13 Aug 2021
Clive Emery, Fund Manager
Having spent nearly 18 months looking through the economic implications of a global pandemic, the market is now becoming fixated with the growth outlook, even as regions optimistically – and with some trepidation – ease restrictions and return us to some normality.
It appears that financial markets prefer the technical and quantifiable embrace of fiscal and monetary life support more than the uncertainty of returning to a world, where natural market forces and multiple Covid-19 variants may lurk to unsettle the economic outlook. However, we expect the outlook for growth to improve through the third quarter, and so our preference for equities remains intact. This has led us to recently upgrade European equities, despite the recent surge in government bonds.
Following months of optimism and the reflation trade dominating investor thinking, we could now get into a period of heightened worries about downside growth risks and market expectations adjusting lower. Commentators are naturally turning to more pessimistic narratives to explain the recent rates price action, and that could – to some extent – become self-reinforcing, as the view takes root that things have become more complicated and fragile.
In terms of the outlook, lower yields should normally be positive for risk assets such as emerging markets and growth stocks, supportive of rates and foreign exchange volatility, but negative for the US dollar. Investors look likely to remain most comfortable in US equities, given expected strong earnings momentum in the near term, structural robustness to the threat of virus variants, and the prospect of additional fiscal support in the form of President Biden’s infrastructure programme.
In contrast, Europe appears more vulnerable due to the spreading Delta variant. Meanwhile, on the political side, the German elections might not result in the Green victory that has so far been broadly expected. This potentially means more resistance to a looser fiscal stance in Germany and more fiscal integration in Europe. However, prospects of renewed growth as the year progresses should be positive for European equities, for cyclicals over defensives, and also for financials.
Looking back over the last month or so, one can look no further than the surge in bonds, which saw yields for US 10-year treasuries drop to 1.13%, while the average yield of G10 10-year government bond sat at just 0.3%. There were a range of explanations for the recent bond rally. The key element appeared to be a growing concern for growth that stemmed from the rise of the Delta variant and from a weakness in global PMI data in June, driven by the US and China. There were other explanations that included a technical positioning squeeze, very high levels of liquidity (implying that investors are desperate to park their cash somewhere), and a concern that tapering and rate rises might happen sooner rather than later.
That last point suggests again that the market remains addicted to quantitative easing (QE) and any suggestion of a dosage cut to that drug regime can lead to volatile impulses. Historically, the tapering or ending of QE has led to lower 10-year bond yields and a flattening of the yield curve. The latest Federal Open Market Committee (FOMC) dot plot, released on 16 June, showed that even though Chair Powell may not have changed his view, a surprisingly large number of regional Fed presidents had substantially brought forward their rate hike expectations.
Over the last decade the Fed has illustrated that it will taper their QE program prior to cutting rates, often about a year in advance, suggesting that tapering could happen earlier than anticipated. This has been reflected in market expectations: 73% of respondents in a recent BoAML survey expected tapering to start in Q1 2022. However, from our point of view it all comes back to the growth and inflation outlook as the decisions made on QE and rates will be strongly influenced by both.
The focus has shifted to the Delta variant and a slowing vaccination rate. Data from Israel suggests that vaccinations may be significantly less effective against the Delta variant, even if protection against hospitalisation and serious illness remains strong.
The slowing vaccination progress in Europe over the summer holiday season, meaning that the goal of 70% of the population being vaccinated by the autumn will likely be hard to reach, does not assist. In Germany, for example, while 40% of the population has been fully vaccinated, the trend appears to have started to flatten – a development also seen in the US over recent weeks.
In developed markets, forecasts of the full vaccination rate by the end of the year have dropped from 85% to 81% of the population (the current rate is 42%); and in emerging markets from 67% to 65% (the current rate is around 26%). On a GDP-weighted basis, the share of the world that had been vaccinated at the end of June was 34%, compared to 26% on a population-weighted basis.
The concern about the Delta variant’s impact on growth has been expressed by many leading central bankers from Mary Daly of the San Francisco Fed, Robert Holzmann, the Governor of the Austrian central bank, as well as Christine Lagarde.
Policy reactions to the spread of the Delta variant look set to vary considerably. In the US, it is hard to imagine any new material restrictions, but in the euro area the possibility of repeated lockdowns exists. Even if any new European restrictions might not be big enough to make a macroeconomic impact, they could easily lead to a dovish ECB outcome in September, as it looks increasingly likely that the pandemic will continue into 2022. This could potentially lead to an extension of the PEPP (Pandemic Emergency Purchase Programme) beyond its current March 2022 deadline.
The euro could therefore struggle to rise above US$1.20/€ over the near term, while the sterling looks more attractive and should be able to push beyond US$1.40/£ on the possibility of early Bank of England rate hikes next year.
If growth is disappointing, then the fiscal and monetary taps will surely be turned back on to assuage market fears. Though pandering to an addict is not necessarily advisable, it has been the reaction function of choice for central banks since 2007 and has been the dominating factor in financial asset prices.
At one stage the support will stop but that appears to be something that will be forced upon central banks, not a decision made intentionally. Hence, the ongoing hegemony of TINA – ‘There Is No Alternative’ – looks set to continue to be the dominating investment philosophy and one that we reflect with our overweight to equities and underweight to government bonds in our tactical asset allocation.
Investment risks
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
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Data as at 23 July 2021, unless otherwise stated.
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