Government Bond Yields are Rising
One of the most meaningful market dynamics through the first quarter has been rising government bond yields and a steepening of the curve. US 10-year treasury yields started the year below 1% and reached 1.75%; there were similar scale moves in Australia and New Zealand, while UK 10-year Gilt yields reached 0.9% from below 0.2%. The trend was followed in other developed markets but with lesser magnitude.
The reason is twofold. Firstly, as the economic recovery has continued to gain momentum, appetite for safe-haven assets has begun to wane, particularly for Government bonds which were providing very little in the way of return. The value of global negative yielding debt that stood at $18 trillion has also now fallen below $14 trillion, which roughly accounts for one quarter of all investment grade fixed income assets.
The second reason is concerns over rising inflation. A build-up of pandemic induced supply chain issues has led to rising commodity prices in the quarter. A strong construction market and infrastructure spending has boosted demand for iron ore and the metal is expected to be in high demand as electrified clean energy networks are developed in the years ahead. Shipping costs have also been rising as the excess demand for goods over services has put pressure on capacity.
Added to these cost-pushes, the sheer amount of liquidity that has been pumped into consumer bank accounts over the last twelve months in theory should assist to drive up prices. The risk is higher in the US where stimulus has been larger and more direct. Despite these concerns, we expect that a dramatic shift in demand from goods to services will ease capacity constraints as the largest global economy reopens in the summer. We do not therefore see inflation running rampant. The Federal Reserve will continue its bond purchasing, may leave interest rates at current levels until 2024 and still predicts inflation to be in the region of 2%.
The UK is on the Up
The Brexit trade deal caused logistical issues in January, but otherwise, any negative consequences of the Brexit trade deal have so far been muted. In executing a world leading vaccine rollout, the UK economy is expected to rebound more quickly than its European counterparts with GDP growth expected to be 4% in 2021 and 7.3% the year after. Sterling has appreciated 6% against the Euro and could buy 1.41 dollars at its peak during the quarter, compared to 1.33 at the end of 2020. Relations with the EU remain frosty but terms for future financial services interaction have been agreed. It certainly feels like the UK could be a market which continues to build momentum.
The Virus is Waning
Despite a flurry of negative press briefly casting doubt over the efficacy and safety of the Astrazeneca vaccine, the only material change in virus fighting capabilities has been additional positive trial data and regulatory approval of yet more vaccines. The rollout continues at pace in the US and UK with approximately half the population having received their first dose, with the second half expected by May and July, respectively.
The EU’s lower cost procurement appears to have backfired as production constraints have held back supply, despite buying more vaccines than any other region. Some eastern European states have been more successful, having embraced vaccines from further east. There is now a serious third wave of infection spreading across Europe and it looks like another summer may pass before lockdowns can be lifted. Boris Johnson shared his roadmap to exit lockdowns by the summer, but the timing of lifting restrictions on travel to Europe and the rest of the world is uncertain.
Early data from Israel, which has vaccinated the entire population, has been very positive with transmission, hospitalisations and deaths down significantly. These trends are now continuing in the UK with excess mortality now below zero (there are less deaths than would be expected before the pandemic).
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Sector Rotation is Ongoing
Financials, materials and energy sectors have been boosted by inflation expectations and cyclical companies have been boosted by the success of the vaccine rollout and the anticipated economic recovery. At the same time, rising yields have dampened valuations of defensive and high growth companies. The shift is most prominent for the technology sector which has been the biggest beneficiary of the pandemic by exhibiting defensive growth characteristics.
The extent to which the sector rotation into cyclicals is sustained is up for debate and the technology sector has already regained some of its lost ground. Our view is that value and cyclical assets will outperform in the near term driven by an ongoing improvement in corporate results instead of anticipatory market shifts. There is also scope for some consolidation and market share gains in industries that have suffered over the past twelve months. However, the long-term prospects for many growth and tech companies remain intact so we do not propose avoiding these sectors altogether. For example, many clean energy stocks have come back to more reasonable valuations.
International Relations are Problematic
2020 ended with a new US president, a conclusion to Brexit and an end to four years of domestic political uncertainty. International relations, however, appear to be becoming more complex. After blocking a shipment of vaccines to Australia, the EU has been tightening vaccine export rules giving rise to concern over vaccine nationalism. China has sanctioned US officials, British MPs and the BBC over reporting of forced labour and human rights abuses against Uyghurs and other minorities in Xinjiang. Chinese consumers are now boycotting western fashion brands including Nike, Adidas and Burberry which have stopped importing cotton from the region.
The US has blacklisted five more Chinese firms on national security grounds and subpoenaed multiple Chinese information and communication firms. Biden is expected to continue with a tough stance on China. The SEC has adopted measures to delist companies who do not comply with US auditing standards putting tech giants such as Alibaba and Baidu in the firing line. China is beginning to respond to these actions.
Outlook
Global equity markets have continued to perform well into 2021; UK +3.1%, Europe +3.6% and US +6.2% in sterling terms. Chinese domestic equities have fallen. The US has been a standout market through the pandemic but the cyclically adjusted (Shiller) P/E ratio indicates that US equity valuations are now much higher than other developed market regions.
We could be in the midst of a “goldilocks scenario,” one in which expansionary monetary and fiscal stimulus continues through a period of economic growth without causing high inflation. Risk assets should outperform through this scenario but it is becoming a consensus view so markets will have already priced in much of this positive sentiment. For now, we expect the upward momentum in equity markets to continue as we look forward in positive anticipation of economies reopening. The UK and US look very well positioned to benefit ahead of many other regions and I would caution against discounting the impact this may have.