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February’s Investment Strategy Committee: Pressure building in government bond markets

By Tim Sharp, Hottinger & Co.

Despite the current restrictions, we still expect to see a significant rotation from growth into cyclical stocks as the ongoing vaccine roll-out in developed nations leads to the re-opening of economies, albeit later than originally anticipated. The combination of a Biden administration fiscal package of over $1trn coupled with the supportive forward guidance of a Federal Reserve on hold continues to offer an environment that favours risk assets. The semi-annual testimony to Congress by Fed Governor Jerome Powell was designed to calm markets with dovish rhetoric as the US Treasury yield curve continues to steepen putting pressure on growth stocks. 10-year rates are approximately 0.35% higher in February, 0.45% year-to-date, yielding 1.41% by the close while 2-year yields have remained relatively anchored to 0.13%. Powell re-iterated the stance of the FOMC[i] that interest rate hikes would not be considered until full employment that was both “broad and inclusive” had been reached, and the inflation rate remained resolutely above the 2% target in line with its new flexible average inflation target. Even with the prospect of significant fiscal stimulus, the Fed is unlikely to slow the pace of asset purchases this year, in our opinion, and interest rate hikes are likely several years away.

Most equity markets managed to register a positive result in February as the strong earnings season outweighed the risks posed by steeper yield curves. The S&P500 outpaced the NASDAQ Composite +2.61% vs. +0.93% as the rotation away from growth stocks seen since the beginning of the year continued. This is best illustrated by the performance of Banks and Technology sectors as an indicator of the underlying moves in growth vs. value. The S&P500 Financials sector gained 10.61% in February (+9.60% year-to-date) while S&P500 Technology sector only managed 1.37% (+0.52% year-to-date). Furthermore, it is also noteworthy that value indices such as the UK FTSE All-share that gained 1.66% in February, the German DAX +2.63% and Paris CAC 40 +5.63% underline the value bias within European markets.

Moreover, newly appointed Treasury Secretary Janet Yellen’s announcement during her January 19 inauguration speech that it was time to “act big” on fiscal easing is already being referred to as her “Draghi moment” referring to Mario Draghi’s “whatever it takes” speech in July 2012. Having a former Fed governor as Treasury Secretary could lead to greater collaboration and have a significant impact on the real economy, whereas we saw that the monetary intervention following the Global Financial Crisis (GFC) probably did more for financial assets. Absolute Strategy Risk (ASR) have pointed out that strong economic and earnings growth coupled with low rates could lead to further upside in US equities, despite the current extreme valuations, and have markedly revised their real US GDP growth forecast for 2021 up to 5%[ii].

As we inch closer to the ending of pandemic restrictions the strength of pent-up demand is palpable and the expectation for both a strong recovery in economic activity and earnings is expected; ASR now expect earnings to grow 25% year-on-year[iii]. We can draw on the experiences of Japan in the 1980’s when we witnessed financial repression combined with loose fiscal policy which led to investments driven by excess liquidity and fundamental valuations being of secondary concern. We believe it is likely that asset allocation decisions will be key to returns over the next 18 months with many rotations within asset classes being more significant than headline returns, and traditional asset classes unwinding some of the excesses of the extended bull runs in both bonds and equities. Recently we have witnessed online retail investors drive a disconnect between fundamental valuations and the share prices of certain popular stocks, such as GameStop, however this is not a new phenomenon. The participation of central banks in financial markets since the GFC with an indifference to valuations has already been central to the movements of assets over the last decade sowing the seeds for profound returns and the potential for equities to rally further from already elevated levels.

We have signaled since the start of the year that a significant move higher in long-dated US Treasury yields based on inflation fears could spook equity markets, particularly growth stocks that have been market leaders, and the first clear signs of this came at the end of the month. The 10-year US Treasury yield hit a high of 1.6% during the session on Thursday 25 before settling below 1.5% once more. Bear in mind that many forecasters had set a target of 1.5 – 2% for yields by year-end so the anxiety amongst equity investors is understandable. Furthermore, yields for long bonds are now comparable with the dividend yield on the S&P500 which means that bonds become a viable alternative to equities again for many fundamental investors. However, for multi-asset investors rising duration risk remains key to future returns and we continue to advocate substituting government bond exposure for alternative assets to lay-off potential equity risk.

During 2020, dollar weakness led to an increase in emerging markets as the main beneficiaries of the improving global outlook, however, the uneven Covid-19 vaccine roll-out has put this scenario on hold. Increasing yields and the expected lifting of pandemic restrictions in the developed world ahead of the developing world we believe should push the emphasis back to US and European markets once more, offering medium term support to the US dollar. The subsequent rally in sterling since the EU-UK trade deal deadline has seen “cable”[iv] reach a near term high of 1.4130 with many forecasters seeing 1.42 – 1.43 as fair value in the short term. A general dollar bounce will present near term headwinds to gains in the developing world and the outlook for broader global growth.

The current nervousness around financial markets as inflation expectations reach an inflection point has led to our continued focus on alternative investments including commodities and private investments. The weakness in gold this year of 8.71% (6.51% in February) on the back of increasing real yields has also led us to the decision to concentrate more on broader commodities, particularly industrial metals and oil. Over the month, the Brent Crude price has reacted to the re-opening trade gaining 16.25% while a broader basket of commodities has returned 5.62%[v]. We are also analysing other real asset solutions, private investments, and products providing lower correlation to traditional asset classes, over past periods of volatility in order to assess the potential current level of protection available to investors.

[i] FOMC – Federal Open Market Committee makes key decisions about interest rates and the growth of the United States money supply.

[ii] ASR Equity Strategy, Back to the 1950’s as Biden Boosts Value, February 18, 2021

[iii] ASR Asset Allocation. Bonds at Risk as Policy Goes “Big”, January 28, 2021

[iv] The term “cable” is a slang term for the exchange rate between the pound and dollar, referring to the time when the exchange rate began to be transmitted across the Atlantic by a submarine communications cable.

[v] Represented by the WisdomTree Enhanced Commodities ETF.


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