Risk, return, repeat
Fiscal dominance is a reality and markets are reacting to that. It doesn’t necessarily mean inflation, it doesn’t necessarily mean crowding out private borrowers. There remains a glut of global savings and borrowing costs will continue to be much lower than nominal GDP growth. Investors should be re-assured that central banks want to play a role in smoothing out the rational increase in long-term bond yields. I am sure they will become more vocal about that. A Q1 market correction is no bad thing. Returns can still be healthy in 2021.
Last week I set out a scenario of markets adjusting to arriving at a better point in the economic cycle. There has not been a great deal of cyclical news since then. Federal Reserve Chairman, Jerome Powell, maintained his dovish posture in his appearance before Congress. What economic data there has been, has been consistent with the reflation theme (higher US house prices and consumer confidence, decent business surveys and a marginally better German Q4 GDP report from Europe). However, the moves have accelerated. Long-term yields are a lot higher and, interestingly, towards the end of this week yields on short-dated bonds also started moving up. Equity markets are also doing what I suspected they might. In response to higher yields, they have stopped going up – for now at least. It’s the normalisation phase – bond yields back to where they were before the crisis, some testing of the Fed’s medium term resolve on rates, and equities consolidating after benefitting from months of rising earnings momentum and lingering suspicions that even more policy support would be forthcoming if necessary. It isn’t, but that doesn’t mean what’s already in place or expected is going to be taken away. Which is good and what we’ve seen from yields so far is not going to derail the recovery.
One of the events of the week was a weak auction for 7-year Treasury bonds in the US which registered a record low bid-to-cover ratio. That’s not surprising in the midst of a bond sell-off. This might be seen by some as an early sign of what increased government bond supply could do to yields as 2021 progresses. Markets have generally responded well to the aggressive stimulus from both monetary and fiscal agencies but there is a strong case for higher clearing yields given the scale of existing and coming bond issuance. Markets are having some issues reconciling that with the potential winding down of central bank asset purchases. If governments are selling more paper but central banks are buying less, then prices might go down (yields go up).
Powell did his best to reassure investors that we are not at that point of the Fed stepping away yet. He said that the US economy was still far short of meeting the Fed’s objectives (full employment and an average inflation rate above 2.0%). But markets sometimes don’t listen, and the message may need to be reiterated a few times. A similar story is playing out in the UK with the Bank of England disappointing many observers when it did not extend its own QE programme this month. At the same time, the Conservative government is under pressure to continue providing a high level of fiscal support. The successful vaccine programme and Boris Johnson’s roadmap for opening the UK economy have led to a more positive view on UK growth. But the recovery still needs supporting. Just like in the US, the key macro indicators are far short of where the authorities would like them to be.
I looked at the sell-off in global government bonds since the US Treasury yield bottomed at just above 0.5% on August 6th last year. The “Anglo” markets of the US, UK, Australia and Canada have seen the biggest increase in benchmark bond yields, of between 80bps and 100bps. One wonders if markets are contesting the view that large fiscal stimulus and aggressively accommodative monetary policy can co-exist for a long time, especially when economic growth is coming back. Consensus GDP growth forecasts for those countries for the second half of this year are impressive and you might not be wrong for questioning whether some of the policy support can start to be wheeled back in (of course, the growth forecasts are so strong partly because of the policy support in place to nurture the post-COVID recovery). It is not irrational to look for higher nominal bond yields when the expectation is of +6% y/y real growth rates (even if that is a temporary surge). But the moves are scaring some participants. Hence the rush to de-risk that we are starting to see.
European government bond yields have risen by much less. German, French and Spanish yields are up between 15bps and 20bps compared to last summer and stayed lower for longer compared to the Anglo group. The execution of fiscal support has been smaller and slower in Europe and there is still some uncertainty as to when Europe will really benefit from the Next Generation fund. As such there is less of a need to question the longevity of the European Central Bank’s stance. It has been notable that several ECB officials have been quite vocal about the need to be watchful of what is happening with long-term rates and be ready to react if moves threaten the economic outlook. As I write on Friday morning, ECB board member Isabel Schnabel repeated that mantra. Bond yields are falling in response.
Monetary policy has been trying for years to stimulate economic growth, with diminishing power at ever lower levels of interest rates. While we can’t know the counter-factual, QE has tended to push asset prices higher through its crowding in of investors to risk assets as risk-free bonds became a negative real return asset. But the impact on the real economy is not clear. Fiscal policy is more direct. It puts money in people’s pockets, it can be directed to buy goods and services and generate income flows. This is a real change in the policy environment. There has been a political shift in favour of fiscal policy (although not all politicians are in favour) and there is huge academic support for this re-balancing of policies. If the price is a 100bps or so on the cost of borrowing then it is well worth it.
Nominal GDP growth in advanced economies is going to be at its highest levels for years in the period up to 2023. The virality of the recovery plus the temporary increase in inflation should mean current dollar GDP growth well above the average of the last decade. Even the most bond bearish observers would not see yields approaching anything like nominal GDP growth (they haven’t since the 1990s). This means the fiscal stance is sustainable because growth will be well above the cost of borrowing. It’s also good for equities because it means strong growth in corporate earnings that will still be discounted at very low interest rates.
Sound and vision
Policy makers have a role to play in more forcefully articulating the new policy world that we are in. The vision of the policy re-balancing is probably best articulated through action and we will see another big fiscal stimulus in the US and continued spending as the Biden Administration gets serious about climate change mitigation. The secular stagnation argument of recent years has rested on the view that the world has had a glut of savings. Governments are now tapping into those savings through increased deficits and borrowing. The marginal cost of capital rises a little as a result. Central banks are not going to step away completely because they want to smooth out the adjustment in long-term interest rates. Market participants today are too short-term focussed and too hysterical about what are pretty modest moves in the big scheme of things. Governments are utilising the global savings glut to provide a sustainable recovery from the pandemic and to make economies more resilient to additional “natural” risks like climate change. It happens at different paces – the US political system makes it imperative that the government acts quickly. In the Euro area, decision making is slower because of the need to get 27 sovereign states to agree on things. But it should happen and the recent appointment of Mario Draghi to lead Italy provides another strong voice pushing the agenda forward.
The world needs growth and jobs and needs to invest trillions of dollars over the next decade to meet the Paris Agreement targets. What we are seeing in markets at the moment is a modest re-pricing of the long-term cost of capital from very low levels. There is still financial repression on rates and that will be a feature for some years to come. But the benefits of increased government spending will be stronger growth and, through the multiplier effects, an encouragement for private sector investment to be directed to the long-term growth themes. In the short-term markets are adjusting to this outlook.
Market volatility is always a risk to long-term investment performance. Risk management means investors get de-railed from their long-term objectives at times and this is a risk facing us right now. Liquidity has deteriorated in government bond markets over the last week. Credit spreads are starting to move a little higher in response to higher underlying yields. Growth stocks are down on the month. It probably makes sense to have some short-term risk hedges on or to move to a more defensive stance, protecting capital when higher returns are not immediately obvious. In a sense, it is encouraging that this is happening now. I fully expect policy makers to steer expectations again and that should allow bond yields to stabilise at some point. Treasury yields are close to a 100bps above last summer’s lows and are back to where they were in January of last year. A bit higher still and the opportunity for making money in fixed income becomes restored. A bit more off “risk” and this becomes even more interesting. Better to have markets correct in February and March than in October and November. I suspect that once yields do stabilise, we will again be reminded that the level of yield does not always equal the consequent return.