A big shake-up is under way in bonds – rising UST yields, a steepening yield curve (2-10Y) and inflation expectations are leading markets to question whether we are facing a taper tantrum 2.0. We think that the risk of the Fed taking pre-emptive measures to stop its buying programme in the next 12 months has been exaggerated. The Fed will remain cautious and downplay inflation risks. Therefore, we could see a healthy increase in yields, driven by expectations of a recovery. US inflation now seems to be having a technical rebound, driven by base effects and ISM input prices, but viewing this as only a short term pattern could be a mistake. Once these so-called base effects fade, markets will realise there is something more structural to inflation. The era of low growth, low inflation and zero rates forever is coming under attack, with a new narrative emerging: inflation is returning. On the other hand, CBs and governments need money to help challenged businesses survive, create new jobs and finance projects to address inequalities and climate issues. Fighting inflation is not the top priority, with the focus on full employment.
With CBs unable to withdraw support measures, we are progressively moving towards a new regime, one we call the road back to the 70s. A change of regime often occurs with a change in the mandate of CBs as in the late 70s. However, markets are expecting that CBs will be able to control the yield curve FOREVER. This is wrong as new priorities may force CBs to move into uncharted waters. The second phase of this sequence should be less benign for bond yields and lead to a rebalancing of risk premia. Keeping these backdrops in mind, there are some key questions investors should address:
- How to manage bond allocation with rising yields? The rise might not be over yet, but the path of acceleration should slow. Looking at the 2013 taper tantrum, more than two-thirds of the bond correction happened in the first three months. That situation appears to be repeating itself in early 2021. Bonds move ahead of a confirmation of change, and that confirmation should occur in the summer. Investors should stay underweight duration, retaining the flexibility to readjust at higher rates. Opportunities are available to extract value in credit, relative value across regions, and across yield curves. This favours a flexible and unconstrained approach in fixed income investing.
- Will higher bond yields trigger a bubble burst in equities? Higher UST yields are important to watch for bonds as well as equities. The gap between the US dividend yield and long-term rates is zero, a sign that a repricing in equities was expected. There is also an element of irrationality in the strong equity performance in the first weeks of 2021. What we see now is a clean-up of some excesses, but certainly not a bear market. The equities outlook remains constructive, but returns are becoming less interest rate-driven and more real economy-driven. For investors, equities remain a key asset class in a recovery phase, but they should avoid expensive areas vulnerable to higher yields.
- Will value’s revenge last? The yield repricing is driving a rebalancing towards value. The first leg of this rotation occurred in November 2020, triggered by an acceleration in the vaccine situation. Now we are seeing a second leg, driven by rising rates. We will have to wait and see how this situation unfolds as inflation and the economic acceleration are confirmed. Investors may seek further opportunities in value, with a cyclical tilt, to benefit from the multi-year rotation.
- With rising yields, is the EM case still valid? EM assets are sensitive to USD and US rates but EM are now in much better shape than in 2013 with regard to inflation and current account imbalances, especially the ‘Fragile Five’. EM bonds could play a key role as income engines in global portfolios. We remain constructive in the medium to long term on EM HC debt, but we remain defensive in the short term. The same applies to FX, which has the potential to outperform the USD on a bearish USD medium-term view but the short-term outlook is less benign, as the USD may strengthen. EM equities are the favoured EM asset – exposure to growth at decent prices and a positive earnings outlook.
- Higher inflation challenges traditional diversification, as correlations between equity and bonds turn positive. Investors should consider increasing their allocations to assets such as inflation-linked bonds, real assets (real estate and infrastructure) and commodities.
To conclude, in a world of stretched absolute equity and bond valuations, relative value is the only value left in markets. Investors should look at relative value ‘within’ and ‘across’ asset classes. In this respect, absolute return approaches that seek to extract relative value in markets, with limited directional risk, could help enhance diversification.