It is certainly an interesting time to be involved in financial markets as we continue to see a curious series of events. We have recently seen bond yields rise steeply and equity markets give up the gains made earlier in the year. Ten-year gilt yields have more than quadrupled this year from 0.18% to 0.81%, and their US counterparts have risen from 0.91% to 1.48%. Within equity markets, particularly in the US, the growth stocks that came through the pandemic in good stead have now suffered most as long-dated interest rates rose.
While the above is clearly beginning to have momentous effects in markets, central banks still do not appear as if they are looking to tighten policy for the foreseeable future through retained low interest rates.
Why are bonds selling off?
It appears to be all about inflation fears. Inflation will rise this year due to the base effect of low prices for oil and commodities during the pandemic shut down last year. The spot price of West Texas Intermediate (WTI) crude oil went briefly negative last year as supply exceeded demand and storage capacity. The fear is that Biden’s $1.9bn stimulus package passed by the House, on top of a post-pandemic recovery, will push inflation up. Federal Reserve Chairman, Powell, clearly thinks this is not an issue. However, the market fears that it is the case and is testing his resolve.
What do the last few days tell us about positioning?
- With inflation likely to be a key theme into 2022, the FC Financial Planning portfolios continue to be positioned to retain inflation protection through being invested in funds that focus solely on US TIPS (Treasury Inflation-Protection Securities) which continue to provide the cushion of inflation protection going forwards. For the first time in many years, we are experiencing an environment where inflation is being driven by both demand-push inflation but also cost-push inflation. We expect these twin forces to continue to nudge inflation upwards.
- Having flexibility within investment thinking could be critical to protect capital going forward through volatile markets. The FC Financial Planning portfolios continue to be actively managed and regularly monitored by our investment partners to ensure the propositions are well-positioned to tackle varying market conditions, as part of our investment planning services. The portfolios continue to use talented alternative investment managers with strong propositions and a proven track record to be able to generate returns in all market environments, with a low level of correlation to equities and bonds.
- We believe maintaining Asian exposure is important. Historically, when bond yields rise in the US, emerging markets (EM) underperform as the higher yields put a handbrake on growth by raising the cost of servicing EM / Asian issued dollar-denominated debt.
However, there are two key reasons why markets may not react as strongly as they have in the past, should the US raise rates. Firstly, unlike previous periods of rising interest rates, Asia now has much stronger sovereign and corporate balance sheets. As we have written about extensively, Asian countries haven’t had to use the ‘bazooka’ like western economies whose debt to GDP ratios have gone through the ceiling. Secondly, any effects of the rate rises will be offset by strong global growth, which we still believe to be robust and in a good position to withstand any monetary tightening. Thus, markets may not react as negatively as they have in the past.
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