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Monthly Market Commentary - February 2021

Markets in February followed a similar pattern to that seen in January. There was a strong rally in equities in the first half of the month, driven by market optimism that policy makers will be able to support global reflation.

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by
Jon Cunliffe

in Fiduciary news

02.03.2021

Markets in February followed a similar pattern to that seen in January. There was a strong rally in equities in the first half of the month, driven by market optimism that policy makers will be able to support global reflation. However, a sharp correction was seen at the end of February on fears that the amount of fiscal and monetary stimulus needed to achieve this may prove unsustainable. Global equities rose by just 0.5% in Sterling terms over the month but had been up as much as 5% before the correction.

A significant rise in sovereign bond yields played a part in pushing equities lower, as holders of fixed income securities began to question whether central banks could credibly remain dovish, given the likelihood that over the next year we shall see the strongest global growth for 20 years allied with a strong pickup in inflation.

Elsewhere, fears over the sustainability of government deficits resurfaced, with the Biden administration pushing for a fiscal package of up to $1.9trn, about 9% of US GDP. With this spending will come a record supply of US Treasuries, and there were signs going into the end of February that the market’s ability to hold government debt at prevailing levels was beginning to weaken. However, this fiscal stance is sustainable if nominal growth comfortably exceeds the cost of borrowing. In the US, nominal growth could be in the region of 8% this year, with ten-year Treasury yields still at 1.4%.

Why does the bond market matter for investors? Quite simply, one of the key props supporting the current high valuations of assets, and in particular equities, has been the exceptionally low level of sovereign and corporate bond yields. Not only do low bond yields create a low discount rate for future equity earnings (boosting present values via higher earnings multiples) but also makes equities more attractive on a relative basis. Take this prop away and equities (particularly the long duration growth stocks) are suddenly vulnerable.

One development which added fuel to the fire late in the month was a more rapid rise in real rates. Rising nominal rates are less of an issue for risk assets if real rates stay anchored, but if real rates lead the selloff in bonds then markets will have a much less supportive interest-rate environment. Falling inflation expectations may then kill off the reflation trade.

This bond market backdrop poses a dilemma for investors. On the one hand, markets expect global growth of up to 6% over the next twelve months, with corporate profits likely to increase by up to 25%. This will combine with unprecedented fiscal and monetary policy support to provide a continuing strong tailwind for equities. On the other hand, the upward pressure on bond yields, which this cocktail is creating as investors worry about higher inflation, threatens to derail the stock-market rally.

This type of disruptive bond market correction is entirely understandable, as investors look ahead to resurgent demand when lockdowns end. Policy makers appear keen to allow economies to “run hot”. However, we still feel that any rise in inflation in the months ahead will largely reflect base effects and prove to be cyclical in nature (output gaps are still large, and demographics are disinflationary).

Our sense is that if the rise in bond yields continues unchecked, then equities are likely to have a tough time in the weeks ahead. However, we would expect central banks to increase their support for bonds should the recent buyers’ strike continue.

In the US, this could be via operation twist (selling short bonds to buy long bonds) and maintaining the exemption on banks’ leverage ratios of their holdings of US Treasuries, which has been in place since last April and is due to expire at the end of March. Outside of the US, central banks may also need to reassess the pace and composition of their bond purchases.

To conclude, because we feel we have already seen a significant portion of the rise in sovereign bond yields, we remain constructive on equities, anticipating outperformance from Emerging Markets and Asia on the back of favourable relative growth differentials, the trend of Dollar weakness and rising US inflation expectations.

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