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Market sentiment: Investors continue to be nervous of rising Treasury yields, which are contributing to a rise in global yields and to (slightly) higher borrowing costs. Long duration assets, such as those tech stocks that are not yet making profits, and long-dated government bonds, appear most vulnerable. Higher yields are being driven by inflation fears, that were given fresh fuel last week by Congress’ passing of the $1.9 tr stimulus bill last week, and the promise by the ECB of an acceleration of its bond-purchase program.
When asked what keeps him awake at night, U.K chancellor Rici Sunak told a House of Commons select committee that it is rising rates (ie, higher bond yields). Understandable, given the nature of his ‘spend now, tax later’ budget of the previous week.
But because loose fiscal and monetary policies will underpin a global economic recovery, hopefully from the second quarter, other financial markets -such as global stock and credit markets- should be protected from higher bond yields, by improved corporate earnings growth. Similarly, Mr Sunak’s support for the economy also supports his need for tax receipts.
Therefore it is likely that stock markets will be able to absorb further increases in yields, but the increase in yields will contribute to further sector rotation. Away from relatively expensive markets (such as tech and perhaps Chinese stocks), and into more cyclical stock market sectors, such as industrials, travel, and financials, as more people receive the Covid-19 vaccination and normal economic activity returns to the developed economies. The U.K stock market looks likely to benefit from global interest in cyclical stocks, and will benefit from its relative lack of tech exposure.
Last week we saw the rotation play out in contrasting stock market index performances: the German Dax stock market index (that has a large weighting of cyclical stocks) reached a new all-time high, while the U.S tech-focused NASDAQ index ended 6% down from its mid-February high.
The dollar. As the U.S economy recovers, sucking in imports, the dollar can be expected to weaken further.
Treasury yields have further to climb. Despite their rapid increase since the lows of last summer, Treasury yields probably have further to climb in the current cycle. First, they come from a very low starting position (the 10 yr yield fell to 0.5% last August, while last week’s jump to 1.6% only takes it to early-February 2020 levels). Second, economists are increasingly forecasting a strong rebound in U.S consumption from the second quarter which will contribute to rising prices and to fears of a longer-term inflation problem.
But we should not forget that rising yields create their own resistance. As bond yields rise, they will tempt back some investors who currently hold cash, gold and other assets that produce no income. This will support bond prices and limiting further yield increases. Second, the rise in bond yields represents a tightening of monetary conditions, and is, therefore, a deflationary force. Higher 10-year yields, for instance, feed through directly to higher 10-year fixed mortgage rates in the U.S housing market. In these ways, the increase in bond yields is a self-correcting mechanism, particularly if inflation proves to be a temporary phenomenon.
But inflation may well be a temporary phenomenon. In recent weeks we have seen some push-back from economists on the fear that Biden’s $1.9trillion stimulus package will be inflationary. It has been pointed out that the package is more about maintaining demand in the U.S economy until normal economic activity resumes than it is about turbo-charging the recovery. Unlike spending on infrastructure, which boosts long term output and demand, spending on income subsidies has a relatively little long-term impact on inflation and growth. This suggests that any inflationary consequence will be temporary, and unlikely to feed through into wage growth so long as unemployment and underemployment remain high.
The impact for investors. The above may seem a dry macro-economic argument, but with inflation concerns being top of many investors’ lists of concerns at the moment, the debate is very relevant. A temporary rise in inflation suggests that any further rise in bond yields is best endured by multi-asset investors, rather than trying to market time the bond market (ie, sell now in the hope of buying back at more advantageous prices). Nervous investors may wish to reduce risk, however, by decreasing the duration of the fixed income exposure by buying short-dated bonds.
Brexit and sterling. A Brexit risk premium applying to sterling looks increasingly likely, and investors should remain diversified in their currency exposure. There was a sharp drop in trade in January between the U.K and the E.U, the first month in which new post-Brexit trade rules applied. Exports fell 41%, and imports 29%, meaning the U.K’s historic trade deficit with the E.U widened. Undoubtedly temporary teething problems with new regulations are partly to blame, but many business organisations (particularly in agriculture and fishing) warn of a permanent loss of E.U market share. Problems do appear to persist, logistics companies are reporting that there are still a much higher proportion of E.U lorries returning to the continent empty, compared to last year.
The U.K government has decided to continue to not apply new import rules on goods coming from the E.U, for fear of disrupting supply chains for British companies, while the E.U has applied the rules since 1st January. This works in favour of the E.U, which can look forward to an enlarged trade surplus with the U.K at least until next January, when the U.K may start applying import controls.
Both the U.K/ E.U trade agreement and the Norther Ireland protocol lack detail on how they will work, meaning good faith and a willingness to be flexible are required from both sides if normal trading relations are to exist. This is being tested over a range of issues, including the import and export of Covid-19 vaccines, the unilateral decision by the U.K to delay phasing in rules trade rules as they apply to Northern Ireland/ mainland U.K trade, and the appointment of the -apparently- abrasive Lord Fox, who negotiated the E.U/U.K trade deal, as a cabinet-level minister for European relations. E.U heads of states, and the Brussels bureaucracy, sense the U.K is being deliberately provocative. The U.K government, meanwhile, is trapped by the unanswerable Northern Ireland border question, and by its position on Brexit matters in general which is that sovereignty trumps any cost to the economy.
Remain diversified. As always, investors should be as diversified as possible in order to maximise returns relative to risk (ie, volatility). This means geographical, sector and asset class diversification.