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An unsustainable trinity

Higher inflation pushes real yields down and equities up, but how long can this dynamic last?

In a relatively quiet week for summertime markets, perhaps the most noteworthy development came from higher-than-expected US inflation data, which led to a slight rise in Treasury yields during the past several days. US Core CPI rebounded to +1.6% year-over-year, reversing the recent trend towards lower inflation prints.

In part, this could represent a reflection of how the Covid-19 recession has impacted the supply curve as well as weighing on aggregate demand.

Anecdotally speaking, it may not come as a surprise to see some firms respond to higher operating costs by increasing their prices despite diminished competition, as weaker entities struggle to survive in some sectors.

Inflation expectations

Nevertheless, we believe that it would be very surprising to see inflation trend too much higher for the time being. Significant output gaps and elevated unemployment should keep a lid on wages and, notwithstanding the economic improvements seen over the past couple of months, output remains substantially below end-2019 levels.

However, with the Federal Reserve communicating that it would like to see inflation above target for a period of time before it even begins to consider raising policy rates, this serves as a reminder that inflation may not be dead and could have ramifications into 2021, as and when the output gap starts to close.

With financial markets constantly looking ahead, one might think that this could lead to bear steepening pressure on the yield curve. However, for the moment it appears difficult to project yields moving very far at a time when central banks globally are focused more on downside risks to economic activity, pursuing a policy stance of abundant liquidity and ensuring de-facto yield curve control.

Meanwhile, breakevens on US inflation-linked bonds have been climbing steadily and are now more than 100bps higher than they were at the end of March. With nominal yields relatively anchored, this has consequently seen real yields move deep into negative territory – a factor which has been cited as giving further fuel to the stock market rally, given the valuation gap between equities and long-dated inflation-linked bonds.

For now at least, even higher inflation prints are good news for stocks, although this won’t always be the case.

September supply reset

In Europe, summer markets have seen a slow-but-steady grind tighter with respect to Eurozone sovereign spreads and investment-grade corporate bonds. More recently, CDS indices have lagged the rally in cash assets.

Decompression has also continued to be a theme in credit markets with higher-quality assets outperforming lower-quality peers on a beta-adjusted basis. Should spreads move wider, we believe that investment grade-rated bonds are likely to find more support in any sell-off thanks to ongoing central bank purchases.

However, should spreads rally further then cyclicals will probably start to outperform and lower-rated issuers could play catch-up. Yet with underlying economic activity still well below end-2019 levels, fundamentals are set to remain challenged in a number of sectors. Meanwhile, supply is set to return in September and this could lead to the re-pricing of issues in the secondary market.

European containment efforts fail to show in the data

UK data demonstrated the extent to which the economy has underperformed during the Covid-19 crisis. Quarter-on-quarter, the UK economy contracted by more than 20% in Q2, while the declines in France, Italy, Germany and the US were much more modest at -13.8%, -12.4%, -10.1% and -9.5% respectively. Data points are likely to rebound in Q3 and Q4, but we would note that prospective economic performance in 2021 could well see the UK underperform again as the reality of Brexit starts to bite.

More broadly, patterns in economic data are yet to show a material outperformance of the Eurozone versus the US economy, despite countries in the region having done a much better job of controlling the spread of the virus. With suggestions that US infection rates having plateaued and that a vaccine is on its way, those calling for the end of US growth exceptionalism may yet prove premature in their assessments should good news continue to dominate.

This could call recent US dollar weakness into question. In this case, we feel that gains versus other currencies in developed markets could be limited, but if there is one part of the market which retains some cheapness on valuation terms it’s emerging market local currencies. From this point a view, a continuation of risk-on sentiment could see some catch-up being played with EMFX largely underinvested at the present point in time.

Elsewhere in emerging markets, ongoing weakness in the Turkish lira has seen EMEA assets underperform Asia and Latin America. However, Turkish credit spreads have tightened in anticipation that renewed FX weakness will act as a catalyst for a return to more policy orthodoxy. In Lebanon, pressure for change is also perceived as potentially positive with respect to credit.

A Democratic clean sweep

We head toward this weekend’s virtual China-US trade discussion expecting an uptick in rhetoric but limited risks with respect to the Phase 1 trade deal agreed earlier this year. At the same time, fiscal discussions in the US continue to drag on – although executive orders from Trump appear to have mitigated the downside risks associated with a continued impasse, at least for the time being.

Otherwise, attention was focused on Joe Biden’s selection of Kamala Harris as his running mate. A Democratic clean sweep appears to be expected by markets, though this prospective outcome seems to have done little to dent enthusiasm for US stocks, with the S&P pushing up to the record highs printed in February, prior to the onset of the coronavirus.

Looking ahead

It appears that we may have navigated some of the potential ‘trip-hazards’ that we highlighted last week with respect to data releases and policy developments. Volatility has subsequently dropped, though sharp falls in the prices of gold and silver offered a reminder that market sentiment can turn abruptly, particularly in markets that have trended for some time.

Thin summer markets also run the risk of exaggerating price action on both the upside and the downside.

Paying particular attention to market technicals and positioning are disproportionately important during such periods and it is interesting to observe some jurisdictions where assets are over-owned in consensual trades with questionable fundamentals relative to other opportunities which seem to be under-owned and under-analysed by comparison. This continues to give rise to relative value opportunities, which may not represent ‘home runs’ that can deliver outsized returns but can offer a solid incremental contribution.

In surveying the economic landscape, the divisions between success and disaster stories only seem to be growing more stark as 2020 unfolds. Many policymakers we speak to remain confused and concerned at the speed of the recovery in financial markets during the past several months. There is a sense that there is still a lot of economic pain ahead, notwithstanding the relatively bullish sentiment implied in many valuations.

On the other hand, the prevailing sense that central banks will only add to asset purchases if we see renewed negative momentum means that equity bulls can shrug off any disappointments with a change in policy rhetoric seeming unlikely.

Equity valuations may appear rich on many traditional measures, yet the dividend yield on the S&P 500 remains almost 3x as great as the prevailing 10-year Treasury yield. From this point of view, it may seem that financial repression from ultra-accommodative monetary policy continues to have the potential to drive investors towards more risk-seeking assets over time.

Generally speaking, the summer months have been quite benign and quiet in financial markets. An absence of negative catalysts may sustain this status quo for some time longer, yet it also seems unlikely to us that such calm conditions can persist uninterrupted through to the end of this year.

Moreover, we have also historically seen that it is just when the bears throw in the towel (as may now be happening in the US stock rally) that this is the time when markets become more vulnerable.

Bulls may argue that a Covid-19 vaccine is just around the corner – though should this lead central banks to start to back away from their supportive stance, higher yields could soon become the biggest threat to the broader market. As a result, we remain content to keep risk at relatively low levels for the time being.

Of late, both good news and bad news has been seen in a constructive light by investors, but ultimately this narrative may appear as likely to persist as Trump is likely to end up with his face all over Mount Rushmore.