Fixed Income
Significant market focus remains on the stimulus fuelled inflationary threat which is pushing up bond yields. The yield on the key US 10-year Government Bond reached 1.77 yield-to-maturity which is the highest point since January 2020 and significantly higher than the 0.90% YTM level in December.
The latest rise centres around economic optimism over the US vaccine rollout and another plan to boost fiscal stimulus. Joe Biden is laying out plans for a $3 Trillion infrastructure stimulus plan on top of the recently passed $1.9 Trillion fiscal stimulus.
Higher bond yields are repricing for higher inflation and higher growth.
European debt has also come under selling pressure with German-10-year Bund yields rising to minus 0.27% and UK 10-year gilt yields reaching 0.84%.
The markets are now pricing in inflation running at 2.4% each year for the next 10 years above the Central Bank’s long term 2 % target. However, the US Federal Reserve is betting that US growth will come roaring back later this year as the economy reopens but that inflation, after a brief overshoot of target, will fall obediently back to about 2%. Thus, there is no need to lift interest rates this year or next. Only in 2024 does fed Chairman Jay Powell see the need for the first rate hike. This is a huge gamble and bond market yields are telling a different story. The markets will be keenly watching the inflation numbers going forward.
Equities
Why are higher bond yields a problem for stocks?
Three reasons:
- Higher bond yields make investment in Fixed Income relatively more attractive versus stock market investments
- Higher yields raise the cost of borrowing for companies meaning lower profits e.g. If IBM has to pay 4% interest rate/coupon/yield to issue its bonds rather than 1.5% – that makes difference!
- Analysts decide whether a stock is cheap or dear using valuations often discounting estimated future company earnings. Those future earnings are discounted more heavily in a higher interest environment resulting in lower present-day valuations
So, US (global) equities are nervous especially considering they are trading close to all-time highs although the NASDAQ index is well off highs for the year given the market’s focus on technology growth stocks and the lack of any investment interest/dividends from such stocks. Indeed, in the first quarter of this year we have seen a classic rotation out of growth stocks into more traditional cyclical stocks linked to economic growth.
The questions are:
- Will inflation resurface (only time will tell)?
- At what level of interest rates is that a problem for the stock market – is it a 1.85 Yield-to-Maturity or 2.25% or 2.75% (only time will tell)?
How have other asset classes responded to stronger economic prospects?
Commodities normal rally with any economic upswing: Indeed, Oil is trading close to $65 a barrel (Brent Oil) having trading at $20 a year ago at the height of the economic crisis. Similarly, Copper and Nickel are at multi-year highs. Gold is now trading below $1,700 per ounce suffering as a non-interest-bearing asset as bond yields rise (Gold’s all-time-high is $2,050 reached last July).
Miscellaneous
So general market sentiment is fragile and equity markets are a bit choppy. This was reflected on Wed March 31st when Deliveroo’s shares plunged by 30 per cent in the company’s debut IPO in a blow to ambitions to lure more British tech companies to list in the UK. This, unfortunately, makes Deliveroo the worst opening-day performance in at least a decade!
The move may fuel doubts among large UK institutional investors about the wisdom of lessening London listing rules to attract fast-growing but lossmaking groups.
Deliveroo set is opening share price at the bottom of its target range at 390 pence citing choppy market conditions and following a backlash from some large British investors over corporate governance. The IPO had given Deliveroo an opening valuation of about £7.6 BN, the highest since resources group Glencore’s 2011 IPO. Is it possible London investors do not have the ‘psyche’ to back current loss-making companies investing for the future?
