April 2021 - Monthly House Views
Showers for the bond market
As we begin the second quarter, global equities are at record highs. This milestone of optimism is belied, however, by underlying angst, particularly in the bond market. This angst has several veins. They include the extraordinary scale of central bank asset purchases and deficit spending; the rapid growth in money supply as households receive direct remittances from governments; overheating fears stoked by hopes that vaccinations will get economies back to normal; and the massive jump in commodity prices since last March.
These factors have prompted a scramble by investors to reassess inflation risks. Swap contracts on investor expectations of 5-year US inflation in 5 years’ time have shot up from 1.22% last March to 2.41%. (Source: Factset. Data as at 14 April 2021) Contracts on Eurozone inflation have doubled from 0.72% to 1.49% in only 12 months. This dramatic shift in inflation fears has put downward pressure on fixed-income securities as investors demand more protection against inflation, pushing yields higher (yields move inversely to bond prices). Ten-year US Treasuries currently offer a 1.63% yield, up from last April’s 0.52% historical low – the Bloomberg Barclays index of long-dated Treasuries has registered a 18.6% loss since then. The yield of UK government Gilts has also risen, with the yield on 10-year issues rising from 0.20% to 0.80% over 2021. This equates to a year-to-date loss of nearly 7% for the FTSE UK Government Gilts Index (All). This downturn in bond markets has been one of the strong supports for equity markets.
Despite these shifts, central banks remained unperturbed. Last summer, the Federal Reserve shifted its priorities to focus on maximum employment – meaning it wants unemployment below the pre-pandemic lows – while indicating that it would be comfortable with a spell of inflation above its 2% target. This message was reinforced by policy-makers’ March projection of no key rate hikes for the next three years. Similarly, the Bank of England stressed that little had changed in its medium-term outlook and it too was in no hurry to raise rates. Elsewhere, faced with tightening financial conditions, the European Central Bank (ECB) announced it would step up the pace of its asset purchases in Q2, which will help keep core bond yields low and periphery yield spreads tight.
Moreover, we do not expect these inflationary pressures to last. Current fiscal spending is designed to alleviate near-term problems for low-income households, the unemployed and businesses and will do little to enhance long-term growth prospects. This rapid money-supply growth has simply led to a build-up in savings, not an increase in velocity – the rate at which money circulates in an economy – which might be a harbinger of inflationary pressure. Furthermore, structural disinflationary factors, such as ageing populations and technology-driven productivity gains, have not disappeared.
Commodity prices will most likely fuel a spike in inflation in coming months which will keep bond yields under pressure, but we expect this to be a transitory phenomenon. Central bankers appear to agree and are likely to keep key rates unchanged, while enormous asset purchases will contribute to stemming any excessive upward pressure on bond yields.
We remain positively postured and are risk-on. As always, we are guided by the four pillars of our investment process:
- Economic regime: Our Leading Economic Macro Indicator (LEMI) suggests the global economy is in a state of expansion, which is clearly favourable for risk-taking.
- Valuations: Valuations for equities – the largest source of risk and return in most strategies – remain challenging in absolute terms, particularly in the US, which remains the most expensive global region. Heightened valuations – particularly in “large-cap, secular growth” companies – have been further challenged by increased inflation expectations, which raises the spectre of rates rising. However, we believe central banks have little appetite to raise rates at present and inflation is likely to remain subdued over time, albeit a transitory rise may well occur. Moreover, while government bonds yields have surged, they still are unattractive relative to equities. For these reasons, we remain tolerant of higher global equity valuations at the headline level, but are tilting our exposure towards cheaper, more cyclical regions.
- Momentum: Global equities are in positive momentum versus their ten-month moving average. This is supportive of increasing exposure to the asset class.
- Sentiment: Sentiment has turned more bullish on our underlying indicators. One in particular, Global Equity Fund Flows, shows huge inflows into global equity funds (and away from fixed income funds). Given the idiosyncrasies associated with the market’s re-evaluation of inflation and the impact on bonds, this is understandable: It is more a function of the market’s rational reaction to central bank policy rather than a signal for complacency or unjustified risk preferences as would be the case in more normal times. Nonetheless, we remain watchful of our sentiment metrics.
We believe the case for risk-taking is well supported given a strengthening economic backdrop and strong momentum. Nonetheless, we are wary of expensive valuations and over-bullish sentiment. On Balance, we are moderately risk-on with a continued preference for equities, but have been tilting more towards cheaper, value-oriented regions. We also continue to hold a stable of safe-haven assets, including gold, low-volatility, defensive alternatives (e.g. hedge funds) and government bonds.
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In accordance with the applicable regulation, we inform the reader that this material is qualified as a marketing document. CA884/Apr2021