Word Up - September

Risk-free yields and curves are range-bound and will remain so as central banks strengthen their resolve to encourage a rise in inflation. As such, the traditional cyclical upturn signal from the yield curve might be weaker in this recovery. Stocks, more than ever, need to take their lead from earnings expectations. Increased forecasts for earnings need confidence in the growth outlook and that in turn probably means more fiscal stimulus and ongoing central bank QE. The Fed and the Bank of England were nuanced in their communications this week, but you can’t rule out more concrete policy steps down the road. 

Get the message?

A meaningful rise in core bond yields became even less likely this week. In the US, the Federal Reserve (Fed) confirmed that rates will remain on hold until core inflation is above and set to remain above 2%. In the UK, the Bank of England admitted that it is preparing to use negative interest rates if necessary. These indications of future policy from the UK and US come a week after Christine Lagarde suggested that the ECB could take steps to counter any negative impact on the inflation outlook from a stronger Euro. Policy remains set against rising yields. Moreover, in our quarterly strategy meetings at which our fixed income portfolio managers discuss the fundamental and technical outlooks for their sectors, it was clear that there remains strong global demand for “duration”. What that means is that if long bond yields do go up a little, pension funds and life insurance companies will buy the bonds to help hedge their long-term liabilities.

In reserve

At this stage it is enough for central bankers to be fairly nuanced in their indications of incremental adjustments to the monetary policy framework. The global economy is in a recovery, of sorts, and markets are orderly. Sending messages about future policy reactions is enough while keeping actual operational changes in reserve. The Fed could still do some kind of yield curve control if longer bond yields do start to rise. Both the Fed and the Bank of England could go to negative rates. More balance sheet expansion is possible. What investors can rely on is that there is no tightening of policy on the horizon even if growth surprises to the upside and inflation increases. 

Flat returns

So government bond market returns will likely flatline and volatility in those markets will be low. Investors won’t lose much or make much in government bonds and making money probably requires some exposure to where curves are steepest, and that is the US Treasury market. The 30-year yield is around 120bps above the Fed Funds rate. The equivalent gap in the German market is 55bps and 65bps in the UK gilt market. No wonder peripheral European sovereign bonds are back in favour. Italy’s 30-year government bond yields 230bps above the ECB’s deposit rate and Spain’s is almost 160bps higher. Who knows what happens to Italian government finances over the next 30-years but for now Europe is safer and investor confidence is much higher than it has been when Euro break-up fears have been evident. There are some political concerns in Italy at the moment with upcoming elections, but I suspect any widening of the BTP-Bund spread will be seen as an opportunity to buy Italy again.

UK risks

For UK gilts there is the looming threat of the UK not reaching a free trade agreement with the EU. While the economic impact of that in the short-term will pale into insignificance compared to the effect of the March-May lockdown, the longer term implications have already hit sterling and led to gilts under performing in recent months. We will see if the Bank of England’s teasing comments about negative rates change the performance, but it is clear that foreign investors are sticking clear of the UK for now. Perhaps there will be more volatility in the UK gilt market than in other government bonds. The 10-yr is just 8bps above the Bank rate at the moment so further gains will rely on investors betting that rates can be moved lower. However, that is likely to be a Q1 next year story at the earliest and there is certainly room for yields to back up a little in the meantime, especially if sterling does suffer more from political risks. The read over to the UK credit market is that negative rates will be a major headwind for UK banks. 

Resolve

The backdrop to the view on core risk-free rates is that policy remains super accommodative. The recovery will continue but it is likely that levels of GDP won’t get back to where they would have been without the crisis for a few years. In the meantime, spare capacity will tend to depress inflation. So central banks have to be even more committed in their determination to convince markets that they will ultimately get inflation higher and keep it there (of course, they can’t by themselves, it depends on the speed at which aggregate demand rises and closes the output gap). Any reversal of the recovery – which could result from rising COVID mortality rates and re-introduction of more severe lockdowns; or from disappointments in the deployment or effectiveness of vaccines; or from a market shock resulting from the US election – will be met by a ratcheting up of that central bank rhetoric. 

2% inflation is a rare thing in the US

Since the mid-1990s there have not been many periods when the US core personal consumption expenditure deflator (PCE) has been above 2%. It was in 2004-2008 and the Fed responded by raising rates to 5.25% in 1.0% in the space of two years. The PCE rate rose from about 1.25% in 2015 to just above 2.0% in 2018 but the Fed had already raised rates from 0.25% to 1.75% by then, and then added another 75bp presumably stop inflation rising further. There are two observations from this. The first is that an inflation rate above 2% has been very uncommon so we probably do need to see much faster GDP growth and much lower unemployment. Second, is that the rates will remain on hold probably much beyond the 2023 time-frame that many pundits discussed following this week’s Fed meeting. 

Reluctantly bullish

If you believe, like I do at the moment, that rates are on hold for a long time and yields remain in a low and fairly narrow range, then I think it is logical to be more bullish on risky assets. For now, I think the environment remains positive for credit where spreads are still some way above their pre-COVID lows. Low rate volatility probably makes the credit risk premium more attractive even if the spread is getting narrower.  What we also observe is incredibly strong technical factors – supply and demand – in most markets. This year is going to be a record year for corporate bond issuance in many markets, but demand has been strong because investors are reassured by the central bank put. Companies have raised cash, largely to sit on the balance sheet, and that may mean less issuance going forward. That is a strong technical support for the market. It will only start to reverse when that gross-net leverage gap is closed by companies spending the cash on share buy-backs, M&A and speculative investment projects. For now, that is not a concern for the most part. I particularly like the long end of the lower rated parts of the US investment grade market. The BBB-rated, over 10-year US corporate bond index has a yield to maturity of 3.45% (relatively miles above the Fed’s not yet achieved inflation target!).

Equities for higher returns

While technical influences are also important for equities, I think investors need to take a more fundamental view. Yes, companies’ ability to reduce their financing costs is important and generally companies are in a fairly healthy cash position either because they have refinanced debt, raised cheap money or are just lowly-indebted cash generating megaliths. Equities in general probably keep going up because the alternatives offer no return (cash and risk-free assets), or very little return (credit). The debate amongst equity investors continues to centre on growth versus value and the concern that growth stocks, and particularly technology stocks, are in a “stay at home” bubble. I don’t think the cyclical parts of the market will be able to take a signal from the yield curve in the coming recovery because of the repression of yields. So, the signal has to come from earnings and earnings have to be forecast higher on the basis of better GDP growth.

Need more earnings upgrades

The earnings data is moving in the right direction although the traditional value/cyclical sectors are not moving quickly enough to get behind a big reversal in the growth/value relationship. On the basis of IBES consensus earnings estimates, forward earnings growth expectations are strong for healthcare and technology and still very weak for consumer services, industrials, energy and financials. Some better earnings news from these sectors is needed to fuel a more sustained rotation and to strengthen the view of a sustained cyclical recovery. If we get that, the signal might be from the equity market to the bond market to put pressure on the yield curve to steepen, rather than the other way around. 

Not another lockdown

All of the above discussion is conditional on the global economy continuing to live with the virus. This week there has been some positive indications on the vaccine development front, but global infection cases are not coming down. In the UK, selective regional lockdown policies have been introduced and there is talk of a more comprehensive 2-week lockdown in October to coincide with the half-term holidays. I am sure that few governments want to go back to the economic paralysis of the early Spring and hopefully, with hospitalisation and mortality rates remaining low, that won’t be necessary. Suffice it to say that a damaging second wave has always been a key risk to markets ever since the risk-recovery began in late March. Finally, as I have discussed recently, there are potentially market negative scenarios from the US election for markets. I like US corporate credit but if there is a bad outcome on November 3rd, that is an asset class that won’t be able to avoid some sell-off. Maybe investors wait to see if there are some better entry levels when the dust has settled in DC.