Weekly Market Update: The Yield, Not “Inflation” Will Determine the Rotation
Mon 22 Mar 2021
Equity market gains early last week were, broadly speaking, eroded as bond yields continued to rise, reaching one-year highs. Amid falling oil prices and rising political uncertainty caused by potential bans on vaccine exports coming out of the EU, many major equity markets fell last week. US equities fell -0.5% from record highs in Sterling terms, despite the country surpassing 100 million vaccinations on Friday. UK equities fell -0.7%, now down -2.4% from their 52-week highs in January. Globally the best performing sector was healthcare, whilst energy, due to oil prices, was the worst performing. Japanese equities rose +3.6% and are the best performing major equity markets this year. The US 10Y yield continued its rise up 9.6bps to 1.7%, while the UK 10Y rose 1.6bps to 0.8%. Gold rose +1.3% on the week. Oil has seen back-to-back weekly declines, down -6.1% to $61.2 a barrel, due to a glut of supply and weakening demand forecasts.
Equity markets continued to tread water last week, with the S&P 500 consolidating its levels below the 4000 points mark. Attention was once again on the bond market, as the US 10 year bond closed above 1.65%, with analyst surveys suggesting that it is nearing a level where managers might be prompted to start shifting allocations towards bonds to lock in the higher yield at a time when yield is projected to remain scarce. Understandably, this is generating caution for equity investors, and vigilance especially for high-dividend allocators, who see the “2021 resurgence of high yield stocks” narrative in peril.
To be sure, we do not quite subscribe to the idea that impending inflation is causing the Fed to lose control over the yield curve. Whereas some short-term inflation is probable, we see very little evidence of long-term inflation which could force higher interest rates and upend the Fed’s ability to suppress risk. Last week’s comments by the US central bank affirmed that view. In fact, we welcome the Fed’s reluctance to intervene and suppress the long end of the curve, as it allows a window for private investors to take advantage of higher rates and maintain -or increase- diversification, without being forced to resort to high yield stocks or risky bonds to fulfil income mandates and objectives.
For us, the main question is “at what level” would a rotation towards bonds happen, which would naturally put a ceiling on the yield curve. The issue is highly speculative and long-term investors couldn’t possibly time a rotation from equity allocation into bonds, so they would have to start building positions rather than aim for a certain high level. It stands to reason that they will do so, with an “opportunity cost” in mind, i.e. when bonds are worth more against stocks on a risk/reward basis. A recent popular asset management survey suggested a range between 1.75% to 2.25% as the highest probability, with 2% (incidentally the dividend yield for the MSCI World Equity Index) being the most popular choice. Another possible level, however, could be around the 3% level (the Earnings Yield of the MSCI world), so one can’t really be certain. Trading flows -or the Fed- will determine peak yield of course, so for “slower” money this means that there’s also an -undetermined- time-limit to this exercise.
David Baker, CIO