Reflation, rotation, drama

Oh, the drama! To be clear, we’re not talking about Meghan Markle and Prince Harry’s explosive interview with talk show maven Oprah Winfrey, but the roller coaster that is the US stock market.

It has not been a smooth ride higher for growth stocks this year, as a surprising surge in long-term bond yields complicates a once seemingly simple pandemic-inspired investment premise: buy growth and see it soar.

Steep valuations may make sense when the yield curve was pretty flat, suggesting that interest rates will remain wedged at crisis lows for longer. A rise in long-term bond yields that has precipitated a steepening of the yield curve has challenged that premise.

Getting used to it

From the outset, the rise in long-term bond yields is not just a US-centric phenomenon – it is global. It reflects, in large part, more buoyant growth expectations on the back of favourable Covid-19 infections, hospitalisations and vaccination trends, as well as the recovery of economic activity as businesses and households increasingly adjust around pandemic restrictions.

More than a year into the pandemic, economies have mostly adapted to the restrictions necessary to keep infection levels low, such that the global economy has continued to function without too much disruption. Of course, the services sector and other activities like global travel have not fully normalised. Even then, this is still a far cry from where we were in 1H2020.

Much has been written about the resilience and robustness of the Chinese economy in the face of Covid-19. After all, China was the only major economy to post positive growth in a pandemic-stricken year. Many thought the US would languish under the weight of Covid-19. But, under a new administration, growth prospects for the largest economy in the world has become decidedly more optimistic, especially on the back of a couple of developments over the past week.

Closing the gap with China

Indeed, investors were treated to some good news on the economic front. First, the US non-farm payrolls report for the month of February surprised on the upside, as the economy added 379,000 jobs, significantly outperforming expectations, while the headline unemployment rate ticked down from 6.3% to 6.2%.

After three months of softer-than-expected job gains and outright losses due to the third wave of Covid-19, the leisure and hospitality sector revved up employment in February, adding a whopping 355,000 jobs. The gains in employment also came despite negative weather effects, underscoring the resilience of the labour market. This might portend better jobs growth ahead.

Of course, as Fed Chair Jerome Powell and Treasury Secretary Janet Yellen have emphasised time and again, these numbers understate the true breadth of the labour market damage from Covid-19. There is still a big hole that needs to be plugged and the labour market has not recovered the 9.5 million jobs lost at the height of the Covid-19 shock.

But there is solace in the fact that the jobs market is showing good progress and the outlook appears bright, especially as Covid-19 infections and hospitalisations recede, vaccination campaigns ramp up and states gradually reopen again.

Second, over the weekend, the US Senate approved President Joe Biden’s US$1.9 trillion Covid-19 relief package – also named the American Rescue Package – on partisan lines via the budget reconciliation process, just in time to bridge the expiration of enhanced jobless benefits sometime next week.

President Biden’s relief package was trimmed around the edges, but it still contained most of the significant elements of the initial proposal, including the US$1,400 stimulus cheques, US$300 enhanced jobless benefits (down from US$400) and funding for federal agencies to bolster vaccine distribution and ramp up Covid-19 testing and tracing activities.

The Senate-approved legislation has also passed the House of Representatives and will now head to the White House for President Biden’s endorsement. Such significant fiscal support will help accelerate the recovery and buttress progress in the labour market.

Adding to the recent slate of good news, is the fact that the tide seems to be turning in the fight against Covid-19. One year later, the trends in infections, hospitalisations and vaccinations look favourable, although there are concerns that a premature reopening of states could squander the hard-fought progress in the war against the pandemic. The spread of new, more infectious, variants of Covid-19 remains a risk as well.

As it stands, more than 90 million vaccination doses have been administered - covering 18% of the population. At the current pace of about 2 million doses of vaccinations administered daily, the US remains on track to meet President Biden's pledge of delivering 100 million Covid-19 vaccine doses in his first 100 days in office.

At the same time, President Biden had announced that supply of the vaccine is no longer a pressing concern given that his administration had secured enough doses of vaccines to inoculate the entire adult population in the US by May. Administering these vaccines will take time, however, and herd immunity is not expected to be reached until sometime in second half of the year.

But good news is bad news if it means a retreat in monetary policy support

The seemingly buoyant outlook for the US economy has triggered concerns about inflation and consequently, a faster-than-expected withdrawal of monetary policy support. Market-based measures of inflation expectations have picked up, even exceeding pre-pandemic levels.

Low base effects, the rise in commodity prices, the injection of more fiscal support and the surge in the money supply have largely stoked concerns about runaway inflation and the need to normalise monetary policy in order to curb such pressures.

As it stands, interest rate futures reflect expectations of a rate hike in 2023 followed by about three rate hikes in 2024. Yet, the median Federal Open Market Committee (FOMC) member expects the Fed to keep interest rates at crisis lows through 2024. These expectations may well change when the FOMC updates their guidance in the upcoming policy meeting next week. Better growth prospects and rising inflation expectations have led US Treasury yields higher.

Long-term yields have climbed more than 60 basis points year-to-date. The 10-year US Treasury benchmark rose from a meagre 91 basis points at end-2020 to 153 basis points at the time of writing. That yields will rise is largely expected. That yields will rise this quickly, however, is surprising and has certainly spooked the market, sparking a sell-off in risk assets. Volatility has also increased as a result.

Growth stocks bore the brunt of the sell-off, with steeply valued tech and health care names suffering significant declines. Frothy segments of the market including SPACs and various electric vehicle stocks have also retreated significantly, although they have clawed back losses recently.

Growth stocks are particularly sensitive to rising long-term yields because their value rests heavily on earnings booked far out in the future, which are discounted more deeply when bond yields increase.

Indeed, the rotation into value and cyclicals has regained momentum in recent weeks as investors expect a more robust economic recovery. This year alone, sectors like energy, financials, industrials and materials have posted handsome gains while growth sectors like technology and healthcare languished. This is to be expected as value and cyclicals become attractive again as the global economy recovers, yields climb, and the yield curve steepens.

Over my dead body: Fed likely to step in should there be a disorderly rise in long-term yields

To be clear, a steepening yield curve due to rising long-term rates is par for the course considering expectations for stronger growth and higher inflation in 2021. It is the rapid pace of increase that has unnerved investors.

So far, the rise in 10-year US Treasury yields has also attracted the attention of policymakers at the Federal Reserve, but not to the extent that they are outrightly concerned about it, which suggests they are willing to tolerate some normalisation in long-term yields.

However, should yields increase sharply to levels that could choke the nascent growth recovery and jeopardise progress in the labour market, we do not expect them to stay quiet.

We do expect some jawboning from policy officials to talk down bond yields or more explicit forward guidance on the quantitative easing front, where they could push back expectations of tapering any time soon.

In addition, the rise in yields is a concern if it does foreshadow a more hawkish Federal Reserve. This was the case in previous yield spike episodes in 1987, 1994 and 2013, where the surge in yields preceded more hawkish moves by the Fed, which then led to a major and sustained sell-off in the bond and equity markets.

History is unlikely to repeat itself this time round, particularly because rising yields have been accompanied by a decidedly dovish Federal Reserve, committed to keeping monetary policy extraordinarily accommodative and extremely cautious not to withdraw support prematurely.

To this end, the Fed has made some key provisions. By switching to an average inflation targeting strategy late last year, the Fed has effectively bought itself some time before it responds to inflation pressures. Under the new strategy, the Fed will compensate for past undershoots of inflation from its 2% target in an effort to ensure that actual core inflation remains at 2% on average over an unspecified period of time.

Considering that inflation has averaged 1.6% –meaningfully lower than its 2% target – over the past nine years since the FOMC formally announced its 2% inflation objective in January 2012, the Fed will have to tolerate a period of above 2% inflation to compensate for past undershoots. More specifically, the Fed’s favourite 12-month core personal consumption expenditure (PCE) inflation have been below 2% in 95 of the past 109 months. In this case, bygones would no longer be bygones.

In addition, the Fed’s recent forward guidance stipulates three key criteria before it considers increasing interest rates which include (1) “maximum employment”, (2) inflation that “has risen to 2%” and (3) “is on track to moderately exceed 2% for some time.” These conditions were vaguely defined, leaving the Fed with ample room to manoeuvre.

For instance, while the FOMC specified a 2% target for inflation, they did not define what “moderately exceed” means in terms of a specific range for the inflation rate. Neither did they specify the exact duration for allowing inflation to exceed 2%.

While condition (2) is easily achievable this year, as the low March and April 2020 price readings fall out of the core inflation measure, condition (3) remains highly uncertain even with the injection of more fiscal stimulus. As Treasury Secretary Janet Yellen noted numerous times, inflation before the pandemic “was too low rather than too high.” To be worried about runaway inflation now seems oddly premature.

As Chart 7 shows, even the market expects higher near-term inflation to dissipate with time. Fed policymakers have reiterated a willingness to look through inflation increases triggered by transitory factors including a temporary surge of demand that outstrips supply in certain sectors when the economy reopens. They remain cognizant that additional fiscal stimulus and a drawdown of accumulated savings could push up aggregate demand but note that the scale and duration of the impact are largely uncertain.

A burst of transitory inflation is certainly possible, but a durable shift of inflation above the 2% target would require a very tight labour market and rising wage pressure. This, the Fed remains far off from achieving. Slack in the labour market will continue to cap inflation.

Furthermore, key labour market metrics including the labour force participation rate, headline unemployment rate and payrolls have yet to return to pre-pandemic levels, let alone signal tight labour market conditions. Payrolls for instance remain more than 6% below the recent pre-pandemic peak, which translates to about 9.5 million missing jobs. Weakness in the jobs market is also concentrated among minorities and women, which is likely to weigh on any debate surrounding tapering or withdrawal of monetary support given the Fed’s commitment to “broad and inclusive” full employment.

The Fed’s dovish disposition should continue to underpin a constructive long-term outlook for risk assets. Yes, the rapid pace of increase in long-term yields is a near-term risk and may inject bouts of volatility in the markets.

But we believe the Fed will step in to prevent a disorderly sell-off in bonds as this could potentially choke the expansion too early in the recovery cycle. The fact that the Fed has not undertaken such measures as yet reflect that the rise in the long-term yields may not be at all troubling for the US economy, at least at this juncture.

The Fed has telegraphed their dovishness widely and frequently, and this would suggest that the move in yields have largely been precipitated by stronger growth expectations as opposed to anticipation of tighter monetary policy. The latter would be more concerning.

Fashion passes, style remains

In line with better economic prospects and rising long-term yields, long duration plays like tech have suffered. Value and cyclicals have largely outperformed on the back of expectations of a more robust economic recovery, and the rotation from growth/momentum to value/cyclicals have also been fast and furious.

This dynamic is likely to sustain in the foreseeable future, probably in the next 6 to 12 months, contingent of course on further evidence of receding Covid-19 infections, improvements in access to vaccinations and further recovery in economic activity. As markets tend to be forward-looking, such buoyant expectations may be enough to continue to drive rotation into value and cyclicals.

While prospects for major technology stocks might be hampered in the near-term – at least relative to value and cyclicals which are enjoying a renaissance after a brutal 2020 – we believe investors should still keep their eyes on the long-term prize. Secular trends do not simply fade away just because they may not be in vogue at the moment.

Coco Chanel once said, “fashion passes; style remains.” One could easily replace the words “fashion” with “rotation” and “style” with “secular trends.” Admittedly, it’s a clunky substitution, but still makes the point: rotation might be a near-term tactical play but exposure to key secular trends is a strategic one.

Ultimately, structural growth themes such as e-commerce, the rise of the cloud, Artificial Intelligence, 5G, renewable energy, health tech, electric vehicles, smart cities and green infrastructure will characterise the world of the future, just not in the immediate sense. It is still important to have exposure to these themes as part of a long-term investment strategy.

At the same time, looking back at past earnings data, we do think that the earnings potential of high growth sectors such as technology will be a greater factor that drives and potentially sustains the sector’s long-term capital appreciation. As such, for long-term investors willing to look through the turbulence, the broad-based sell-down in growth stocks creates an attractive opportunity to incrementally accumulate quality names in the tech sector, especially those which were previously trading at rather stretched valuations.

Volatility is certainly par for the course, but this is where opportunities are created.

Skimming the froth

If anything, the rise in long-term interest rates have sparked a repricing of risks, washing out some of the froth that has been building in financial markets of late. This is healthy especially in a market where bubble-like valuations are a key concern. But we would caution that standard corrections can easily deteriorate into outright routs should sentiment sour. The upshot is turbulence and higher volatility.

So, while we remain constructive on the long-term outlook for risk assets on the back of the vaccine driven economic recovery, aggressive fiscal support and continued monetary policy accommodation, investors should still mitigate potential downside risks with adequate diversification.

For completeness, we maintain a risk on stance in our overall asset allocation strategy, with an overweight position in equities and a preference for the US and Asia ex-Japan stocks. In fixed income, we remain overweight in Emerging Market High Yield bonds, which still offer attractive carry and are a beneficiary of the global search for yield, but we are now underweight in both Developed Market and Emerging Market Investment Grade bonds, which face headwinds from a steepening yield curve.