July 8, 2021—There has been a very clear shift in investor sentiment in the past few weeks, manifested most clearly by an acute drop in long-term interest rates and a flattening of the yield curve, both in the U.S. and globally. What is much less clear is what is causing this shift that, until recently, has left equities unscathed but may now be broadening to look more like a classic risk-off market. In brief, we believe that these market shifts are being primarily driven by concerns on the part of both market participants and global central banks that the Delta variant will significantly slow the post-COVID global economic recovery. While we are sympathetic to that view, we nonetheless expect any U.S. equity correction to be short and shallow before stocks resume their climb upward, and we are retaining our current equity overweight.

Taking stock of the market

The 10-year Treasury yield peaked (for the year thus far) on March 31 at 1.74%. Not long after, inflation expectations, as measured by the 10-year TIPS (Treasury inflation-protected securities) breakeven rate, topped out at 2.56%. Since then, interest rates and inflation expectations have fallen, with the 10-year yield nearly half a point lower—a dramatic drop in percentage terms of -26%. This move has defied the expectations of many investors—including us—for rates to head higher and the 10-year yield to approach 2% by the end of the year. The broad equity market, as evidenced by the S&P 500 index, had remained unharmed until this week. However, underneath the surface the market has rotated away from cyclicals and value-oriented stocks and back toward growth stocks, which have shown themselves to be resilient and able to generate earnings and revenue growth in the face of weaker economic conditions. In the last month alone, the Bloomberg pure growth factor (with market beta peeled out to isolate just the factor return) has outperformed its value equivalent by 3.9%.

A compounding of concerns

While movements in the market are observable, the causes for investors piling into bonds or out of cyclical equities are not. Instead, we are left to conjecture about what has shifted in terms of investor expectations and whether these concerns will persist. We point to a few interrelated factors that appear to be feeding off one another and resulting in elevated market risk:

  1. COVID-19 variants—Newer viral strains pose a growing risk to the global economic recovery, particularly in areas of the world with lower vaccination rates (Figure 1). Even in the UK, where nearly half the population is fully vaccinated, the Delta variant is causing an increase in daily cases—particularly in younger, unvaccinated individuals, though death and hospitalization rates have not yet increased materially. Initial trials have revealed mixed results for the efficacy of existing vaccines against the various strains. For those countries facing greater vaccination challenges, the faster-spreading variants could result in more lockdowns and a stalled economic recovery.

Figure 1: COVID-19 variants remain a risk

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Sources: World Health Organization, Macrobond. Data as of July 7, 2021.

  1. Supply chain disruptions and labor shortages—There is a causal relationship between a delayed global economic recovery and more persistent supply chain issues that have resulted in delayed production and delivery of goods, increased input prices, and slowing economic growth. A key reason we have expected inflationary pressures to fade as we move into 2022 is because we see supply chain disruptions and labor supply shortages receding as the global economy moves beyond COVID. In the U.S., labor is in short supply for a number of reasons, and the ISM Services report on business employment showed a contraction of labor conditions in June, yet job openings are the highest on record (Figure 2). An extension of the global recovery timeline could lead to more durable increases in input, wage, and end-consumer prices that accelerates monetary policy tightening.

Figure 2: Record level of job openings in the U.S.

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Source: U.S. Bureau of Labor Statistics. Data as of May 31, 2021.

  1. Hawkish Fed—A decline in TIPS breakeven inflation rates would suggest inflation risks are actually receding, likely because there is a growing consensus that the Fed’s tolerance for above-target inflation may not be as high as once believed. For some market participants, this means reduced probability of the Fed falling “behind the curve,” while others have gone as far as to allude to the Fed abandoning its average inflation targeting policy (a policy made public in 2020 whereby the Fed is trying to target an average inflation rate over a period of time, meaning inflation would have to overshoot the 2% target to compensate for prolonged periods of undershooting). In our view, we think this is a misinterpretation of the June FOMC meeting and newly released meeting minutes. While the Fed’s median expectation for the first rate hike was accelerated into the end of 2023, we still think Chair Powell is focused more on recovery of the labor market than reacting to above-trend inflation. On the labor market, the June jobs report showed an impressive 850,000 net new jobs created but a stagnant labor participation rate, suggesting a longer road to a full, inclusive labor market recovery and a shallow rate-hike cycle.
  1. Short squeeze and rebalancing—Lastly, technical factors are likely exacerbating the move lower in yields. A consensus that rates would move higher put all investors on the same side of the boat, so to speak. With so many investors short fixed-income duration, an initial move lower in rates below key technical levels would result in “short covering” of those positions, which forces investors to sell securities to buy bonds, thereby further reducing rates (as bond yields move inversely to prices and tend to decline when demand for bonds increases). This type of vicious cycle was discussed in our 2021 Capital Markets Forecast as a possible contributor to broader market volatility. In addition, with the first half of the year behind us, investors could be rebalancing away from equities, which have had an impressive run, toward bonds, an asset class many are currently underweight versus their targets.

Staying the course

We are not dismissive of the risk factors described above and are monitoring market and economic developments closely, but we expect these risks to recede as the summer continues. The global vaccination campaign remains on track, if uneven across regions. Moreover, domestic fears about the variants could serve to motivate more individuals currently on the fence to receive the vaccine. While inflationary pressures could be stickier if the global economic recovery is delayed, we do not think the conditions are ripe for runaway inflation like we witnessed in the U.S. in the 1970s. Changes in policy are coming, including details around a tapering of asset purchases and eventual increase in policy rates. In our view, the Fed has the balance right and does not appear to be on the verge of committing a major policy mistake.

Our July/August Capital Perspectives letter warned of a possible increase in volatility in the second half of the year, and we are maintaining our conviction in our key calls: overweight to equities versus bonds, expectation of higher rates and a steeper yield curve, and a slight preference for value over growth but a commitment to diversification with no less than a market weight to technology stocks. We think the current volatility bout comprises a bump in the road of a much longer economic recovery and bull market for equities. 

 

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Definitions:

Beta: Beta is a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole. 

Bloomberg Pure Growth Index: The Bloomberg Pure Growth Index represents Bloomberg estimated performance of the growth factor, a composite metric, that aims to capture the difference between high and low growers by using historical fundamental and forward-looking analyst data.

Bloomberg Pure Value Index: Bloomberg Pure Value Index represents Bloomberg estimated performance of the value factor, a composite metric that aims to differentiate “cheap” from “rich” stocks based on fundamental and analyst consensus data.

The S&P 500 index measures the performance of approximately 500 widely held common stocks listed on U.S. exchanges. Most of the stocks in the index are large-capitalization U.S. issues. The index accounts for roughly 75% of the total market capitalization of all U.S. equities.

Indexes are not available for direct investment.

Reference to the company names mentioned in this blog is merely for explaining the market view and should not be construed as investment advice or investment recommendations of those companies. Third party trademarks and brands are the property of their respective owners.

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