Groundhog day for Europe with further lockdowns as a result of a new COVID surge plus a vaccination rollout that continues to be in a state of confusion to say the least. The US is motoring ahead, having reached the 100m vaccination goal after 58 days but there have been some signs (not unexpected) of a resurgence of the virus in certain states.
There is one question that we have not asked for a while that may be becoming more relevant even if it is still a tail risk hedge at present…Is the expected re-opening and resultant economic rebound still in place for 2021? The timing may have become less certain, but investors are still pricing in what seems to be an inevitable re-opening. Certainly sitting in London, the constant barrage of cautious messaging from scientists is not fuelling the kind of optimism one would expect given 50% of adults in the UK have now received the first dose of the vaccine, but it does seem that irrespective of the caution, there is little appetite for continued restrictions as we move into spring and summer. A week is a long time in politics and certainly if Europe can begin to sort out its vaccine distribution process, there is every reason to hope the situation will be better in a few months’ time.
Ahead of the pack
The US is again ahead of the pack. The action of Treasuries this week would seem to reflect that optimism. 10 year Treasuries were 20bps lower a week ago and with a huge stimulus package ready to go, together with a very supportive US Federal Reserve (Fed), we can see why optimism pervades the financial markets, with heightened expectations of a growth plus inflation rebound. The Bloomberg Barclays US Long Treasury Total Return Index has lost approximately 15% YTD according to Bloomberg analysis. From the March 2020 peak that is a decline of 22%, which is the worst peak to trough move since the index’s inception in 1973*.
What does this mean for financial markets? There has been a lot of talk about a taper tantrum. The Fed has made it clear that interest rates and market support are going nowhere. We believe that US Treasury yields could easily go past 2% on the 10 year given the current economic projections and the Fed is comfortable with that. We should therefore expect the curve to continue to widen and steepen over the next several months. What this does mean is that more expensive growth stocks begin to look vulnerable as shown by the sell-off in the NASDAQ as yields have moved higher. This should push investors into cheaper parts of the equity market more leveraged to the expected economic recovery. The positive economic story is still positive for equities and higher yielding parts of Fixed Income. Financial and commodity sectors could be two key beneficiaries of this. One can also differentiate between regions – the problems in Europe mean that inflation is less of a concern to bond investors, and equally if there is a lag in the economic recovery story given the problems with the vaccine rollout, it may well be that both equities and credit benefit later in the year. Do not forget that we still expect the economic and inflationary boost to be transitory (in line with the Fed).
The US Dollar
Interestingly one of the key consensus trades of the year – a weaker US dollar – is somewhat under pressure at this point. As US Treasury yields go higher as a result of the US recovery story, so the US dollar’s decline has stalled. This has pressured some Emerging Market economy currencies and resulted in rate hikes just at the time when they are at their most vulnerable. Brazil and Turkey have both raised rates significantly this week. According to Bloomberg analysis, the Turkish lira has weakened 7% in the last month alone*. I would expect that once the economic boost unfolds and investors become more comfortable with it being a broader based recovery and then a move back towards longer trend growth and inflation, we should see the US Dollar continue its longer-term decline. But again, uncertainties are rising and the US Dollar is still the go to risk off currency.
*Source: Mirabaud Asset Management and Bloomberg, 19 March 2021
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