Equity markets continued their upward trend last week. Global equities gained another 0.5% and are now up around 13% since the start of the year. The continuing gains, despite now being in traditionally the weakest time of the year for equities, can be largely put down to the bond markets.
10-year US Treasury yields fell 0.10% last week to 1.47% and are now down 0.30% from the high touched in late March following their spike higher in the first quarter. The recent decline is sizeable, particularly relative to the low level of yields, but the real surprise is that it has occurred despite the latest inflation news.
One of the most basic relationships we are taught is that higher inflation almost invariably leads to a rise in bond yields, causing capital losses for investors. Instead, US inflation shot up in May by more than expected for the second month running and bond yields fell.
US consumer price inflation has hit 5.0% and the more important core measure is now running at 3.8%, the highest level since 1992. So what’s going on – other than the markets as usual having the last laugh?
The old investment adage ‘buy the rumour, sell the fact’ may be part of the answer. Bond yields rose sharply early in the year on fears of the inflation spike now underway. Arguably, yields rose too far too fast and are now just correcting this overshoot. The only flaw here is that the surge in inflation is proving larger, not smaller, than expected.
The Fed is also almost certainly a major factor. It has been sticking to the story that the current surge is down to temporary demand/supply imbalances and should prove transitory. Whilst there are marked shortages both in a whole range of goods and also the labour market, much of the rise in inflation has been concentrated in a few categories such as used cars.
Equally important, the Fed’s primary focus at the moment seems to be on achieving full employment rather than inflation. Despite the anecdotal evidence of shortages, the labour market overall is recovering slower than expected with a considerable amount of slack to use up. Employment remains some 7 million below the pre-pandemic level.
The Fed meeting on Wednesday will be watched closely to see if there is any update on its ‘tapering’ plans (QE purchases should start to be scaled back early next year) and whether it brings forward its forecast for the first rate hike to 2023 from 2024.
Despite these valiant attempts to rationalise the latest decline in bond yields, we are still left concluding it is basically unwarranted, just like the overshoot in March. The risk of a more pronounced and persistent rise in inflation has undoubtedly risen. And, with inflation likely to remain elevated over coming months, we believe yields will resume their upward trend in due course.
Our portfolios are positioned for a rise, albeit not a surge, in inflation. Our fixed income exposure is on the low side and the bond holdings are of quite short maturity, limiting our vulnerability to a further rise in yields. We also hold inflation-linked bonds and have an allocation to gold where we can. Both should fare reasonably well in a rising inflation environment.
Finally, equities provide some protection against higher inflation and we have recently added some exposure into our lower risk fixed income heavy portfolios. As long as it remains below 3% or so, equities have tended to fare reasonably well when inflation picks up. This is because firms can pass on cost increases into higher prices, allowing earnings growth to keep pace with inflation. The coupon payments on conventional bonds, by contrast, are fixed.
To end on a note closer to home, the UK GDP numbers out last week confirmed a rapid recovery is well underway. Activity grew 2.3% in April and is now only 3.7% below pre-pandemic levels. A four week delay in the final easing of lockdown restrictions will be the last news the hospitality sector wants to hear. But it should not derail the recovery or prevent the economy recovering all its pandemic losses within the next few months.
Chief Investment Officer