Choppy markets in a moment of truth for rates
Markets closed 2020 on strong footing and the recent Democratic sweep in the US makes a greater fiscal push more likely, leading us to lift our 2021 GDP growth forecast for the US to 5.2-5.7%, 1% above previous estimates. This marks a great divergence between the US and the rest of DM, where we have been lowering our forecasts.
Markets are suddenly questioning the no inflation forever narrative, especially in the US, amid an accelerating economy. UST yields have been rising and the US curve steepening further at a very fast rate in just a few days. Market inflation expectations have also risen to two-year highs. While bond markets have been adjusting to this acceleration in the possible return of inflation narrative, equities have remained resilient. The adjustment has instead been felt in some areas of excess, such as cryptocurrency. President Biden’s proposed Covid-19 relief package, of $1.9tn, is further supporting this trend, which has also been felt on the currency side. The USD has paused in its weakening trend since the beginning of the year, after strong moves in 2020. For investors, the reinforced reflation narrative calls for some adjustments:
- Move towards a more cautious stance on duration. CBs will remain dovish, but markets are starting to price in a possible reduction in asset purchases. For the first time, discussions about potential tapering by the Fed have been making the news. This debate was kick-started by the acceleration in economic growth and the progress regarding Covid-19 vaccine programmes. But many members of the Fed consider such discussions to be premature. Chairman Powell recently reiterated the importance of not exiting too early and being careful in terms of communication on this front. A more cautious stance on duration is also recommended in the EM space, where bonds still offer valuable opportunities in the hunt for yield, though duration must be carefully managed.
- Include forms of inflation protection with liquid and illiquid assets in a year when a resurgence of inflation in the US will likely be one of the key themes. The prospects of a larger-than-expected fiscal boost, an acceleration in economic growth, an unleashing of pent-up demand, supply chain relocations and energy price rebounds are all elements that could further drive inflation expectations higher and lead to relative market adjustments. Inflation-linked bonds will become increasingly appealing (inflation breakeven and TIPS) as well as some real assets.
- From a cross-asset perspective, equities continue to be favoured over bonds. However, investors should seek opportunities in areas supported by reflation, starting with value and more cyclical markets, such as Japan and EM, where commodity trends are also supportive. When it comes to any adjustment of expectations on rates, we see little space for strong directional moves of indices, but for leadership rotation within the indices to continue, with value stocks and interest rate and energy-sensitive stocks recovering vs high/hyper growth stocks. This rotation could see a temporary slowdown in Q1 with the activity deceleration and stricter lockdowns, especially in Europe, but the recovery trend in the medium term looks to be intact, as is the value rotation theme.
- It’s important to be watchful on equities as absolute valuations are far from appealing. In particular, should 10Y yields rise further, equity market performance will be challenged. A 1.3% level for the UST 10Y would, in our view, test the market. However, we don’t believe we will reach this level any time soon, and instead see the most likely scenario as one of a sideways market movement cleaning up some of the excesses that the year-end rally brought. Overall, this calls for some hedging on equity exposure to mitigate downside risks.
So far, the monetary factor narrative of low rates, low growth, and low inflation has been dominant, but a different narrative, of a faster real growth catch-up, is gaining ground. Obviously the monetary narrative remains dominant and seems firmly grounded, but even a small change would cause big noises in both bonds and, at some point, in equities. To avoid being trapped in a lose-lose game, it is important to be highly selective in the equity space by looking at attractive names able to benefit from the cyclical recovery but also prompt longer-term earnings growth. In bonds, investors should stay active in duration management and play relative value trades (at curve and regional levels). In an era during which traditional asset diversification may be challenged by rising inflation expectations, investors should remain agile and flexible in their allocation, and consider less correlated investment strategies to enhance diversification and make portfolios more resilient to a possible regime shift.