Possibility of higher inflation – risk for certain assets, but opportunity for the other

Expected fiscal stimulus and encouraging COVID trends continued boosting equity prices higher in February; but by the end of the month rising treasury yields put such rally on hold;

Rising Inflation expectations were largely responsible for correction in bond markets, but also for very diverse performance in equity space.

To a large extent global equity performance in February resembled January developments. During most of the month indices rallied higher to new all-time highs for similar reasons as in January – upcoming 1.9 trillion stimulus bill and COVID trend improvements. However, by March large part of these gains did not hold. And if key reason for late month sell-off in January was related to financial risks associated with Gamestop ‘’short squeeze” saga, this time negative impact was mainly linked to developments observed in bond markets.

Performance of global equities (MSCI ACWI EUR index)

Source: Bloomberg

In last report we already mentioned how rising bond yields may negatively impact “growth” equities through revaluation of their fair value, and unfortunately this risk materialized during second half of last month. As previously discussed, new fiscal stimulus bill should significantly increase supply of treasuries in USA, and if it is not balanced by the same increase in demand, it is natural for treasury yields to rise. Moreover, negative impact on price of bonds and not just in USA, but globally may come from rising inflation expectations.

Performance of global bonds

Source: Bloomberg

Worry about rising inflation comes from already observed supply shortages for certain goods like semiconductor chips or various commodities. Such shortages are mainly explained by the fact that due to government fiscal support, which did not reduce personal income and capacity to spend during pandemic despite recession, demand for certain goods continues to be strong. Meanwhile, lockdowns put some limitations on available supply and manufacturing capacity.

But in addition to existing inflation pressures, there is maybe even bigger fear that when economies would reopen, demand for yet unavailable in lockdown goods and services would be so significant that their prices would immediately and drastically jump. For example, when borders would be reopened and air travelling fully allowed, desire to have vacation abroad may be so strong and widespread among population that there would be both not enough plane tickets available for everyone, as well as larger indifference as to what amount of money to pay. And this is just one of many examples how spike in inflation may be realized.

US 10-year expected inflation rate

Source: Bloomberg

So with each month bond investors are becoming more and more concerned that rising inflation expectations may actually cause FED and other central banks start thinking about shifting their monetary policy from easing to tightening much sooner than it was previously expected. From historic perspective global bond yields still remain close to record low “zero” levels (or even negative as for European treasuries), and if with time inflation concerns indeed would cause central banks to raise rates, negative impact on bond prices (especially, those with higher duration) can be very prolonged and significant.

Long term trend in 10-year treasury yields

Source: Bloomberg

But let us return to equity markets. Indeed, since mid-February on revaluation concerns “growth” stocks, predominantly found in IT and consumer discretionary sectors, had one of the worst short-term performances since last March. From this perspective, not surprising that absolutely worst performance in S&P-500 index was shown by one of the main 2020 and “growth story” leaders – Tesla, which declined by 23.5% throughout the month. And another one of the worst performances was shown by even more stable 2020 leader – Apple, which declined by 15.3%. So the question you are probably asking, if performance of leading 2020 names was so poor throughout February, why on balance global indices still managed to show positive month?

The explanation comes from the fact that though rising bond yields negatively impact “growth” companies, it usually positively impact cheaper “value” companies, which often are cyclical in nature and can benefit from higher inflation and return of more stable economic growth (which is expected to happen when countries finally remove all lockdown measures). Indeed, February was very positive month for these “inflation protection” ideas, as sectors such as energy and financials increased by 13% and 9%, and one of the best performances was shown, for example, by airlines and cruise ship stocks. And that plane ticket analog we mentioned earlier should help to understand why.

Performance of selected sectors in February

Source: Bloomberg

However, as global equity index composition is still tilted towards “growth” sectors like IT and communications, global equity indices may on balance still decline in price, if yields would continue to rise. On the contrary, if central banks will be able to stabilize bond markets in March, we might see once again outperformance of high growth equity stories.

Therefore, despite late February sell-off and mentioned risks, for March we remain relatively optimistic. Markets still are likely to be dominated by passing of new $1.9 trillion US fiscal bill, which should stimulate both spending and savings, latter also partially going to financial markets, creating extra demand for risky assets. Meanwhile, if developments in bond markets would start to get out of control FED would probably act to stabilize and put a cap on further increase in treasury yields. Reason is that, given massive budget deficit, unlikely that US authorities would allow budget debt servicing costs to increase significantly, at least for a while and at least until actual inflation indeed becomes exceedingly high. Finally COVID-19 vaccination process is on track and existing decline in spread of virus is very encouraging. Therefore, it may be hoped that lifting of lockdown restrictions might be just around the corner.

US federal outlays interest as % o GDP

Source: Bloomberg

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