Chief Investment Strategist and Chief Economist
March 22, 2021Posted InInvestment Strategy
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US policymakers are focusing upon further rescuing the economy rather than fixed income investors. We see further upward pressure on long-term interest rates, steepening the yield curve intermittently during the next two years.
Who needs the rescue now, the economy or the bond market?
History’s largest fiscal stimulus (14% of US GDP) at a time when vaccines are putting down the COVID pandemic should vault US growth to 6% or above in 2021 and boost imports sharply. Global growth may eclipse 5% this year and sustain a 4% rate through 2022 or longer.
US inflation should rise above 3% over the remainder of 2021.
The inflation outlook for the longer-term depends on how gradually central banks move away from monetary policies suited for economic collapse and the global health emergency.
The Federal Reserve says its key policy rate is expected to average 2.5% over the longer-term. This is very likely an exaggeration. However, given the central bank’s higher inflation target and an eventual normalization of term premia, 2.5% does seem a reasonable average for 10-year US Treasury yields in the coming few years.
In the near term, a large rise in US bond yields relative to other developed markets and a plunge in hedging costs suggests upward yield pressures will soon slow.
In 2019, we added gold as a tactical overweight on plunging global interest rates. With long-term yields reversing their plunge after gold has appreciated sharply, we’ve eliminated the overweight. We do see gold and other real asset returns supported over a longer-term time frame as central banks seek higher inflation to ease debt burdens.
We’ve raised tactical allocations to UK shares and US Treasury Inflation Protected Securities, pushing up both our global equity and bond allocations slightly. UK equities have been hamstrung by a heavy cyclical composition of industries most exposed to COVID disruptions. The now largely resolved political uncertainties of the past five years have left UK valuations cheap. Shares trade at 14X 2021 EPS with a 4% average yield.
Like most bonds, TIPS have a high valuation. Nonetheless, the 14% drop in long-term US Treasury prices in the year-to-date has improved the return outlook. Investors will directly earn gains in US consumer prices. The TIPS inflation benchmark trends higher than the Fed’s preferred inflation gauge. We see TIPS as a low risk asset within our deeply underweight global fixed income allocation (now -9.5%).
The Fed’s decision to end emergency rules allowing US banks to buy Treasuries with lessoned capital requirements may slightly exacerbate the bond rout. At the margin, however, it is more likely to raise customer funding costs and put even more downward pressure on deposit rates.
We discuss Brazil’s struggle with a Covid surge and populist pushes below and in a separate LATAM bulletin.Download: Quadrant