When Good News Becomes Bad News
Just like in January, global markets gave up most of their gains in the last few days of February this time because of rising bond yields, which made the market nervous.
What is important to note that it was not only U.S. Treasury yields that rose but also the European and Chinese bond yields, so it was a global sell off in government bonds.
Why Did the Equity Market Get Rattled by Rising Bond Yields?
Normally rising bond yields are an indication of strong economic growth, which should be positive for equity markets. However, historically, rising yields have been negative for stock valuations when yields increased in response to hawkish central bank rhetoric. This is clearly not the case today. The Fed’s accommodative stance should limit any near-term upward pressure on U.S. bond yields. Therefore, we continue to favor equities over a 12-month horizon.
This equity and bond market sell off was triggered by fears that all the fiscal and monetary stimulus will lead to much higher inflation, which would force the Fed to raise interest rates and tighten monetary policy, which in turn would put pressure on stock market valuations, especially on stocks with high valuation multiples. That is the reason why for example the NASDAQ dropped more than the Dow Jones Index.
Rising Yields and Inflation
We expect U.S. inflation to move higher over the coming months. Oil prices have risen 70% since the end of October and rising energy prices will likely push up headline inflation. In addition, the effect from a weaker dollar should translate into higher goods prices in the U.S.
A stronger labor market and a slower pace of rent forgiveness should also boost housing inflation. If we add everything together, we think there is a risk that headline inflation in the US could temporarily rise to 3 to 4% in the coming months, which would increase the long-term inflation expectations and could again lead to a short-term increase in bond yields, which could cause another scare in the equity market.
Fiscal stimulus could further supercharge demand, adding to inflationary pressures. The impending passage of the $1.9 trillion American Rescue Act, combined with the economic stimulus packages from 2020 brings the total fiscal support to almost 25% of U.S. Gross Domestic Product (GDP), which is arguably larger than the economic damage caused by the pandemic.
However, we think this increase in inflation numbers will be temporary as the economy is still in recovery mode. So, we do believe Fed chairman Powell when he says the Fed is planning not to take any action for the next two years. If the Fed sticks to that plan, then the economic stimulus will support corporate earnings.
We have to remember that inflation is not necessarily bad for equity markets. Deflation is bad for stocks, just as is high inflation. Somewhere between deflation and inflation, however, lies reflation. Reflation is good for stocks. We are currently in a reflationary zone, where inflation expectations have risen but not by enough to force the Fed to tighten monetary policy.
A period of ultra-easy monetary policy can sow the seeds for economic overheating, rising inflation, and ultimately, much higher interest rates. Since this is precisely what happened in the 1970s, it is prudent to ask whether something like that could happen again. Investors today certainly do not believe a replay of the 1970s is in the cards. Yet, we would argue that a 1970s-style inflationary episode is at least a risk we need to keep in mind.
While no two periods are exactly the same, there are a number of striking similarities between the late 1960s and today. As is the case today, fiscal policy was highly expansionary back then. The same goes for monetary policy: just like today, the Fed kept interest rates well below the growth rate of the economy. In the 1960s, the Federal Reserve was still focused on avoiding a repeat of the Great Depression and the deflationary wave that accompanied it. Today, the Fed is equally focused on reflating the economy.
As long as the economy is growing solidly and the Fed remains on the sidelines, it is too early for investors to sell out of equities. Instead, equity investors should favor sectors that could benefit from higher inflation. Looking further out, the secular bull market in stocks will end when inflation rises to a level that the Fed cannot ignore. That day will arrive, but probably not for another two years.
We cannot yet declare victory over COVID-19 but it is clearly going in the right direction as new case counts have plummeted from their January peak. Restrictions helped turn the tide in Europe, albeit at the cost of cutting off oxygen to the economy, but even in Sweden and the U.S., which avoided EU-style restrictions, the virus has lost momentum. The roll-out of the vaccines will help to suppress another flare up of the virus and supports our view that economies will be able to open up sustainably within the next three months. The potential for vaccine-resistant variants is a concern, but the pandemic news is clearly trending in the right direction.
Why This Time It is Different
The global economy has seen two significant crises in the space of a dozen years. The monetary policy response to both events has been substantially identical; the Fed swiftly cut the fed funds rate back to zero and started buying large amounts of Treasury and agency securities to support market liquidity.
The fiscal response has been dramatically different, however, with governments this time seemingly not concerned at all by borrowing large amounts of money to finance the economic stimulus plans.
Therefore, the outlook is quite different today compared to 2010 as central banks have gained a powerful and willing partner in their efforts to combat the damage wrought by a sudden shock. Pandemic fiscal stimulus initiatives have dwarfed the fiscal efforts after the Global Financial Crisis across the major economies. Once Congress passes the $1.9 trillion American Rescue Act, the U.S. will have doubled down on its 2020 initiatives, committing to aid equivalent to an extraordinary 25% of its annual output. The ultimate effect on inflation, interest rates and exchange rates remain to be seen, but it is clear that the post-pandemic economic recovery will not unfold in the same way as in the past decade.
From 1966 until 1997, U.S. equity prices were negatively correlated with U.S. Treasury yields. Since 1997, U.S. share prices have been positively correlated with US government bond yields. We believe we are now in the process of a major paradigm shift in the stock-bond correlation, reverting to the pre-1997 relationship.
The positive correlation between share prices and US bond yields – that has been in place since 1997 – is likely to turn negative, which effectively means that stock prices will fall when U.S. bond yields rise and will rally when Treasury yields drop. The reason is that the market will shift its focus from seeing deflation as the major risk to seeing higher inflation as the main macro risk. Investment strategies and frameworks that have worked over the past 24 years might require modifications as balanced portfolios that only hold equities and fixed income might not provide sufficient diversification in this macro climate.
What Happened in 1997?
In case you are wondering what happened in 1997: The basis for the 1997 reversal in the stock-bond correlation was a regime shift in the global macro backdrop. Before 1997, the main risk to business cycles and share prices was inflation. From 1997 until very recently, the main risk to equity markets was deflation or very low inflation. The watershed event that triggered this global macro shift from inflation to deflation was the Asian Crisis in 1997. The Asian currency devaluations allowed local producers – operating in these large manufacturing hubs – to cut their export prices in US dollar terms. The price reductions unleashed deflationary forces that spread all over the world.
The Impact on the USD
The Fed’s accommodative stance should limit any near-term upward pressure on the U.S. dollar. Whereas stocks are most sensitive to absolute changes in long-term real bond yields, the dollar is more sensitive to changes in short-term real rate differentials with U.S. trading partners. Since the Fed is unlikely to tighten monetary policy anytime soon, U.S. short-term real rates could fall further as inflation rises.
The Fed falling behind the inflation curve is fundamentally bearish for the U.S. dollar. That is why the primary trend for the dollar remains down. However, the dollar is oversold, and a short-term rebound is possible, especially if U.S. bond yields continue to rise, triggering a period of risk-off in global financial markets.
Given these conclusions, we recommend the following investment stance over the next 12 months: Stay positive on equities, which will generate excess returns over government bonds and cash in the absence of a negative COVID surprise.
Despite the high valuations of growth stocks, we favor a balanced approach as we expect corporate earnings to remain strong this year, also for growth stocks. We could see periods of rising bond yields which will create short-term fears and corrections in the markets. But we think bond yields will not rise sustainably this year and the monetary backdrop will remain supportive for equity valuations.
Longer-Term Investment Strategy
Relatively higher equity valuations means that a lot of good news is already discounted in prices and that means the equity rally is entering a riskier period where short-term corrections become more likely. Share prices will advance when U.S. bond yields drop, and they will dip when Treasury yields rise. As and when share prices drop due to concerns about higher inflation, the Fed will attempt to calm investors arguing that inflation is transitory, and it knows how to deal with it. Stocks and bonds will likely rally on reassurances of this kind.
We are following commodities and may favor holding a position in precious metals and base commodities as a long-term diversification in a multi-asset portfolio.
Base metals prices have rallied by over 50% in dollar terms since last year’s COVID-induced meltdown. Nevertheless, we see further upside in metals prices, with the potential to develop into a multi-year structural bull market. The key driver is the world’s decisive push to a greener future, which in turn will significantly boost demand for several key base metals used in new energy infrastructure.
Although the world’s awareness of climate change has been increasing over the past several decades, 2020 became a pivotal year as major countries affirmed their commitment with concrete and measurable targets. The EU and Japan announced last year that they are striving for net zero greenhouse gas emission by 2050, while China is aiming for the decade after.
In the U.S., President Joe Biden also intends to set the U.S. on a path to net zero emissions by 2050 and has issued an executive order to rejoin the Paris Climate Accord, alongside other actions in favor of environmental policies. To meet the ambitious goals outlined in the Paris Agreement, governments need to implement aggressive efforts focused on improving energy efficiency, decarbonizing the power sector, switching to low or zero-carbon fuels, and utilizing carbon-capture technologies. These efforts could profoundly change energy infrastructure and consumption patterns in the coming decades.
In short, the combination of regulatory, financial, and social incentives points to an acceleration in the development of green infrastructure, including the construction of solar and wind energy power plants and electrification of vehicles, many of which are heavy consumers of copper and some other base metals. This holds the promise of significantly boosting demand for these resources.
China’s demand for copper has been strong in the past several decades, and still holds the key in the near future. While the country’s transportation infrastructure has vastly improved, its campaign to build “new infrastructure” on the digitalization of its economy has just begun. The country has laid out ambitious plans to expand its 5G network and data centers, all of which are heavy consumers of copper.
Global Equity markets performed strongly up till the last week of February when the rising bond yields created a sell-off which wiped out most of last month’s gains. Our balanced approach in portfolios of combining value with momentum worked well.
As bond yields have been rising globally, bonds didn’t have a great start of the year. Global fixed income markets are down 2.5% since the start of the year while equity markets are up 1.5%. Which means that fixed income heavy portfolios are lagging. Non-qualified models have benefitted from municipal bond holdings as they have fared better than their treasury counterparts. Qualified models will see the return of senior floating rate bank notes to the lineup after a short absence. The potential for rising rates and the low duration associated with senior notes make them a favorable addition.