Equities have ground higher despite a resurgence in COVID cases in many parts of the world. Meanwhile, bond yields have ground lower despite elevated inflation readings in many parts of the world. This month, we touch on the paradox of higher inflation leading to lower yields and why this could bring higher risk for fixed income investors.
Over the past two months, equities have largely ground higher despite worries around the resurgence in global COVID cases due to the more infectious delta variant. The S&P/ASX 200 has risen nearly 5% in this period, largely keeping pace with the U.S. S&P 500. Emerging markets was a laggard as Chinese tech stocks continued to suffer the ire of regulators.
The rally was driven by a rebound in tech and growth stocks which had been lagging earlier in the year. This latest rotation came about as yields headed lower despite higher than expected inflation readings in the U.S., with the market choosing to focus on the U.S. Federal Reserve’s (Fed) commentary around potentially bringing rate hikes forward and the prospect of earlier tapering of quantitative easing measures. Perversely, this brought down longer-dated government bond yields as the market reduced the likelihood of longer-term inflation. U.S. 10-year bond yields sit around 1.35% at the time of writing, whilst Australian 10-year yields sit around 1.3%, down 0.25% and 0.45% respectively since the last update.
Commodities continued higher despite recent actions by China to weigh down prices, with iron ore prices still around USD $220, though copper prices have moderated to USD $4.25. Brent Crude rose to USD $75 per barrel as oil demand recovers and OPEC+ had some difficulty in agreeing on the pace of production hikes. Gold fell for most of the past couple of months before staging a rebound in the past week and now sits close to USD $1,830.
The Australian Dollar has largely weakened against the U.S. Dollar to 74.5 cents.
The recent lockdowns have put a dent in Australia’s strong recovery, though its impacts are yet to be felt in earnest in most of the economic data. Employment figures continue to be very strong, with the unemployment rate falling to 4.9% and job advertisements continue to rise. Business and consumer sentiment remain well above long-term averages, though the latest readings show some moderation as some of the surveys were taken as recently as the first couple of weeks of the New South Wales lockdown. Activity indicators remain strong for both manufacturing and services, but have been falling from peaks earlier in the year. Overall, these developments support the view that the Australian economy is now past peak growth and is slowing to more normalised levels. Barring an extended lockdown and serious damage to consumer and business confidence, the domestic economy remains in good shape for the rest of 2021.
In the U.S. employment growth is recovering with some better job gains over the past couple of months. Like Australia, economic data remain strong but indicate that the U.S. is also past peak growth and slowing. Consumer price inflation, however, has continued to rise well above expectations and will continue to be closely watched by investors as the transitory narrative is hotly contested, with longer-term inflationary pressures rising seen in rising inflation expectations, producer prices, and news of large wage increases by companies like McDonalds, Amazon and Blackrock.
Over to China, growth has been slowing since late 2020 as the earliest economy to enter and subsequently recover from the pandemic. The first half of 2021 largely saw authorities shift from focusing on a recovery to focusing on reining in speculative excesses and debt. Recently, we have seen China start to pivot once again, reducing the reserve requirement ratio for banks which allows banks to reduce capital and release up to 1 trillion yuan or $200b into the system. This could lend support to the global economy as many developing countries begin to struggle again with the pandemic in resurgence.
Outside of economic data, markets will be watching commentary from Fed members closely for further changes to interest rate and tapering expectations. The global earnings season has also kicked off in the U.S. but will begin in earnest for Australian companies in a couple of weeks. Analysts have continued to revise earnings higher in the lead-up, but guidance will be closely watched with concerns of rising wages and raw material costs posing threats to profit margins moving forward.
The paradox of higher inflation, lower yields
In the last edition of our Investment Perspectives, we looked at rising inflation in the U.S. given its current importance to investment markets and largely agreed with the Fed and market consensus view that the spike will likely be transitory. Despite several higher than expected inflation readings in the U.S., but also in many other parts of the world, the market has continued to drive long-term yields lower in recent weeks after peaking in late February.
Green = U.S. 10-year yield, Blue = Australian 10-year yield
Source: IRESS, Partners Wealth Group
Part of this has been due to the Fed’s change in stance, forecasting a potentially earlier rate hike and reiterating that it intends to be data driven, leading the market to see a lower likelihood for a policy mistake by the Fed by allowing inflation to linger which could shift inflation expectations structurally higher and lead to too much inflation.
Whilst we continue to see transitory inflation as the most likely outcome, markets now seem to be getting too complacent based on the bond yields. In the last couple of months, inflation has shown no signs of weakening, with core U.S. inflation readings growing 0.7% between April and May, and accelerating to 0.9% between May and June. Much of this can still be attributed to transitory segments, but adjusting price growth using the pre-COVID level as a fixed base shows that inflation is still picking up speed.
Supply chain constraints are the likely driver for most of this, but the longer this continues, the more likely there may be a shift in long-term consumer expectations for inflation. This potentially creates a self-fulfilling cycle where consumers bring forward spending on the fear of higher inflation driving down purchasing power only to spur higher inflation with such behaviour. Further exacerbating the issue of higher inflation in the near-term, some of the more sticky inflation data is likely to be higher in the coming months. Rent inflation will likely rise on the surge in residential property prices earlier in the year given that rent increases take some time to flow through the system. Wage inflation may also start to pick up given the well-discussed imbalances in the U.S. labour market. We have already seen large companies like McDonald’s, Blackrock and Amazon announce big wage hikes.
As a result, we see higher risks for higher inflation to become sticky, and therefore, higher risks for duration (yield-sensitive) exposures in the near-term. The current low yields offer little protection against rising inflation and potential capital loss from rising yields. We continue to favour other areas of the fixed income investment universe, preferring to take credit risk in exchange for higher income rather than duration risk.
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