You can’t have enough of a good thing – or can you? Global bond markets have been troubled for some time by the implications of the $1.9 trillion American Rescue Plan Act but thought that the largesse would be reined in by the Senate. Well it wasn’t and the Act is more expansionary than probably expected. Bad for bonds but good for equities.
But it may not turn out to be that way. What has driven equity markets forward over the last few years has not been earnings growth – it is the multiple that investors are prepared to pay for those earnings. That multiple has been boosted by ultra-low long dated bond yields. And here is the rub – the $1.9tr fiscal response sounds good for the consumer but if it pushes up the discount factor (long bond yields) the consequences could be bad for equities and risk assets more generally.
What actually happens will depend upon inflation. If we get growth without inflation (unlikely) most financial asset markets will be happy. If we get inflation without growth (not likely) markets will fall. If we get some higher inflation and above trend growth (most likely) the key question is: At what point does higher bond yields undermine risk assets?
One question we discussed ‘on desk’ this week was set by my colleague Eric Holt: Will the global savings glut unleashed in a post-pandemic world trigger inflation? Eric thinks that these savings pools are not what they seem. In the UK consumption has fallen far further than aggregate income and a large amount of savings has been accumulated. The Bank of England think it’s possible by mid-2021 excess accumulated savings could top £250bn, worth over 15% of annual household income. But the key point is that this distribution is very uneven with the bottom 40% of the income distribution seeing a marked decline in savings. It is mostly households in the top 40% of the income distribution that have experienced an increase and this segment has a much lower propensity to consume. Less reason to worry about inflation.
However, the situation is different in the US where household income has risen and the increase in savings has been more evenly distributed. And it will be the US that sets the benchmark for global bond yields. For choice I am a bit more worried about inflation following the passing of the Act but still feel that there are enough stabilisers to keep inflation in check (i.e. higher interest rates squeeze consumption and business investment).
What is clear is that the rise in government bond yields is having an impact on risk assets. During the week the NASDAQ index recorded a fall of 10% from its February peak and sector rotation was the theme. Financial markets have generally done well in the ‘not too hot’ and ‘not too cold’ pre-Covid world; an alteration of this balance through higher bond yields may not play out as expected. Not all fiscal expansion is good for risk assets.
Cash, government bonds and currencies
Cash rates were broadly unchanged over the week; sterling nudged up against the US dollar and continued to gain ground against the euro. Since the beginning of the year sterling has appreciated more against the euro than it has against the US dollar.
The UK economy shrank in January but by less than expected: GDP fell 2.9%, compared to consensus expectations of 4.9%. Unsurprisingly, the driver of the contraction was services whilst construction output actually rose. A concern was the trade figures which showed a sharp fall-off in UK-Euro activity. Is this just a blip / teething troubles or a sign of things to come?
10-year US government bond yields ended above 1.6% with 30-year yields approaching 2.4% (compared with under 1.7% at year-end). UK 10-year gilt yields rose above 0.8% with the flattening seen last week being reversed. In the eurozone, government yields were broadly unchanged. Implied inflation moved higher in all markets – generally 20-30 bps higher year to date in most areas. Our government funds are now flat / slightly long duration.
Despite the volatility in government bond markets sterling credit spreads were broadly unchanged with credit indices reflecting the move lower in gilt prices.
There were several new issues we bought in the week: a 6-year Heathrow bond at mid swaps +215 bps and a Nat West Group junior subordinated bond at 4% over gilts (call 2028). Overall, I have been surprised at the relative lack of issuance given that all-in costs are low.
Ratings band performance showed very little divergence over the week. Year to date BBB remains the best investment grade sterling sector and this has generally suited the way our strategies are positioned. From a duration viewpoint the sell-off in gilts has had a big impact on long dated credit – with over 15-year sterling bond indices generally being down by more than 8% since the start of the year.
In investment grade markets the main focus was on the dovish statements from the ECB. Although we don’t expect an acceleration in corporate bond buying, with the impact being felt in sovereign markets, it is likely to keep credit spreads in the Euro area capped at the present levels.
Funds bought into a new issue from Verizon – which we bought across our range – preferring the issue to existing sterling bonds.
In high yield, spreads tightened on the week with indices marginally higher. Funds were more active this week buying into a variety of issues: Healthcare Trust of America, VTR Communications, Energean and Entercom.
A key question is whether higher government bond yields will undermine risk assets: investment grade and high yield credit. At the moment investors are relatively relaxed and I continue to favour these areas over government markets. However, my degree of conviction is lower, and I still prefer shorter duration strategies in credit markets.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.