Monthly Market Blueprint: April 2021

Tue 20 Apr 2021

Global economic divergence has caused a surge in input prices evident in various Purchase Manager Index reports as well as producer price indices. In early February markets began to price in the probability of higher inflation. The long end of the yield curves (where inflation lives) rose, while the short end (affected more by interest rates) remained at the same levels.

However, at this point we have to say that rising inflation expectations are mostly a US phenomenon. This is due to the fact that the US is projected to vastly outspend the rest of the world in terms of fiscal easing. While there may be technical factors behind the rise in market ‘expectations’ (the difference in yield between an inflation-linked and its simple equivalent bond), like increased demand by the Fed for inflation protected securities, there’s also solid economic reasoning. The narrative goes: authorities are willing to risk an overheating the economy, rather than risk a post-pandemic slump which could further hurt already sluggish economic growth.

The US’s projected $3tn infrastructure project was the piece of news that launched the ‘inflation trade’. The US central bank was quick to endorse those hopes, changing its framework to target ‘average’ inflation and reiterating that it would tolerate a modicum of higher inflation over a short period of time, especially if this improved growth conditions and helped it achieve its other mandate, full employment.

As a result, US 10y bond yields rose by almost a full percentage to 1.71% at the time of writing since November, and the market quickly saw the biggest yield curve steepening in the past five years. In the past two weeks bonds moved in a small sideways. Evidence shows that the market still hasn’t seen massive influx of capital.

We believe that at this range bonds are still too expensive versus equities to make a difference within the context of a diversified portfolio. The MSCI World’s Dividend Yield is at 2% and the MSCI World’s Earnings Yield (Earnings/Price) is at 3%. Currently, fund managers have very low allocations towards cash, which means that for bond yields to see inflows, it would have to be between the 2% and 3% range. Thus, above 2% they start becoming interesting and near 3% they would start to become attractive and offer pension funds and other income-seeking vehicle a good risk-free yield.

Various manager surveys also corroborate those levels. We feel, however, that the global appetite for yield is so large that demand would soon bring yields down again. Also, we should note that credit spreads (the difference between a sovereign and a similar maturity corporate bond) are persistently low, which means that corporate exposure offers only slightly better returns than sovereign.

Thus, our view on the matter is simple and in line with consensus: we feel that lack of free cash and unattractive valuations versus equities could allow the bond selloff to continue for a little while. After all, there are still $14tn worth of global bonds still in negative yield territory.

However, much of the market also believes that inflation will eventually underwhelm, which is why the selloff seems to have paused at current levels. 

We would not add to our allocation at the current yield levels and would consider expanding our bond holdings only if the US 10-year yield found itself sustainable within the 2%-3% range.

-George Lagarias, Chief Economist