Growth is expected to surge in the months ahead. Nominal GDP will be stronger than seen for years. The rise in rates is limited in comparison and policy makers are fairly relaxed so far. Fiscal stimulus and pent-up demand should deliver more growth than the rise in bond yields will take away. The question is whether market sentiment and current valuation levels allow returns to be as good as they were in 2020. The evidence so far is that performance won’t be quite as easy to come by but an optimistic bias in portfolios is still the right way to go.
Ask the question
If you are an equity investor at the moment there are a couple of questions that might be pertinent to whether you stay in the market or not. The first is a macro question. Do you think that the positive impact on economic growth coming from the combined effect of pent-up demand and fiscal stimulus is more important than the potential negative impact of (marginally) higher long-term bond yields? If yes, stay invested. The second question is a relative value one. Does the (marginal) increase in bond yields or even the expectation that bond yields could go even higher (say, to 2% US Treasury 10-years) make you want to switch out of equities into fixed income? In other words, has the prospect of a dividend yield of 1.5% and a growth rate of 3%-6% over the next few years become less attractive relative to a 1.5% risk-free Treasury bond yield? If yes, start to wind-down your equity exposure. If not, stay invested. The numbers I quote here are for the US market, but the same principle applies elsewhere.
Open to grow
In my opinion, the growth side of the equation is more important than the yield side of the equation. I suspect that this is what policy makers think. Many economists are forecasting a surge in growth in the remainder of 2021 as economies are released from the grip of restrictions on social mobility. The road ahead has already been lit to some extent by economies like China and Australia. They did a good job in managing the pandemic and have been able to re-open sooner than most others. China grew by 6.5% in Q4 and is set to record more than 8% GDP growth this year, according to the consensus of forecasts compiled by Bloomberg. Australia just announced that Q4 was the second consecutive quarter in which the economy expanded at a sequential rate of more than 3%. Yes, the H1 2020 period saw a massive hit, but by the end of this year a lot of the lost output will have been recouped. Pent-up demand in the private sector, plus fiscal stimulus and continued plentiful growth in liquidity, are the engines behind this growth.
Boom like it's '80s
There is also an expectation of higher inflation. Even though this is likely to be modest and temporary, it will provide an additional boost to nominal GDP growth, or GDP in today’s money rather than inflation adjusted GDP which is how we usually refer to economic growth. On average, nominal GDP growth in the developed economies will be higher this year (beyond Q1) than at any time since the 1980s. It will be higher than most market participants have experienced in their careers. It will be higher than most policy makers have faced. The idea that central bankers will sit back as nominal growth surges is anathema to many market players and commentators. It’s little wonder that bond yields are moving up and there has been a surge of sell-side research notes on inflation and when central banks will hike rates or taper their bond buying. For the moment, the prudent position to take is to expect yields to move higher still. But keep the drama in check.
Corporate earnings growth is higher beta than GDP growth. So the 20-25% increase in earnings that is expected for 2021 is not out of line with fundamentals, given how much earnings fell in the first half of last year. Nominal growth is expected to remain strong into 2022. That means there is still upside to earnings forecasts. That should be a key support for a positive stance on equities. The question is how do bonds trade in such a world? There is not really a road-map because the world has rarely had the combination of high single-digit nominal growth with extremely low interest rates at the same time. It used to be the case that nominal bond yields fairly closely tracked nominal GDP growth. If that was still the case, we would be looking for much higher yields. However, the relationship broke down following the global financial crisis. Bond yields have been much lower than nominal GDP growth since then. Quantitative easing has repressed long-term yields as monetary policy sought additional tools once the zero bound on policy rates had been reached. We are not at the end of QE so it is unlikely that we go back to the old relationship until the world has returned to “normality” (and in this context I mean that the secular stagnation story of a global savings glut no longer is relevant to the pricing of capital).
Yet it’s an unprecedented cyclical position. I suspect that central banker and government Treasury officials in a number of economic regions take the view that fiscal stimulus is driving the recovery and so far the rise in yields does not create a major drag. Monetary policy has tried for years to stimulate growth and get inflation higher; it is now the turn of fiscal policy and markets seem to think it has a better chance of working (note the rise in break-even inflation rates). Central banks can help smooth the moves in yields. They might be a bit clumsy about that from time to time, but they all have the ability to create reserves and buy additional bonds if things get out of hand. They aren’t going to halt the experiment yet – it’s working. So market participants should think about what assets gain most from strong nominal economic growth (equities) and what assets benefit from keeping rates down and providing lots of liquidity (credit and inflation linked). The game is not over yet.
This weeks’ UK budget fitted into the broader policy narrative. Chancellor Sunak made some concessions to those in his party concerned about the size of the UK budget deficit and the increase in outstanding debt by pre-announcing an increase in the tax take. However, the benefits of that to the public accounts won’t be seen until 2023. In the meantime, there was another £65bn of emergency funds announced with the extension of the furlough scheme, the stamp duty partial holiday and other measures. The Office for Budget Responsibility estimates that the budget deficit will decline this year – from 13.3% of GDP to 7.6% next year largely on the back of the increase in GDP growth. The forecast for Q4-21 over Q4-20 is 6.4% with a further 3% expansion in 2022.
Still cheap to run deficits
The expectation that fiscal policy delivers the recovery in lost growth has to partly rely on financing costs remaining low. The policy agreement does not seem quite as joined up in the UK as it is in the US, but keep in mind the Bank of England has not entirely closed the door on negative interest rates. It seriously is not going to tighten policy anytime soon despite the improved outlook for the UK economy. For governments, borrowing costs are way below expected nominal growth so there is an opportunity to reduce debt to GDP ratios in the next few years even with aggressive fiscal stimulus today. Of course, should a bond rout occur, the economics do start to change. There will be time to address that. For now the message from central banks has to be “Keep Calm and Carry On”. Tightening is not on the cards yet, there is more recovery to come and the rise in bond yields is totally for the right reasons.
Diversification in fixed income
It was never going to be easy for fixed income this year considering what happened to yields and spreads in 2020. So far, total returns are negative. However, giving back all the gains made in 2020 is highly unlikely and bonds should still do a decent job in providing some relative capital protection if portfolios are well diversified between rates and credit and actively manage their duration exposure. Most bond total return indices are down with government bond indices down more than credit and long duration indices down more than short ones. Equity returns are modestly positive and the gap is consistent with where we are in the macro cycle. Until there is evidence that the macro cycle is rolling over, I expect the pattern of returns will remain the same.
City riches delivering
I guess there is a reason why Pep Guardiola is talked about as being the best football coach in the world. Of course, it helps to be working at one of the richest football clubs in the world. Nevertheless, Manchester City’s recent record is impressive by any standards and they look to be pretty much done in terms of winning the English Premier League this season. What’s more impressive is that City have won the league lots of times in recent seasons, contrasting starkly with Liverpool’s failed attempt to retain the title. It’s hard to win the league and really hard to win it in consecutive seasons. The battle for the next three spots is going to be tense in the run in to season’s end. United are well placed but their recent form has dipped – they aren’t scoring. Leicester have become inconsistent and Chelsea are looking strong under Tuchel (although they weren’t that impressive at Old Trafford last week). Eleven more games in empty stadiums to go. If we are done with social restrictions by the time next season starts in August, even City might be playing to a full house as champions again.