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Weekly investment update – Waiting for the summer

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BNP Paribas Asset Management
 

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As economies reopen, stronger economic data demonstrates that the cyclical recovery is progressing well. Signs of an intensifying spread of the Delta variant of Covid-19 are, however, raising questions about the outlook.   

COVID-19 – Delta on the rise

Worldwide new Covid-19 cases have now plateaued at 370 000 per day, while infection rates in India have encouragingly fallen to 50 000 per day.

In the UK, however, infection rates are at their highest since early February; and the detection of the ‘Delta-plus’ variant is a concern as it presents a risk of the vaccine-resistant variant spreading. Moreover, the pace of vaccinations in the UK has eased, with less than two-thirds of the adult population having received two doses.

Elsewhere, rising cases have led to renewed pressure on some countries to implement lockdowns, with South Africa and Malaysia imposing fresh restrictions on activity over the past week.

The intensifying spread of the Delta variant threatens to unnerve markets. European travel stocks dropped 1.2 % today, taking their weekly fall to close to 6 %.

Valuations of safe haven assets have risen this week. The yield on the benchmark 10-year US Treasury bond, which has sat below 1.6 % for most of June as markets await clear monetary policy signals, has dropped by 2bp to 1.46%. Germany’s equivalent Bund yield fell by the same amount to minus 0.19%.

A lot of Fedspeak

Commentary from the US Federal Reserve should moderate after a large number of central bankers spoke last week. We saw clear hawkish differentiation from policy-setting committee members Kaplan, Bullard and Rosengren, but there was a relatively dovish tone from the weightier Williams and on balance from the more centrist members of the Federal Open Markets Committee (FOMC).

Hawks Kaplan, Bullard and Rosengren are seeing upside risks to inflation and prefer to begin tapering sooner than later. Williams – one of the more influential FOMC participants outside of Chair Powell, Clarida and Brainard – struck a relatively dovish tone, saying that although the economy is opening more quickly and strongly than expected, now is not the time to normalise policy.

On 29 June, Fed governor Christopher Waller told Bloomberg TV: “We are now in a different phase of economic policy, and so it’s appropriate to start thinking about pulling back on some of the stimulus”.

The Fed has bought USD 120 billion of bonds a month since last March under its monetary stimulus programme that has raised government debt prices and reduced yields, making equities and other risky assets more attractive investments.

Markets have brought their expectations of Fed rate rises closer and are now expecting the central bank to raise policy rates once in 2022 and twice in 2023.

Moving towards stimulus tapering

As we move closer to the point where the Fed first signals and then starts tapering its asset purchases, US real yields should rise and breakeven inflation rates fall, although to a lesser extent.

It seems unlikely that such tapering will provoke a tantrum in the markets this time around; it could even be a non-event. The result could be US 10-year yields rising to end the year at 1.9% before extending their rise to 2.2% by the end of 2022.

Such a move would imply 10-year real (inflation-adjusted) yields rising by about 20bp a quarter in the third and fourth quarter and by 10bp in 2022 such that they finish next year at zero.

Next up, June US employment report

This week (2 July) will see publication of the latest US non-farm payroll report. Supply constraints are expected to continue to limit the pace of hiring.

The consensus is for non-farm payrolls to have risen by around 700 000 for the month, up from 559 000 last month. This would take the unemployment rate down by 0.2% to 5.6% and the employment-to-population ratio up by 0.2% to 58.2%.

US infrastructure deal back on track

After a U-turn from President Biden, the bipartisan infrastructure deal appears to be back on track.

Following opposition GOP criticism of Biden for making a USD 1.2 trillion bipartisan agreement conditional on passing another reconciliation bill, the president retreated on that conditionality, bringing Republicans back into the fold with reassurances.

The revised base case for the total amount of extraordinary fiscal spending, including the bipartisan infrastructure bill, is now USD 2.5 trillion, partially offset by USD 1 trillion of taxes, over the next eight to 10 years.

Meanwhile in the eurozone

After a consensus-beating improvement in the national economic surveys for June, including the German Ifo business climate index and the Italian economic sentiment index, the eurozone economic sentiment indicator showed a significant improvement.

It exceeded consensus forecasts, with the index rising to its highest since 2000. The rapid recovery in demand, while in the eurozone too supply is still constricted by bottlenecks, is producing growing inflationary pressures, which some think could be persistent rather than transitory.

In June, however, eurozone inflation fell

As was expected, eurozone inflation inched back to 1.9% in June from 2% in May. Markets are not reading too much into this decline since adverse base effects are distorting the picture somewhat.

The expectation is for inflation to reaccelerate soon, with a rise in the eurozone harmonised consumer price index to above 3% towards the end of the year. While transitory forces will still largely be at play over the coming months, these are expected to translate into more underlying pressures such as wage growth and higher medium-term inflation expectations over time.

Higher inflation in Europe could lead to higher eurozone bond yields and steeper yield curves into early 2022. After peaking in early 2022, inflation should slow due to seasonal factors. This decline, together with a softening in macroeconomic data, is likely to see the benchmark 10-year Bund yield back at zero by the end of 2022.

Exhibit 1 A small fall in eurozone inflation

Overall, the coast looks clear

The outlook remains constructive for risky assets since they should do well in an environment where economies are reopening, growth is rebounding, and policymakers remain accommodative.

Equity markets should generally cope with higher bond yields and may even surprise to the upside.

In credit markets, we believe valuations are on the rich side, especially in investment-grade (IG) credit. Rising yields make IG credit look less attractive versus government bonds. In such a context, high-yield debt may be preferable for income and its shorter duration.


Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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