In this week’s market update: Nasdaq corrects as bond yields rise; the oil price tops $70 threatening more cost-push inflation; and the changing shape of the ongoing bull market
There are clearly echoes of the 2013 Taper Tantrum in today’s volatile markets. The bond market is exerting a big influence on the equity market as it did eight years ago. But no-one is calling this Taper Tantrum 2.0 for the good reason that while there’s a hint of tantrum there’s no evidence yet of a taper.
Last time around the stock market wobbled because comments from the then Fed chairman Ben Bernanke led investors to think that the big market stimulus delivered by the post-financial-crisis quantitative easing programme was coming to an end.
This time the current Fed chair Jay Powell is doing his best to convince markets that the US central bank has its foot to the monetary floor. But bond yields suggest otherwise. The 10-year Treasury yield has risen from around 0.9% at the start of the year to 1.6% today. From a low base that’s a big rise and it reflects fears that the authorities are turning a blind eye to resurgent inflation in their desperation not to choke off the nascent post-pandemic recovery.
The passing at the weekend of Joe Biden’s $1.9trn stimulus bill in the Senate, by just one vote, has raised the inflationary stakes. The package includes cheques worth $1,400 to most Americans. And that points to further upgrades in expectations for US growth, more inflation to come and yet further hikes in bond yields. Because they move in the opposite direction to bond prices that is naturally bad news for the fixed income market.
But it is also bad news for shares, and in particular those parts of the market where valuations are dependent on low rates, the so-called long duration stocks that are expected to grow strongly for many years into the future. These shares have until recently traded at high valuations because using a low interest rate to discount those future earnings increases their value to investors today. Switch to a higher discount rate and today’s value falls.
And that is exactly what has happened since the announcement of vaccines in November but more particularly in the last few weeks. The Nasdaq index which is dominated by these high growth tech stocks has fallen by more than 8% in the past two weeks alone, heading towards the 10% definition of a stock market correction.
For funds that are heavily exposed to this part of the market, it’s been a painful experience. Scottish Mortgage investment trust, with a heavy exposure to the likes of Amazon, Alphabet and Apple has fallen by nearly 30% in just the past month. It remains up more than 70% over the past year, of course, but it is uniquely exposed to a rotation from growth to value.
We will get some hard data on US inflation this week when consumer price index is unveiled. The Fed’s preferred inflation gauge is still below target at just 1.5% but market measures of inflation expectations have risen strongly since the start of the year. Last week, the so-called five-year break-even rate, which indicates the outlook for prices in five years’ time, hit 2.5% for the first time since 2008.
It’s not just the Federal Reserve that is keeping a close eye on bond yields. Here the Bank of England governor Andrew Bailey said this week that the risks of inflation are ‘increasingly two-sided’. Although the Bank recently ramped up its preparations for the possibility of negative interest rates if the ongoing recovery were to disappoint, it is now looking at how best to tighten policy if rapid spending growth pushes prices higher here too.
Last week’s Budget confirmed that the Government remains focused on stimulating the economy and securing the recovery despite making soothing noises to fiscal hawks about the need to balance the books in due course. Although corporation tax is due to rise from 19% to 25%, from the bottom to the top of the G7 range, the tightening is not due to take effect for another two years. In the meantime, spending on supporting jobs and businesses will continue at historically unprecedented levels.
Bond yields have risen sharply in the UK too. At 0.77% for the 10-year debt, these interest rates have risen 50% over the past month.
Later this week, we will hear from the European Central Bank too about its plans to lean against the rise in bond yields, which push up funding costs for businesses and households and so act against the recovery. Inflation expectations are lower in Europe, suggesting that the bond vigilantes, pushing yields higher to test central banks, may have overplayed their hand.
Of course, nothing is set in stone when it comes to bond yields. Markets tend to be self-correcting to an extent and one of the factors limiting the rise in bond yields to even more uncomfortable levels is how they compare with the yield on shares. In the US, the gap that had opened up between the yield on S&P 500 shares and those on Treasury bonds has now closed. An investor can get the same yield on both today making it less obvious that shares represent better value than bonds. That could ease some of the selling pressure on bonds and allow yields to settle again.
This week will test that thesis because the US Treasury is set to issue $120bn of bonds, mainly three year notes but also some with 10 and 30 year maturities.
However, investors looking for reasons to expect inflation to return need look no further than the oil market, which is both a reflection of rising inflation expectations but also a cause. The oil price this week jumped above $70 a barrel for the first time in 14 months after Saudi Arabia, the world’s biggest oil producer, said a storage facility had been attacked. The oil price was already on the front foot after Saudi Arabia and its allies in Opec said they would keep restricting production to underpin the price.
So, there are good reasons to be nervous about the market. The long-term case for a continuing bull market remains intact, however. Some market watchers have argued that the market rally that began in 2009 in the wake of the financial crisis has the potential to be another long-term bull market or supercycle. The extended gains between 1949 and 1968 and again from 1982 to 2000 are the template for such a period of above-average gains and relatively small pauses for breath.
Typically, these periods have lasted for 18 years and delivered an annual growth rate of 18% on average. By contrast secular bear markets tend to be shorter, about 14 years on average, to deliver flat nominal and declining real returns and to include some nasty declines. The period from 2000 to 2013, when the market starting making new all-time highs again is a good example - there were two drops of more than 50% in this period and the market basically went sideways.
Well the current bull market is shorter than the average secular bull and has risen less far. Importantly, valuations, while high, are not excessive.
The interesting feature of long-run bull markets is that they often change shape as they go along. In particular, about half way through the leadership can change from growth focused shares to value, exactly the rotation that we have experienced since last November’s good news on the vaccine front. For stock pickers and the buyers of funds this is a potentially very important shift. If the rotation is more than a passing reflection of rising bond yields and inflation fears and something more serious then the underperformance of tech stocks and the funds, like Scottish Mortgage, which have bet big on that theme could have further to go.
There are other ways to play this shift too. In the second, value-focused phase of the cycle, commodities often outperform, so too do smaller companies. And being on the right side of contrasting pairs of sectors can be very profitable. The classic example of this is energy and technology. When one performs the other tends not to and vice versa. Well currently the gap between the two is wide and has started to reverse.
Investing in the ESG unfriendly energy sector and shunning the future winners in technology is a bold call. But then the best contrarian calls always are at the time.
One last market worth keeping an eye on is China, where shares dropped further this week, taking the decline from recent record highs to 12%, safely past the definition of a correction. Shares in Shanghai have fallen on fears that the market is overvalued and vulnerable to rising US bond yields.
Chinese shares have boomed on the belief that the country was first in and first out of the pandemic. Regulators in the country have been warning about bubbles forming, with a further dose of cold water coming in the form of a lower than expected long-term growth target for the Chinese economy at the recent National People’s Congress.