Worries about the economy overheating appear to have been overdone as the delta variant reminds us that the battle with the pandemic is far from over. Bond yields have responded accordingly and investors should prepare for the possibility that the US 10-year yield will hit 1% again soon. Meanwhile the planet is overheating and climate disorder is very evident. Carbon reduction will become one of the most important investment strategies as investors respond to the urgency of combatting climate change.
Recovery still the story
The macro narrative remains one of a post-pandemic recovery. However, recently markets have been reflecting concerns about growing COVID case numbers as the Delta variant becomes dominant and what that might mean for the pace of re-opening, the effect on supply of goods and labour and renewed pressures on healthcare provision. The good thing is that in developed economies, vaccination rates have risen strongly in recent months and the evidence is that, on the whole, vaccines provide protection against serious illness. So despite some wobbles, equity and credit markets continue to reflect a positive macro outlook.
Policy on hold
Monetary policy remains supportive and markets are still only fully pricing in a first rate hike in the US at the beginning of 2023. Moreover, concerns around inflation appear to have eased. The 5-year/5-year forward break-even inflation rate derived from the US Treasury Inflation Protected Securities markets (TIPS) has fallen by 30 basis points (bps) since it peaked in May. The bond market is saying that the US economy is not overheating.
Rates remain low and could go lower
So it looks like long-term bond yields will remain low for some time. Real yields have fallen below -1% again and with inflation expectations coming off the boil, this has meant a sharp fall in nominal US Treasury yields during the last month. There are technical factors impacting bond pricing – namely the fact that the US Federal Reserve is buying more bonds than are being issued by the Treasury on a net basis. I would also repeat the strength of US bank buying of Treasuries as well. Of course, summer illiquidity is adding to a bit of volatility in rates markets but the trend is lower 10-year yields. I would not rule out Treasury yields testing the 1% level in the weeks ahead.
Equities still provide a risk premium
Lower for longer rates, ongoing QE, potentially more US fiscal stimulus, huge household savings – these are the ingredients for further positive returns from equity markets which reflect growth and benefit from positive relative valuations compared to fixed income. In my opinion, mapping asset valuations to fundamentals suggests that rates (government bonds) are the most over-valued because of central bank buying related distortions, followed by credit where spreads probably don’t compensate for longer-term credit risks, and then equities which reflect a powerful earnings cycle.
Risks - pandemic
It is worth going through an exercise of thinking about the risks. Earlier in the year it was inflation and either early Fed tightening or a policy mistake that was seen to be the biggest risk, but central banks seem confident that they can navigate the “transitory” rise in inflation. Perhaps we should focus on some other risks. One might be that the pandemic is far from being under control and that the relaxation of non-pharmaceutical interventions is raising the risk of new variants that will test the efficacy of the 2020 vintage of COVID vaccines. The rapid acceleration of the Delta variant is certainly causing alarm in government and public health circles. Here in the UK, the test-and-trace system is going into overload as a result of Delta, with massively disruptive implications for businesses who face shortages of workers being forced to self-isolate. This continued pandemic risk is likely to be a recurring source of “risk-off” events in the financial markets until more and more countries can reach herd immunity and the risk of further mutations is thus reduced.
Risks - climate
Something which is clearly not under control is climate change. Just in July, the world registered record high temperatures in North America and catastrophic flooding in Europe and China. There is a growing sense that government complacency is not addressing the urgent need to slow CO2 emissions. A focus on limiting the upfront costs of the energy transition risks much bigger costs later on in terms of disruption to economies, social systems and the natural environment. It’s easy to see how climatic events impact on economic activity and – potentially – investor confidence in the outlook. The checklist of policy initiatives really needs to include an acceleration in the growth of renewable energy; increased infrastructure spending to facilitate the shift to electric powered transportation; more funding for research and development of technology to address the hard to abate levels of economic activity; tax incentives for carbon offset projects and tax increases for carbon consumption. There is a social aspect too. Education has a role to play as CO2 reduction targets won’t be met if the public doesn’t get the message and change some behaviour accordingly. Within the financial industry, carbon reduction strategies are becoming increasingly important, helping to facilitate the energy transition.
Long-term trends to ponder
The long-term investment outlook has to consider what the lasting implications of the pandemic and the urgency of the climate crisis will be. Some of the things that spring to mind include the notion that peak air travel is well and truly behind us until an economically scalable sustainable alternative to jet fuel is developed. Another is that the working from home genie is not going back in the bottle. The machismo displayed by some financial institutions insisting on full time back in the office is unlikely to be the norm across the private sector. Thus, there are long-term implications for urban planning and infrastructure spending, on the demand for smart-housing and on how much households spend on leisure relative to commuting. On the financial side, blockchain technology is likely to lead to changes in bank operating models, on payments systems and potentially even on financial instruments like equity and mutual funds. Decentralising all kinds of activity has become desirable and achievable which has huge organisational implications.
Need to adapt
The growth opportunities lie in companies that are disruptive, that embrace new technologies and show flexibility in managing their human capital. Most companies need to be transitioning to become more sustainable and investors will facilitate that by their ability to allocate capital and their role in engaging with the management of companies as equity owners and creditors. Unfortunately, I am not so enthusiastic that governments will lead the way when politicians remain focused on the electoral cycle and ideological vanity projects. The EU stands a good chance with its overarching plans for net zero and green infrastructure plans. In contrast, bipartisanship in the US and what appears increasingly like incompetence in the UK risk policy not being able to meet the needs of adapting quickly to a more sustainable future.
I was mostly joking when I last wrote this note about England’s prospects in the Euro 2020 championship. In the end, the team did very well and really had good opportunities to beat Italy in the final. Penalties are harsh, as my French and Spanish colleagues will agree. It was a great tournament and I can’t wait for the season to start in August. But before then I hope everyone can enjoy summer, at home or away.
All data sourced by AXA IM as at Friday 23 July, 2021.
Advertencia sobre riesgos