Market Update.

·        Higher yields unsettle bond markets but boost cyclical stocks.

·        Any jump in inflation will be temporary unless it feeds into wage growth.

·        Sterling and the Brexit risk discount…do not assume it has gone.

Market sentiment: some unease in fixed income as government bond yields rise on inflation fears. But stock markets see rising inflation expectations as confirmation of an imminent, and strong, economic recovery. This will be good for corporate earnings, which have -so far- not reacted to the higher bond yields. On stock markets we continue to see sector rotation into economically sensitive sectors such mining, travel and financials continues, as interest wanes in tech stocks and so-called ‘bond proxies’, which are most sensitive to increase in risk-free rates. This same sector rotation accounts for the strong outperformance so far this year of the U. K’s FTSE100 index over the American S&P500 (in which tech accounts for more than a quarter of its value).

Higher bond yields. Last August the 10-year U.S Treasury yield fell to a low of 0.5%. Today, the yield is 1.4% as bond markets focus on the possible inflation implications of a $1.9 trillion fiscal stimulus package, coming at a time when the American economy appears about to enjoy a period of strong cyclical growth. But although many commentators believe yields will climb higher, in the U.S, the U.K and in other major economies, it seems unlikely that this Is the great bond market reversal that some doom-mongers have been expecting for the past decade.

Why? Inflation, though expected to rise, is also expected to be a temporary phenomenon. It will reflect a one-off jump in consumer and business demand, and temporary supply bottlenecks. Few economists are predicting a wages-prices inflation spiral similar to what we saw in the 1970s, on account of the excess spare capacity in the labour force (i.e., unemployment and under-employment). However, any sign of wage inflation would justify more fear amongst stock market investors.

Most economists expect ‘the world of small numbers’ that came about after the financial crisis to persist after the pandemic. JP Morgan Asset Management, for instance, are forecasting U.S inflation to stabilise at around 2%, from 1.4% in January. Assuming continued Fed buying of $120bn of bonds a month in its current asset purchase program (a policy reiterated yesterday by Fed chair Jay Powell), they predict 10-year Treasury yields peaking at 3% in the current cycle.

Cyclicals. Stock and credit markets should be able to take such numbers in their stride, thanks to expected strong corporate earnings growth arising from the recovery. It is for this reason that economically sensitive sectors, such as travel, consumer discretionary, industrials and mining, have shrugged off the increase in bond yields. Indeed, one cyclical sector -financials- positively revels in the steeper yield curves that we are seeing across major bond markets. As long-term yields increase relative to short term yields and overnight interest rates, the spread between what banks pay to borrow money, and what they can charge their own borrowers, increases. This increases their profits.

Tech stocks, particularly in the U.S, have been trading at expensive valuations in recent months. These are justified so long as the return on risk free alternatives, such as government bonds, is miniscule. But as risk free rates (such as government bond yields) rise, the relative attractiveness of these ‘long duration’ assets (so called because investors are buying into a promise of perhaps distant future earnings) declines.

Bond proxies. Another group of stocks are also at risk from higher bond yields. These are utilities, insurers and other dull but reliable dividend payers, that have acquired the description of ‘bond proxies. As global interest rates and bond yields fell in the decade before the pandemic, their generous and stable dividend yields meant that income-seeking investors increasing included them in their portfolios, rather than fixed income. But these now look vulnerable as bond yields rise. The best will be able to grow their earnings and their dividends sufficient to counter the increasingly strong pull of government bonds. But others, in declining sectors or those with very limited room for expansion, will be vulnerable to an investor sell-off.

Sterling and Brexit. Sterling continues to rally against the dollar, now up five U.S cents to $1.42 since the start of January. This reflects relief at the signing of the December Brexit deal and the Bank of England’s apparent re-think over negative interest rates (it is against them). There is also an increasing recognition of an improving economic outlook for the country’s economy, as the mass vaccination program proceeds at a brisk pace. This has allowed the government to issue a ‘roadmap’ of dates, on which it hopes that various aspects of the lockdown can be lifted. As Brexit moves into the past, will sterling stop being a sensitive bell weather to changes in sentiment regarding U.K/E. U trade arrangements?

One would hope so, but the Brexit trade agreement with the E.U appears increasingly to not mark the end of a relationship, but just a stage on an endless path of confrontation. The Irish border remains a problem, and the longer uncertainty persists on this the greater the risk it becomes fuel for the return of sectarian violence. Industries important to Westminster, and which voted heavily for Brexit, such as fishing and agriculture, are demanding a better deal regarding access to E.U markets for fresh produce. Service sectors were not covered by the December agreement, and the financial services industry fears being abandoned by the U.K government in current negotiations. There appears much work still needs to be done. Relations between the U.K and the E.U remain tense, with a low level of trust. The Brexit discount to sterling, which has waxed and waned since the 2016 referendum, my yet reappear.

Remain diversified. As always, investors should be as diversified as possible to maximise returns relative to risk (i.e., volatility). This means geographical, sector and asset class diversification.

Stay safe.