The scenario of a strong economic recovery, with inflation also projected to rise, has been clearly mapped out for several quarters now. Luckily springtime dished out a few surprises to keep us on our toes.
Chief among them is the change in US long yields. It stands to reason that, with the economy gaining speed and inflation surprising to the upside, even temporarily, we might have expected the increase in long yields to resume. In reality, in the second quarter the US yield curve flattened – despite the rebound in long yields observed after the Fed meeting – as demonstrated by the well-subscribed US Treasury issues. There has been no lack of attempts at interpretation, ranging from the idea that the markets are already looking beyond the rise in inflation to the one that disappointments on job creations are giving the Fed, and thus the bond markets, some time.
That is why the markets’ reaction to Jerome Powell’s press conference on 16 June was so important, with a surprise increase in rate predictions for 2023 which caused the US 10-year yield to climb and led to a pick-up in so-called Value stocks (and financials in particular), which have underperformed for a month. Gold has been hit the hardest in this environment, reminding us that there is no safe haven that works in every market regime.
Never lose hope in Europe: that is perhaps another nice surprise from this spring, which saw a sharp acceleration in the vaccination campaigns which had lagged the United States. Given the galloping momentum of Biden’s America, media coverage had portrayed Europe as bogged down by the Brussels technocracy. A few months later, France boasted 30 million partially vaccinated people, and ultimately it seems there is likely only a one-quarter lag between the US cycle and the European cycle.
If we take together the historic recovery, record earnings season and supportive economic policy, and add in negative real rates pushing equity market valuations higher, in the spring investors enjoyed exceptional conditions that are rarely in place in reality.
However, the question now is whether the markets might be overly optimistic or whether this combination of highly favourable factors will last. If the forward momentum were to subside somewhat, which would make sense, the outlook for the second half of the year would then rely on the central banks, which would be even closer to the heart of the action. With a rapid rebound in growth and inflation, which could last beyond this quarter, it would be logical for the central banks to suggest that an end to their balance sheet policy is in sight.
That is the key question for the summer: will the Fed be able to maintain an ultra-accommodative policy for long? If this is done early and gradually and helps keep real rates low to ensure that valuations are maintained and the debt is sustainable, investors may remain confident, but the Fed is increasingly walking a fine line.
While the Fed’s message remains cautious on the possibility that it will tighten its monetary policy in the coming months, the key point of the last meeting of the members of the FOMC was the dot plot surprise, with two rate hikes now expected in 2023 versus none previously. If the timing between the tapering of the Fed’s purchases and the rate hike narrows, this could cause more disruptions in the market.
In other words, a continued rise in the markets is based on a subtle equation, which a communication error by the central bank could quickly subvert.
Once again, it’s likely all about the inflation outlooks; if this rise is temporary, the central banks – and thus investors – will still have some time on their hands. If inflation continues to surprise and stabilises at a much higher level and raises concerns about an overly accommodative monetary policy error, investors would be expected to increasingly adjust their equity positioning, while the question of the sustainability of sovereign debt could surface again. We are truly moving quickly from the virtuous circle to Dante’s inferno.
Monthly House View, 18/06/2021 release - Excerpt of the Editorial
June 25, 2021