28 February 2021

There’s a whiff of inflation in the air: commodities are soaring, bond yields are rising, and yield curves are steepening. And, while these trends actually began last Summer (and despite Federal Reserve Chairman Powell’s reassuring comments in Congress), equity market volatility is increasing.

In the period ahead, financial markets will confront several important issues. How sustainable is a global economic recovery fueled by massive monetary and fiscal stimulus? How will President Biden’s fiscal plan balance the immediate need to provide Covid-related support against efforts to boost the economy’s long-term supply-side performance? What are the implications for inflation and bond yields? If, as I suspect bond yields rise towards 2-1/4% during the next 12-18 months, how will increasingly nervous global equity markets respond? Who said this job is easy?!

Rising Bond Yields: Can History Provide Clues?

As Mark Twain advised, “learn from the mistakes of others, as we don’t have enough time to make them all ourselves”! What can history tell us about recent bond market performance? First of all, the Chart above illustrates that while the US yield curve has steepened alot, this is normal at this stage of an economic recovery. Indeed, 10-year bond yields often exceed 2-year rates by up to 2.5% early in the economic cycle.

Decomposing the rise in US bond yields also offers key insights. Econ 101 teaches us that nominal bond yields equal the sum of real interest rates and expected future long-term inflation. Importantly, the entirety of the current bond market sell-off has resulted from rising inflationary fears; indeed, real yields have hardly budged from rock-bottom levels.

Despite recent market volatility, I share the US Fed’s view that while inflation will rise in coming years, CPI increases will not greatly exceed the central bank’s 2% target over the medium term. And, continued low inflation is not confined to the USA. The Chart above illustrates that long-term inflation will remain below targeted levels in virtually all countries. I do warn, however, rapidly rising food prices in some emerging markets could lift CPI increases in coming months. For example, food accounts for up to 40% and 30% of the price index in India and China respectively.

As recently as last summer, bond markets were priced for an extended period of near deflation. Now, however, fixed-income yields more correctly anticipate long-term inflation both in line with history (see earlier Chart) and the Fed’s medium-term outlook. On the other hand, however, as the US economic recovery takes hold and the Biden Administration provides additional fiscal stimulus, US real rates could rise towards a still ultra-low 0%. Doing the simple math, 10-year nominal yields could easily approach 2-1/4% during the next 12-18 months.

Why is this so important? The Chart above illustrates that equities have been very cheap relative to bonds for many years. But, this is no longer the case. As the Equity Risk Premium (the gap stock and bond yields) is now low, equities are much more vulnerable to rising interest rates. Pick your own scenario. Run your own numbers. The Table below projects the S&P 500 using 2022 EPS forecasts and an ERP at 3.75%.

I outlined the rationale for my cautious 3,500 S&P 500 target in my November 2020 blog entitled “Strategy 2021: V(accine)-Driven Recovery”. I had expected the bullish market to overshoot my target before correcting by up to 10%. I think we may now be in the midst of that adjustment. However, it’s critical to determine the reason for rising bond yields. On the one hand, if inflation is the cause, the bull market could be over for now. Alternatively, if higher nominal yields simply reflect strong GDP recovery and rising real rates, any equity market correction would represent a buying opportunity. I am in the latter camp….buy on a meaningful pullback.

Biden: Going Big is Good, But Building Back is Better

Until recently, financial markets have fully endorsed the prospect of a V-shaped economic recovery. And, my projections (Chart above) are also in-line with this scenario; indeed, China and the USA will recoup previous output losses during 2021. (I have recently raised my US GDP forecast reflecting additional fiscal stimulus, and cut Europe’s outlook due to slow vaccination rollout. I no longer expect European growth to outperform).

However, fiscal and monetary stimulus alone can not sustainably drive economic activity. And, indeed, I project US (and global) GDP growth to slow significantly in 2022 (Chart above). In his America Rescue (ARP) stimulus plan, President Biden must provide support to households and businesses still suffering during the ongoing pandemic. In addition, however, the Administration should also consider measures to address the long-term economic consequences of the health emergency — what economists refer to as “scarring”.

All recessions leave scars. Following the Global Financial Crisis, for example, US productivity slowed sharply. Indeed, this world-wide trend began even prior to the Great Recession of 2008. Weak efficiency gains are headwinds to long-term GDP growth and prosperity. Remarkably, unlike past recessions, US productivity actually accelerated 2.5% during 2020, despite the sharp decline in GDP. Many long-term, productivity-enhancing trends were accelerated during the recession, e.g. digitalisation, e-commerce, automation, work-at-home, reshoring, etc. The ARP should seek to build upon these achievements.

The Chart above illustrates America’s investment rate is both below the world-wide average (especially Asia) and declining. Infrastructure spending and promoting climate-related capital expenditures, therefore, should be prioritised (in line with campaign pledges). While US firms benefit from relatively low taxes, financial markets should not forget the planned rise in the marginal corporate tax rate.

In addition, US corporations (like the government) have taken advantage of low interest rates to increase leverage during the pandemic. High levels of indebtedness may impede needed business investment (Chart above). On the other hand, household balance sheets are in good shape; consequently, healthy consumer spending should be the key driver of the economic upturn in 2021.

The US and Europe have taken different approaches to supporting workers during the pandemic. Europe’s furlough schemes have led to fewer outright job losses than in the USA, which relied on direct payments to households (Chart above). If European governments have been simply supporting unviable business, large job losses and lower corporate profitability may result as these programs end.

On the other hand, massive US job losses may have contributed to greater US innovation during the recession (recall the boost to productivity). It is easy to image, however, some workers will be reluctant to return to work following the pandemic. Ensuring Covid-secure workplaces, effective vaccination programs, successful test-trace-isolate programs will all help. Health care reform, aimed at widening coverage and reducing costs, both will boost worker productivity and participation rates. Both Chairman Powell and Treasury Secretary Yellen (a labour market specialist) have pledged ongoing macro-stimulus until the 10-million lost jobs have been restored.

Experience in Japan and Europe indicates that very high levels of government debt contributes to diminished long-term GDP growth prospects. Unlike many Emerging Market nations, the USA may eventually face this problem. To be sure, with interest rates low, the Biden Administration’s priority is correctly to “go big” in support of near-term economic recovery. However, with debt levels rising, President Biden must ensure sufficient resources remain available for his supply-side initiatives.

Rest of the World: More of a Cushion

Financial market risks pose by inflation risks may prove more manageable in the rest of the world compared to the United States. In Europe, for example, inflationary expectations are lower and have deteriorated less than in the USA (Chart above). Consequently, European bond markets have outperformed since last summer, which I expect with continue.

Unlike the USA market, European equities remain cheap relative to bonds. That is, Europe’s ERP is still high compared to the historical levels (Chart above). Consequently, European equities enjoy considerable protection against the volatility caused by higher bond yields. Despite weaker GDP growth, therefore, I still expect European markets to outperform US equities in 2021.

The same is true of Asia markets, which should provide the world’s best returns in 2021 (thanks to friends at Morgan Stanley for these useful Charts!).

Strategic Considerations

• US bond yields could rise towards a 2.25-2.5% range during the next 12-18 months.
• As the Federal Reserve will remain on hold during this period, the US yield curve will steepen further (the gap between 10-yr and 2-yr maturities could reach 2%.
• Equity market volatility will increase, as bond yields rise. However, I remain confident about the economic recovery, and that inflation will remain near the Fed’s target. Therefore, I remain fundamentally optimistic, and would buy equites if the S&P 500 declines towards 3,500. Pro-cyclical, reflation strategies still make sense.
• European and Asian equity (and bond) markets should outperform as bond yields rise.
• While higher US yields may provide some support for the US dollar, I expect the greenback to depreciate towards Euro 1.25 and Yen 99 in 2021, as twin deficits continue to widen.