Monthly Investment Letter: Bond vigilantes

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In 1994, US President Bill Clinton’s political advisor James Carville famously quipped, “If there was reincarnation…I would like to come back as the bond market. You can intimidate everybody.”

At the time, he was referring to the notion of higher yields forcing fiscal restraint among policymakers. Yet more than 25 years later, the bond market now seems to intimidate markets for precisely the opposite reason—because rates are so low. This month, 10-year US Treasury yields fell as low as 1.25%, forcing equity investors to question their beliefs about the economic recovery.

Over the last six months, equities have been driven by a “Roaring 20s” narrative we highlighted here in the April Monthly Letter. This interpretation of the macro environment supported stocks, particularly those exposed to reflation such as energy and financials. But in recent weeks, that narrative has given way to one of “secular stagnation”—low growth, low inflation, and low rates. Stocks have continued to move higher overall, but bonds are rallying, volatility is up, and companies most exposed to economic recovery are underperforming those exposed to secular growth.

The drivers of this shift appear to be some combination of several ideas:

1. high rates of inflation may force the Federal Reserve to hike interest rates prematurely, curbing future growth;
2. the effects of the COVID-19 Delta variant might stall the global economic recovery; and
3. policy changes and slowing growth momentum could undermine sentiment on China, the world’s biggest driver of economic growth.

In this letter, we update our macro view and address some of the main questions we’re getting from investors in light of this shift in narrative.

In short, we do not believe that the “secular stagnation” narrative is supported by the underlying data at this time. We are staying positive on risky assets, expect yields to move higher by year-end, and continue to advocate positioning for reopening and recovery. In equities we prefer Japan, emerging markets, financials, and energy. Given our view on rates we move our view on EURUSD to neutral.

Fears about inflation are unlikely to recede for several months. This can drive volatility, even if we are right about our view of the medium-term outlook. Accordingly, we also advocate boosting portfolio yield, diversifying exposures to protect against potential downside, and ensuring portfolios are set up to maintain purchasing power over the long term. For more, please refer to our 3Q Outlook, “Ideas for growth, income, and protection.”

Will inflation force the Fed to tighten earlier than expected?

The June FOMC meeting revealed that the Fed appears to be adopting a more hawkish stance in response to higher inflation data. FOMC members’ interest rate projections point to a first Fed rate hike in 2023, earlier than previously forecast, with some Fed officials projecting hikes in 2022. Policymakers noted that the level of US inflation had surprised to the upside, and a majority of FOMC members believed inflation risks are now tilted to the upside.

Since then, 10- and 30-year yields have fallen. In equities, economically sensitive S&P 500 sectors like financials, energy, and materials have underperformed (falling 1.7%, 8.1%, and 1.7% respectively since the FOMC meeting), but stocks exposed to secular growth have outperformed (tech +8.1%).

We might reasonably expect nominal bond yields to rise, not fall, if inflation is going up. One interpretation of the market moves since the Fed meeting is that investors fear the Fed will make a policy mistake by hiking too soon, destroying the economic recovery.

While we do have long-term questions about policymakers’ ability to overcome disinflationary forces in the economy, we don’t think the Fed will be forced to overtighten by the near-term inflation:

Inflation expectations remain well anchored.

• US 10-year breakeven inflation rates are currently 2.33% (breakevens are the difference between the yield on nominal and inflation-protected Treasuries and are a market-based measure of inflation expectations). In our view, under average inflation targeting, the upper limit of the Fed’s tolerance band is sustained inflation of 3%. In other words, as long as the medium-term outlook for inflation does not exceed 3%, the central bank will not be forced to hike rates.

We expect inflation to moderate in the coming months.

• The Fed believes inflation is transitory and will ease as pandemic-related disruptions clear and base effects dissipate. We share this view. Four straight months of large price increases have pushed US headline CPI to 5.4% year-over-year in June, up from only 1.7% in February. Relatively few items such as used cars and gasoline have contributed disproportionately to the rise in inflation, and they will start to exert a disinflationary impact as previous price rises reverse. In fact, we expect negative base effects will push core PCE inflation below the 2% target by the middle of next year.

The Fed’s employment criteria are still unmet.

• Over the past year, the Fed’s strategy has been to focus most heavily on promoting employment, stating that it wants to see “substantial further progress” toward full employment. Yet today’s unemployment rate of 5.9% is well above prevailing pre-pandemic levels of below 4%. Fed Chair Jerome Powell has also stated that he wants to see several months of payroll growth of around 1 million a month. In June payroll growth recovered to 850,000, but Powell’s bar has yet to be cleared.

Key Fed members are more dovish.

• Focusing on the FOMC’s median interest rate dot plot may put too much emphasis on the views of non-permanent voting members of the FOMC. Key voting members appear more dovish. For example, New York Fed President John Williams has said since the June FOMC meeting that he still sees tapering as “quite a ways off.” Fed Chair Powell has testified that “a pretty substantial part, or perhaps all of the overshoot in inflation comes from categories that are directly affected by the reopening of the economy such as used cars and trucks.”

We also do not think higher house prices and wages will induce the Fed to act.

• US house prices are rising at their fastest pace in 30 years, but only indirectly feed into inflation indexes. The housing part of inflation is calculated using rents as an input, and US rents remain subdued. Away from the direct inflation calculations, very low long-term interest rates limit monthly mortgage costs, so most homeowners are not facing significantly higher direct housing costs, despite rising home prices. While large wage increases in a couple of sectors are also making headlines in the current political environment, broader level wage pressure is less evident. The Atlanta Fed wage tracker, for example, shows wages falling for higher income workers.

Can the Delta variant derail the economic recovery?

The spread of the Delta variant has led to an increase in global COVID-19 cases and prompted the reimposition of social and economic restrictions in some countries. Japan has declared another state of emergency. Korea, Indonesia, and Vietnam have introduced additional measures, and even Israel—a world leader in the vaccination drive—has reimposed some restrictions and will offer a third booster vaccine.

We do not expect the Delta variant, or others currently in circulation, to disrupt the economic recovery:

Vaccines appear to be effective at reducing healthcare burdens.

• Multiple sources of real-world data indicate that vaccines are still effective against variants, including Delta. UK data shows sharply rising new cases (see figure 3), yet hospitalizations remain well below the levels of previous waves. A similar pattern is visible in Israel, where 86% of the population is fully vaccinated and Delta is the predominant virus strain. Government data from Singapore also continues to show limited serious illness among breakthrough infections. With the virus continuing to circulate, new variants should be expected to emerge. However, early research from the US suggests that the diversity of mutations is declining over time, and that this trend is more evident in vaccinated people. Our base case is that vaccines will remain broadly effective against emerging variants.

We expect governments to increasingly look through rising case numbers.

• As long as mortality rates are controlled and healthcare systems do not come under undue strain, we think governments will be increasingly willing to tolerate higher cases, particularly given the likely unpopularity of imposing new restrictions. For example, renewed lockdowns would be politically impossible in many US states. In the UK, the easing of restrictions was delayed, but the Delta variant is not preventing them from being lifted on 19 July, even as cases rise. Singapore has also suggested it will move away from its zero-tolerance stance toward the virus.

Ongoing waves in Indonesia, Malaysia, and other regions illustrate that controls will likely be required in countries with lower vaccination rates. Healthcare infrastructure, vaccination rates, and domestic social and political attitudes will also determine how quickly countries can move toward reopening. In our view, this likely puts some emerging market economies on a slower path to reopening than that being followed in the US and Europe. But while the Delta variant is likely to mean a more uneven recovery, we do not expect it to knock the recovery off course.

Why are long-term yields falling?

A combination of the aforementioned fears around tighter Fed policy and COVID-19 variants appears to be a key contributing factor to lower bond yields. Another reason may be technical factors related to the supply of—and demand for—US Treasury securities:

• The Fed’s balance sheet grew by USD 200bn last month, compared with a scheduled monthly asset purchase program of USD 120bn, which likely reflects increased liquidity provisions over the quarter-end. Overall, the Fed now owns 21% of the total Treasury stock, up from 12% at the end of 2019.
• Ahead of the debt ceiling expiry, the Treasury is no longer issuing new debt, which is reducing supply. As a result, the three-month moving average of net Treasury issuance is currently being completely absorbed by net Fed purchases. For comparison, at the start of the year, three-month average issuance was USD 120bn greater than net Fed purchases. This also has the effect of increasing demand: The Treasury is instead funding its spending by running down the size of the Treasury General Account, which creates excess reserves on commercial bank balance sheets that are, in turn, invested in high-quality liquid assets, including Treasuries.
• US banks have been giving guidance ahead of the earnings season that loan growth is tepid. This, combined with high levels of activity in the five- to 10-year segment of the Treasury curve, suggests to us that banks are instead investing funds in other assets, including Treasuries, to supplement earnings.

In the months ahead, we expect these technical factors to abate (see boxout). Given our view that fears about early Fed hikes and COVID-19 variants are overdone, we forecast yields to reach 2% by the end of the year. We think current economic conditions, which still include an ISM index above 60, don’t warrant bond markets starting to price a return to secular stagnation.

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Downward pressure on yields from technical factors will ease

In our view, a technical matter concerning the US Treasury account at the Federal Reserve, known as the Treasury General Account (TGA), has played an important role in putting downward pressure on long-end interest rates, despite stronger growth and inflation. The TGA is the general checking account from which the US government makes all its official payments.

Last year, the US Treasury raised a large cash buffer in the TGA and has been running that balance down since February. This has reduced the recent borrowing needs of the US government to such an extent that net issuance of Treasuries (issuance minus Fed purchases) over the past several months has been negative. So the lower supply of Treasuries could have driven prices up and yields down.

As the Treasury distributes money from the TGA, much of it ends up as deposits in the banking system. Historically there is a strong correlation between bank holdings of Treasuries and bank deposits.

We anticipate the drawdown of the TGA will continue until the end of the month. The Treasury has stated that it has a target cash balance of USD 450bn at the TGA, yet currently it sits at USD 750bn.

Furthermore, given that Congress has to decide whether to extend the debt ceiling or raise it at the end of the month, the Treasury is not currently adding to cash balances because doing so could be viewed as circumventing the borrowing limit. As the debt ceiling is under consideration alongside other Biden administration fiscal policy objectives, it is unlikely that we’ll get a quick resolution. However, after 31 July the Treasury will be able to use extraordinary measures to fund the government. This typically happens through bill issuance, which should help slow the rate of increase in commercial bank excess reserves, and technical demand for longer-term Treasuries.

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Is the reflation trade over?

Since the June FOMC meeting the S&P 500 has gained 3.6%, but energy and financials have fallen 8.1% and 1.7% respectively, while tech has rallied by 8.1%.

Looking ahead, we remain positive on equities as a whole. We expect 38% growth in global corporate earnings this year and 10% in 2022. For US equities, which constitute 59% of the global index, we now expect 40% growth in S&P 500 corporate earnings in 2021, and we think consensus forecasts for 10% growth in 2022 are likely to be revised upward. We have increased our June 2022 S&P 500 price target to 4,650 as a result.

Within equities, we expect the underperformance of the “reflation trade” to reverse:

• We think fears about early Fed tightening, COVID-19 variants, and slower growth will abate, and 10-year yields will rise.
• Consumers are still sitting on substantial excess savings that have yet to be deployed into the economy. Interest payments as a percentage of disposable income are at 40-year lows, suggesting that consumers could easily afford to take on more debt if they desired.

• Business activity should remain robust well into 2022, as it will take businesses some time to catch up with demand. Capex/depreciation is near 20-year lows, even though aggregate demand is higher than pre-pandemic levels.
• The ISM index should remain expansionary for the next year. The customers’ inventories component of the ISM manufacturing survey for June came in at 30.8 and has been hovering close to record lows. With accelerating demand, companies have an incentive to rebuild those inventories. Historically, lean inventories suggest business sentiment will remain strong in the months ahead. When ISM customer inventory levels have been below 39, the headline ISM reading 12 months out has averaged 55—comfortably in expansionary territory.

• The second-quarter earnings season is underway, and we expect earnings growth for value companies to outpace that of growth companies. If GDP growth is as strong as we anticipate through next year, cyclical/value companies should continue to outgrow growth companies.

Will Asian equities lead reflation?

We still see both short- and long-term opportunity in Asia, but believe a more selective approach is warranted following recent developments.

Our regional tactical preference for Japanese equities has underperformed recently, as the country extended its state of emergency to contain the Delta variant. But we retain our positive view for several reasons:

1. First, the nation’s vaccine rollout has accelerated. Around 26% of Japan’s population has received at least one dose, and if the current pace of administering 1 million doses per day continues, the country could vaccinate half its population by end-September.
2. Second, Japan is a cyclical equity market that should benefit from the economic recovery. The biggest sectors are industrials and consumer discretionary, each making up around 20% of the index.
3. Third, Japanese equities are exposed to global growth. Over 40% of MSCI Japan’s revenues come from abroad, and we expect global GDP to grow 6.5% this year, followed by 5.5% next year, well above the 3–4% growth range in the previous decade.
4. Fourth, Japan has the highest operating leverage among the major regions, meaning earnings tend to bounce sharply as revenues recover.
5. Finally, a weaker yen should bolster the index. The yen has fallen some 6.5% against the US dollar this year, supporting exporters. Overall, we expect 40% earnings growth for the fiscal year ending in March 2022.

China’s equity market has also underperformed in recent months. The MSCI China index has trailed the MSCI All Country World index by 8 percentage points over the past three months, driven by slowing exports, weaker credit growth, and, most notably of late, regulatory pressure on the tech sector.

As macro momentum has softened, the People’s Bank of China (PBoC) has adopted a more pro-growth monetary policy, providing a positive backdrop for stocks as a whole. The PBoC has cut the reserve requirement ratio (RRR) for nearly all Chinese banks by 50bps, the first cut since January 2020, which is expected to release about CNY 1tr into the financial system. This stands in stark contrast to many other central banks, including the Fed, which are edging toward withdrawing liquidity.

However, an unprecedented round of tech regulatory action has dampened sentiment, and it is difficult for investors to predict when this regulatory cycle might ease, or which industries could next face scrutiny. Earlier this month, Beijing ordered domestic app stores to halt downloads of a ride-hailing firm’s app following its US IPO. China’s cyberspace authority has subsequently drafted new rules requiring its approval of tech user data practices before allowing international IPOs. This follows moves in recent months to subject various tech giants including Ant, Alibaba, Tencent, and Meituan to regulatory scrutiny, for reasons ranging from anti-trust to privacy issues.

With roughly 50% of China’s offshore index tilted to new economy names, we see less scope for relative near-term outperformance until there is a clear catalyst or a signal that the current regulatory cycle is easing. Within our Asia strategy, we have moved our preference for China stocks back to neutral and have raised Hong Kong equities from least preferred to neutral in part due to their bias towards value. An anticipated rise in 10-year US yields, now trading near 1.33%, should benefit Hong Kong financials, as would any regulatory-driven diversion of Chinese offshore capital markets activity to Hong Kong. Within Chinese equities we are cautious on tech and prefer materials, financials, and energy.

We believe the medium- to longer-term earnings prospects for China’s new economy sector remain positive, especially for themes relating to the digital economy and the Next Big Thing. Though the regulatory pressure on near-term earnings is still feeding through, we think the authorities are seeking to level the playing field rather than curb long-term innovation. China’s latest Five-Year Plan places a strong emphasis on tech self-sufficiency, and competitive tensions with the US may preclude more severe actions against the domestic tech sector. Regulatory action also has a historically weak record in disrupting dominant firms over the long term, as demonstrated by government measures aimed at the online payment and ecommerce segments in recent years.

Investment ideas

In our base case, we expect the global economy to continue to reopen in the second half amid the ongoing vaccine rollout. We think inflation will fall from current levels as base effects and pandemic-related supply issues dissipate, enabling major central banks to keep monetary accommodation in place. A continued risk-on stance in equities is warranted, in our view, and we favor sectors and regions that have the most to gain from the reopening trade.

Position for reopening and recovery

Given our view that fears over growth momentum and premature Fed tightening are at a peak, we think the reflation trade has further to run. We prefer Japan, emerging markets, energy, and financials. We expect energy stocks to benefit from a further rise in oil prices in the second half. We also forecast 10-year Treasury yields to move toward 2%, which should support financials.

In global portfolios we no longer prefer small-caps over large-caps but in US portfolios we maintain our preference for mid-caps. While earnings growth and relative valuations both remain attractive for smaller size segments, small-caps typically perform best in the early stages of a recovery, prior to the peak in economic leading indicators. As the recovery matures, it appears prudent to reduce our small-cap exposure. Mid-caps are higher quality and should have greater potential for outperformance in the coming months. In addition, small-cap relative performance is inversely correlated with credit spreads, which have tightened by 100 basis points since we initiated the position and are unlikely to tighten further, in our view.

We continue to hold exposure to emerging market (EM) equities. Both EM and Asia ex-Japan equities have underperformed recently, and we see reasons for that trend to reverse. The PBoC’s RRR cut suggests that China wants to stabilize growth, which should support other Asian markets. We see the spread of the Delta variant delaying not derailing economic reopening in EM. Valuations are attractive and earnings growth is strong. Upward revisions to earnings in EM have lagged developed markets but have recently stabilized, while Korea, Taiwan, and Russia continue to surprise on the upside. The main risk to our view is Fed tightening, but commentary by senior officials suggests the central bank is in no hurry.

Our rates view and the hawkish shift in the Fed’s thinking underpin the change in our view for the USD to neutral from least preferred, and the EUR to neutral from most preferred. While we no longer expect the greenback to weaken, we don’t see sustained US dollar appreciation that might undermine our EM position.

Seek opportunities in Asia

See above for our views on Japan and China.

Position for structural growth

A variety of secular trends accelerated during the pandemic, driving strong performance across the tech sector. But as economies reopen, we think now is a good time to diversify excess exposure away from mega-cap tech and move into lesser-known structural growth winners, including small- and mid-cap technology, and digital subscriptions.

Protect against inflation

As the post-pandemic recovery takes hold, prices of various goods and services are rising. We think this uptick will be transitory, but the Federal Reserve’s new average inflation targeting framework, unprecedented fiscal stimulus, and policymakers’ more tolerant attitude toward high debt-to-GDP levels could trigger an inflation regime change. In particular, the current spike in inflation could prove sustainable if labor market imbalances lead to higher wages, excess savings are spent, or companies seek to exercise their pricing power. So, it is prudent for investors to seek to protect their purchasing power. We see opportunities in stocks with pricing power, short duration bonds with a yield, private markets infrastructure, and commodities including oil.

Protect against downside risks

While the current environment leads us to seek out opportunities in risk assets, in these fast moving markets, investors should regularly review their portfolios for excessive risk. Ways to reduce some risk include rebalancing excessive equity market gains and locking in outperformance, seeking downside protection via hedge funds, options, and structures, or diversifying into select defensive stocks.

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