiment has been supported by expectations of vaccines and subsequent strong growth. We are getting the vaccine roll-out now – impressively in the US – and the economic numbers look great. January saw retail sales in the US grow by a consensus shattering 5.3%. Maybe markets need something new? At the same time sentiment is being tested by the narrative about speculative activity, too much leverage and high valuations – and higher bond yields.

Hard to keep revising higher 

I wouldn’t be surprised if market returns are more volatile in the coming months. The current reporting season has been strong and the forecasts for the rest of 2021 and 2022 are optimistic. Can they grow even more? Potentially yes if the growth spurt is realistic. But US style growth is not likely to be seen in other major economies – with the exception of China. If earnings momentum starts to fade a little this could be reflected in some valuation adjustments in the stock market.

Bonds more attractive than they were 

My approach to fixed income would be to look for opportunities to start to buy the long-end again. If investors have exposure to equities and are faced with potentially higher volatility in returns, then having some fixed income hedge again looks attractive. Treasury yields are almost 80bp higher than they were in the middle of last year. For non-US fixed income investors, the dollar market looks very attractive relative to domestic yields. For EUR and JPY based investors there is around an 80 basis points (bps) pick-up from investing in Treasuries hedged back to their local currency. The hedged yield has not been so attractive in EUR and JPY for years. With the Bank of Japan still committed to yield curve control and the European economic outlook not justifying higher yields, foreign investors are very likely to take advantage of this opportunity.

Credit looks fine 

Credit markets have benefitted from the twin pillars as well. Yet they don’t suffer from the upside exuberance of equities. The tightness of spreads reflects the combined policy effect and the “stronger economy/less credit issues” effect. Now, credit benefits from higher underlying risk-free rates. We aren’t talking big moves in investment grade yields – the US ICE/BofA Corporate Bond index yield-to-worst is currently 1.94% compared to a low of 1.78% a few weeks ago. The BBB-rated tranche of that index offers almost 2.20%. Again, hedged back into EUR and JPY this is potentially attractive for European and Japanese investors. The hedged US BBB yield in Euro is a full 100bp above the equivalent Euro basket. The same is true for high yield. If the risk of an equity wobble has increased, credit might not be a bad place to park some capital for a while.

Shifting sands 

This year always had the potential to be better in terms of macro performance, but worse in terms of market performance. There is a re-pricing of the US outlook and the debate on inflation is not likely to be resolved anytime soon (follow the discussions between Paul Krugman and Larry Summers that my colleague, Gilles Moëc has recently highlighted). I can’t see break-even inflation rates falling significantly until we are at least over the Q2 hump in inflation. That makes it hard for nominal rates to go back down significantly unless there is another negative growth shock. A new higher range for Treasury yields will take some time to establish and equity markets, with nothing really new to focus on, might be disturbed by that. Still I remain of the view that 2021 will be a positive year for stocks. It would be an unusual one if there were not opportunities to buy at cheaper levels.

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