It’s been another week where we have seen equity markets struggling against a backdrop of bond market volatility and rising government bond yields with the ‘reflation trade’ resuming across financial markets. While the central banks continue to send the message to financial markets that they are not concerned by what they expect to be transient inflation in the short term, the prospects for stronger economic growth continue to weigh on bond markets, with government bond yields continuing to rise, and yield curves steepening. While a stronger economic outlook should be welcome, the expectations of a recovery have been built into equity market valuations for some time, as evidenced by lofty price/earnings multiples. Meanwhile, bond market yields have drifted higher from the lows we saw last summer back towards the levels seen before the pandemic but the past few weeks have seen more dramatic moves and this heightened volatility in fixed income has been felt across financial markets. While equity markets have made progress, once again the longer duration sectors – those that benefit from low interest rates – have underperformed, and we have seen further strength from the value and cyclical names that should benefit most from a stronger economic environment.
The central banks have duly noted the moves in bond markets and continue to send dovish messages. The European Central Bank President Christine Lagarde said they were “closely monitoring the evolution of longer term nominal bond yields”, while the US Federal Reserve Chair Jay Powell spent two days this week testifying to Congress, and at the same time reiterated his message to financial markets that the Fed is intending to keep policy accommodative for an extended period. Powell said that it could take more than three years before the Fed reached their 2% inflation target and noted there was still “a long way to go” before the US gets to maximum employment. It seems clear the Fed is set to emphasise their dual employment and inflation mandate, and the bar to tighten policy remains very high until both goals have been met. Powell told Congress that bond yields were rising because of stronger confidence, but highlighted that the economy was still 10 million jobs down on 12 months ago. Powell also argued that in his view the forthcoming fiscal stimulus and release of pent up consumer demand would not cause an inflationary shock. He sees “enthusiastic” spending pushing up short term inflation but does not see it as being large or persistent with the Fed still viewing inflation risks as skewed to the downside. His colleague Lael Brainard noted that transitory inflation “was not the kind of inflation that monetary policy would react to” and that the Fed would need to examine a number of factors beyond the unemployment rate to assess shortfalls from maximum employment. The soothing words from the Fed certainly boosted equity market sentiment, but as yet have failed to halt the rise in government bond yields.The news on the vaccine response to the Covid-19 pandemic continues to be encouraging, with yet more reports from Israel of very strong efficacy in the real world. Having vaccinated close to 90% of their population, Israel continues to be a useful lead indicator as to the effectiveness of the vaccine rollout. Studies released this week showed that two doses reduced the risk of illness by 95.8% and the vaccine is 98% effective at preventing fever or breathing problems. Even more encouraging was a study showing that the vaccine is 89.4% effective at preventing transmission – this suggests that once sufficient numbers of a population is vaccinated, case transmissions should slow sharply. The pace of the vaccine rollout varies significantly even across developed markets but increasing supplies and new vaccine approvals should make a significant difference over the next few months. This week saw the single dose Johnson & Johnson vaccine reported to be “safe and effective” by the US Federal Drug Administration, with emergency use authorisation set to follow soon.
As expected, the UK government set out their roadmap for the easing of Covid-19 restrictions in England over the coming months starting with the reopening of schools on March 8th and leading up to June 21st when all social restrictions will be removed, provided that four key tests are met around the vaccine programme, reducing demands on hospitals, infection rates not surging and no issues with new variants of the virus. Each stage of the easing will see a five-week interval to allow for four weeks of analysis of the impact of the easing, followed by a one-week notification that the next stage of easing will go ahead. The devolved administrations also set out their own policies with schools returning sooner but a longer path to complete reopening. The Prime Minister said that “there is no credible route to a zero Covid Britain or indeed a zero Covid world”, which highlights the government is expecting the fall in cases to slow or even reverse in the short term as reopening takes place but over time the vaccine rollout should lead to significant suppression, but not eradication, of Covid-19. Last week the PM spoke of a “data, not dates” approach but the government has now given the a long timetable of reopening dates to be judged by, while the ‘tests’ to judge the impact of the easing appear to give some flexibility to allow the scientific evidence to be judged through a political lens. The news of the reopening was welcomed in financial markets, with sterling strengthening and ‘reopening stocks’ across travel, leisure and retail performing strongly. Next week we will learn more about the ongoing fiscal response, with the Chancellor’s budget set to take more of a focus on continued ‘safety net’ measures, involving the extension of the furlough scheme and supplemental benefit payments. There has also been plenty of speculation this week we may see an extension of the stamp duty ‘holiday’ which has turbocharged the UK housing market, and possibly some news on a corporation tax hike as the government begins what is set to be a very long process of restoring the public finances in the aftermath of the huge increase in public debt as a result of the pandemic.
Moving on to the economic data, and we saw UK unemployment rate climbing to 5.1% for the three months to the end of December. Payroll data showed there were 28.3 million people on payrolls in January, 726,000 fewer than in February 2020 before the pandemic began to impact the employment market. There were still 4.7 million people furloughed in January which is a long way from the peak of almost 9 million people last April but still around 16% of all employees in the UK. The flash PMI data continued with the same theme we have seen since the end of the first lockdown across developed markets, with strength in the manufacturing sector offset by persistent weakness in services. That said, the most recent dip in the services data, driven by the higher restrictions we have seen in the US, Europe and the UK since early January, has been mild by comparison with what we saw earlier in the pandemic and survey participants saw the slowdown as ‘temporary’. As restrictions ease over the coming months and the service sector opens up, a very strong rebound is to be expected.
It seems that the immediate outlook for financial markets set to be driven by the moves in the bond markets as a new range is established that reflects market expectations for economic growth and the potential for tighter monetary policy, even as the central banks continue to highlight that policy moves are not even on the distant horizon. There will be fallout in equity markets as higher rates continue to cause a rotation between sectors that have benefitted from a low rate environment to those that will thrive in an environment of higher economic growth and potentially higher rates. Of course, there is a ‘sweet spot’ for equities in that a little inflation and slightly higher rates can be tolerated up to a point. That point is much lower for bonds, however. In terms of the portfolios, we continue to be underweight in both equities and fixed income. After the moves we have seen in equities in the past few months we still have some concerns that the good news is already ‘priced in’, while fixed income continues to look expensive and parts of the universe are clearly at risk from sentiment shifts over the economic and rates outlook. We continue to have exposure to selected absolute return funds, niche property and specialist funds, and some cash. At the regional level, we continue with our Asian and UK overweights, and indeed are leaning into our UK overweight further by trimming Europe back from neutral to slightly underweight. We continue with our US underweight. Overall, we do expect some further volatility in fixed income and this will inevitably impact equity markets. We continue to believe this is not a time to take on additional risk and while we remain positive on the economic outlook as we hope that the worst of the pandemic is behind us, we think that our positioning in value funds benefitting from style rotation rather than being too aggressive in our overall allocation should serve the portfolios well in this environment.