This move has triggered — and has been reinforced by — a shift in narrative. Concerns about economic relapses, which had dominated market narratives, have been replaced by concerns about inflation from rapidly recovering economies in the short term and an upward shift in fiscal spending over the longer term. In reality, much of the coverage has conflated the near-term and medium-term issues. In the near-term, sharply rising headline inflation numbers in the United States and elsewhere are actually largely the mechanistic result of low base effects of extremely weak inflation a year or so ago.
The medium-term question is whether the rise in long-term rates reflects growing evidence that, led by the Biden administration, we would be entering a new policy regime which would give pride of place to sustained deficit spending to boost median incomes. This would be occurring in a context where the world was adjusting to arguably less free trade, certainly more regulation, and monetary policy that has been ‘unorthodox’ for over a decade. Yet, a durable spell of inflation takes years to form—the inflationary decade of the 1970s had its root in the monetary policy mistakes that began in the early 1960s. Therefore, it is not yet necessary to make a call on whether the inflation has reached a ‘regime change’ moment. After all, to be too early is the same as being wrong.
In any case, worrying about inflation feels very retro, and it is, especially when the term “bond vigilantes” starts being revived. Yet it is clear these worries have driven an adjustment in inflation expectations, which has, in turn, spurred a powerful rotation in equity markets and strong performances by commodities. In our view, there is every chance of a respite from the seemingly relentless recent rise in long-term interest rates, because from May the base effects that have been making the momentum of change seem so uncomfortable, should fall away and headline inflation rates should moderate as a result.
Such a respite, should it occur, would have important implications for performance across asset classes and geographies over the next two quarters. Bonds could rally or at least consolidate, a weaker dollar could take the pressure off emerging markets and some of the rotation that has occurred within equity markets could unwind. Nevertheless, we expect growth to be powerful and globally synchronised over the next 18 months and this pause not to be permanent. The interest rate cycle has by no means run its course.
The key thing to watch is the path of real rates in the years ahead. For now, it is hard not to remain broadly sanguine on risk assets given the quiescent level of real rates. Real five-year rates five years from now are currently 0.11%, well below the circa 2% peak seen after the GFC, let alone in the 1990s. Most of the adjustment in bond yields has been driven by a shift in inflation expectations. Provided real rates remain anchored, risk assets should continue to do well. These fundamental dynamics and anchors should always interest us more than market narratives, which as we saw last year can be quite flawed and a perennial source of misdirection.
So what are the implications for the positioning of the Ninety One Global Strategic Managed Fund? We stuck with a long equity view throughout the first quarter and in the event equities traded well, despite the increasingly shrill inflation narrative. We took profits early in the year on the investment-grade bonds that we had bought in the aftermath of the Covid crisis – spreads had tightened to levels that were unlikely to compensate our investors for the inherent duration in the position and that took our overall bond duration down to minimal levels. We suspect that as headline inflation figures improve from May, the upward march in longer dated US Treasury bond yields is likely to flatten out. Indeed we could already have entered a counter trend rally in bond markets – our strategic preference however is to remain short duration. Such a development should be good for equities over the next two quarters, which are also likely to benefit from normalisation and ‘opening up’ and robust earnings. It could also see the Dollar soften once more, which would be good for Asia and emerging markets – the very areas that suffered as the inflation narrative took hold in the first quarter.
So ‘make hay while the sun shines’ because concerns about moderating liquidity support are likely to resurface later in the year as investors start to look to 2022. DM/BM
This article was written by Philip Saunders, Co-Head of Multi-Asset Growth, Ninety One