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With the notable exception of tech stocks, stock markets are learning to live with higher bond yields. Strong economic growth this year will boost corporate profits, justifying the optimism around equities. Government bond yields may well creep up further, but more in response to economic growth -which tempts investors into other assets- than to inflation. Indeed, fears of inflation appear overdone.
Tech and other growth stocks that have yet to make a profit (‘jam tomorrow’ investments) have suffered from higher bond yields because higher bond yields lead to higher financing costs. In contrast, recent upgrades to the U.S and global growth forecasts have contributed to a further run of outperformance in March from so-called value stocks. These are often in ‘old economy’ sectors, such as industrials, financials and energy, that are highly sensitive to the economic cycle and will see the greatest increase in profits and dividends.
The rotation out of government bonds and into equities, and within equities a bias towards value, is likely to persist given the recent upgrades to global economic growth. Consensus estimates are for U.S GDP to grow at over 6% this year, more than making up for lost output last year, while the IMF forecasts the strongest global growth in five decades at around 5.2%. In the U.K, the Office of Budget Responsibility (OBR) is forecasting 4% GDP growth this year, but rising to a somewhat astonishing 7.2% next year as the country’s large service sector rebounds.
It is almost exactly a year ago, on 27th March 2020, that the VIX index (of implied future volatility on the S&P 500) peaked at 65. Commonly known as the ‘gauge of fear’, it now stands at 18.8, its lowest since late February and before Covid-19 fears hit Wall Street.
Financials and energy sectors. Big U.S banks and global oil companies lack the glamour of cutting-edge tech stocks. But both demonstrate why value sectors are currently in vogue. Financials benefit from steeper yield curves on government bond markets, which have come with the bond sell-off. This is because the ‘net margin’ grows (being the difference between what a bank pays to borrow money, and what it receives when it lends it out to customers). Financials also benefit from increased demand for loans, in the upswing of an economic cycle. Given the expected strength of the U.S economy, U.S financials look like they are in a sweet spot. Last week the Fed said it would lift restrictions on banks to resume dividend payments and share buybacks, dividend growth is expected to be robust after last-years trimmed down pay-outs.
There is much talk of a new commodities supercycle about to start, and within that is a distinct energy theme. Few oil companies dispute that the long-term future for hydrocarbon energy may be challenging, given the progress being made in generating cheap renewable energy. But that is the long-term, and who says Big Oil cant adapt?
In the near term, a supply squeeze (helped by coordination between the so-called ‘OPEC Plus’ group of producers, and Russia) and a strong bounce-back in demand, could keep oil prices in the $75-$80 range for much of the second and third quarter, according to estimates from investment bank Goldman Sachs. Given the high fixed costs of the industry, any extra dollar earned in revenue flows is profit, meaning that energy companies earnings are a highly geared play on the oil price. This will help fund investment into new reserves, support dividends and share buybacks, and -importantly- investment into renewable energy. European oil majors are leading the way in transforming themselves into renewable energy companies.
Other ‘old economy’ sectors have their own recovery stories, whether travel, industrials, hospitality, luxury goods, and -compared to much of tech- are attractively valued. This, together with the aforementioned increased cost of finance that growth stocks will face as bond yields rise, helps explain the rotation into value sectors.
Investors are closely watching central banks’ analysis of the recent sell-off in Treasuries and other government bond markets, and the central banks’ response. So far there has been no reversal by any major central bank to their commitment to low-interest rates. They are in no hurry to remove the proverbial punch bowl from the party. This is heartening. It suggests that they will avoid the mistake of tightening monetary policy prematurely, as they did after the global financial crisis, and so curtailing economic recovery.
Despite the column inches written on the subject in recent weeks, there is no sign yet of a structural inflation problem emerging in the U.S, the U.K or any major economy. This is no doubt influencing central bank decision making. Indeed, the risk in the eurozone is of a return to deflation if the third wave of Covid-19 results in more lockdown and the ECB, together with the Reserve Bank of Australia, are printing more money -not less- in response to higher bond yields.
The inflation pressures that do exist are coming from disruptions to supply lines, and from higher energy prices, all of which are temporary phenomena. There is no evidence of wage growth fuelling consumer demand and higher prices, leading to calls for higher wages, and so on. It is this wage/price spiral, similar to what we saw in the 1970s and 1980s, that investors should fear.
Disrupted supply chains have led to bottlenecks and to higher prices for many inputs int the manufacturing process. Hence factory output prices are rising. There are, for instance, global shortages of computer chips, steel, and cardboard. Shipping containers are stuck in the wrong ports, contributing to higher container prices. Energy prices have risen from $15 a barrel to $64 in March, in anticipation of the strong demand that 5.2% global GDP growth represents. These are all what economists describe as ‘supply side’ shocks, but crucially they tend to be temporary in nature because the supply and demand response to higher prices tends to bring them down again.
Sometimes supply shocks are event-driven, and the event passes. The blocking of the Suez Canal by the container boat The Ever given is a good example of such a shock. 12% of global trade passes through the canal. Lloyds List have estimated that $9.6bn worth of goods are held up each day the canal is blocked up, and there is speculation that this will drive goods and energy prices up further. But we know that this is a temporary problem. The canal will reopen, and any price increases on account of its closure will, in time, reverse.
The West and China. The recent acrimonious U.S/ China summit in Anchorage ended with an invitation from the Chinese to host a follow-up series of meetings in China. The U.S apparently replied ambiguously, simply saying ‘thank you’. The dispute between China and the U.S, and increasingly the West in general, now covers so many issues -including trade, security, human rights and the status of Hong Kong and Taiwan- that any talks will be welcome.
However, the U.S has much bridge-building with its European and Pacific allies to do before it can force concessions from China, or offer concessions itself. The E.U ignored U.S protests and signed a trade deal with China in December (which has yet to be ratified). Australian beef and wine producers, hit by Chinese tariffs, have seen U.S rivals willingly step in to the Chinese market. Furthermore, Germany -without whom no E.U co-ordination with the U.S is possible- is in a separate dispute with the U.S over its controversial Nord Stream 2 pipeline project with Russia.
While President Biden attempts to build coalitions, President Xia will seek to dissuade America’s allies from joining it. It is in this context that last week’s measures by China are best interpreted, in which it targeted companies with tariffs and sanctions a range of countries, companies and individuals in Europe and Australia that have given it offence at one time or another.
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.