Two sides of the same recovery coin

Higher U.S. Treasury (UST) yields are the result of healthier growth expectations and investors anticipating higher inflation. Recognizing this fact will help investors allocate their assets appropriately for the next 12-24 months.

Since the COVID-19 pandemic began 12 months ago, everyone has been looking forward to the day when life can return to normal. Families can gather for celebrations with no limitations. Travelers can travel across the world. Stadiums and concert halls can be packed with crowds enjoying a sports game or a concert. Even though there is still a debate on whether life will ever return to the way it was during Christmas 2019, some steady progress is being made that could pave the way for some economies, such as the U.S. and UK, to reopen more broadly in the summer. The flip side of this normalization from the pandemic is that investors are raising questions whether fiscal and monetary stimulus will come to an end. This has led to a surge in government bond yields around the world, notably in the U.S.

Doubts on doves

The recent market rally, both in equities and other risk assets, such as corporate credits and emerging market (EM) fixed income, has run largely uninterrupted since March 2020. The aggressive monetary policies by the Federal Reserve (Fed) and other developed market central banks have provided ample liquidity to calm investors’ nerves and boost asset prices. Hence, any potential shift in this policy stance could reverse this rally, especially given the rich valuations in some assets, such as U.S. technology stocks, and selected corporate credits.

Investors are increasingly concerned that accelerating inflation could force the Fed to scale back its asset purchases and/or raise policy rates sooner than expected. Even though Fed Chair Jay Powell and several senior Fed officials have reiterated that the central bank would look to maintain the prevailing policy stance given uncertainties in the U.S. economic recovery, investors are not particularly convinced by this dovish bias, and there are some valid reasons. 

Despite a significant surge in infections, hospitalizations and deaths since October 2020, the U.S. economic performance has been more resilient than expected, especially entering 2021. This is partly due to the USD 900billion fiscal package passed in late December that provided much-needed support to households and businesses. Looking forward, there are factors that could cause recovery to surprise on the upside. For example, U.S. President Joe Biden is looking to pass a USD 1.9trillion fiscal package before the end of 1Q21. While some parts of the proposal may be left behind, such as the USD 15 minimum wage, the Democrats’ simple majority in the Senate should pass most of the proposed spending package. That would be equivalent to 8-9% of U.S. GDP, most of which could be deployed in 2Q20 and 3Q20.

In addition to fiscal stimulus, the U.S. is also making steady progress in vaccinating its population. By the end of February, it had already administered over 70 million doses. At this current pace, most of the vulnerable and those who want to be vaccinated could be inoculated by mid-year. This implies many services and economic activities could resume and boost growth in the second half of the year. The pent-up demand could lead to higher prices and generate additional inflation pressure. This is mirrored by the rise in oil and commodity prices.

The key then becomes whether the Fed and investors view this bout of inflation to be temporary or sustainable? If this is sustainable, it will be a test of the Fed’s average inflation targeting (how long the Fed would tolerate above-target inflation before starting to act). The futures market is currently pricing the first policy rate increase to come in early 2023, earlier than the Fed’s own projection. New York Fed’s primary dealer survey ahead of the January Federal Open Market Committee meeting showed that these primary dealers expect the Fed to maintain its net purchase of UST at USD 80billion per month for the rest of 2021, and then start reducing in 1Q22.

While the Fed’s policy credibility is under scrutiny, it is largely business as usual for other developed market central banks. The recovery momentum in Europe (not including the UK) is less certain given the relatively slow progress in vaccinations, even though the continent is improving from the latest wave of outbreaks.

In China, economic data over the first two months of 2021 continue to show robust performance, despite some isolated outbreaks of COVID-19 in several cities. The People’s Bank of China also seems to be positioning for a gradual policy normalization given the robust growth momentum and the need to prevent excessive credit growth. We could also see a more conservative fiscal policy outlook, in contrast to the U.S. and Europe.

Higher Treasury yields could prompt a rethink in asset allocation

The rise in yields could reset the asset allocation consideration going into 2Q20. The challenge with investing in U.S. government bonds at the start of the year was the unattractive yield (less than 1% for 10-year) and the prospects of higher rates, or duration risk. This also applied to some high-quality fixed income, such as investment-grade (IG) corporate credits. U.S. IG credit spreads started 2021 at the pre-pandemic low, implying limited room to tighten and generate price return to investors.

UST yields are likely to rise further in the coming years as the economy continues to improve, and hence duration risk will still be a factor. To address this challenge, investors can focus on short duration fixed income assets or bonds that are less sensitive to the rise in interest rates. Also, debt with higher yields, such as high yield corporate debt or EM fixed income, offers a larger buffer to offset such duration risk.

On equities, the rise in risk-free rates, or UST yields, could prompt a more abrupt correction in technology and health care, which historically do not react well to rising rates. In contrast, financials and banks, energy and materials and industrials are more resilient in this environment. This coincides with the style rotation that is more generally known as value outperformance. This also fits in with the macroeconomic outlook, as these sectors were hard hit by the pandemic and have a stronger potential to bounce back as global recovery becomes more comprehensive.

Overall, we are still constructive on risk assets for 2021 on the back of the global economy rebounding from the worst of the pandemic. Equities, corporate credits and EM debt should benefit. For equities, instead of focusing on only the U.S. and China, or tech and health care, investors should diversify their equity allocations globally and across broader sectors. Low defaults should support high yield corporate debt. The resumption of U.S. dollar depreciation should continue to provide a favorable condition for EM fixed income. 

Global economy:

• The latest Purchasing Managers’ Index (PMI) data continued to show expanding manufacturing activity in many parts of the world as vaccinations progress and normality returns. In the U.S., the services sector also saw a strong increase in business activity, with the services PMI coming in above expectations at 58.9. China’s economy slowed slightly in February as both the Caixin/Markit and the National Bureau of Statistics manufacturing PMIs fell from January, although this could be attributed in part to factory closures and travel restrictions during the Lunar New Year period.
  (GTMA P. 12, 13)
• The economic outlook has been buoyed by optimisms over COVID-19 vaccines and the prospects of more fiscal stimulus. In the U.S., COVID-19 cases have come down more than 70% from their peak. The House of Representatives has also passed a USD 1.9trillion relief package, which includes USD 1,400 in direct payments, and the bill will now head to the Senate for approval. These factors have fueled the belief that economic recovery will return sooner rather than later, raising expectations for higher inflation this year.
  (GTMA P. 17, 24, 26)

Equities:

• Higher inflation expectations and yields sparked a correction in risk assets toward the end of February, particularly in technology names, although markets still ended the month positive (S&P 500: +2.8%, NASDAQ: +1.0%). The global bond sell-off also caused global equities to pare off some of their earlier gains from vaccine optimism. The FTSE 100 and Stoxx 50 returned +1.6% and +4.6%, respectively, in February.
  (GTMA P. 29)
• China’s CSI 300 fell 0.27% in February, as markets faced headwinds from tightening monetary conditions and expectations of a normalization in economic policy. In Hong Kong, a decision to raise the stamp duty on equity transactions to fund the government budget deficit led to a sell-off in the Hang Seng index. Rising borrowing costs also sent ripples into EM equities. The MSCI Turkey and MSCI Brazil indices fell 2.5% and 6.3%, respectively, in February.
  (GTMA P. 29, 32, 35)

Fixed income:

• The bond sell-off that was triggered by rising economic sentiment resulted in 10-year UST yields surging past 1.6%. The rise in UST yields also spilled over to Europe, as German 10-year yields rose 25bps over the month. The sell-off has led policymakers to step in and assuage concerns that monetary policy will be tightened soon.
  (GTMA P. 46, 47)
• Credit spreads tightened slightly across the board. With the global recovery helping keep default risks in line with their long-term averages, returns for corporate credit are increasingly driven by their interest rate component.
  (GTMA P. 45, 52)

Other assets:

• Stronger economic prospects have fueled commodity demand and led to a surge in prices. The oil market continued its rise in February as Brent crude gained 20% to USD 66.13 / barrel. On the other hand, the price of gold fell 6.6% to its lowest level since June 2020, as the rise in government bond yields undermined demand for the asset.
  (GTMA P. 63-65)
• The U.S. dollar index rose 0.3% over February on the back of higher UST yields, while riskier currencies weakened. EM currencies slid as the Turkish lira and Brazilian real fell 1.6% and 2.1%, respectively, against the U.S. dollar over February.
  (GTMA P. 60, 61)