As expected, May was a month with numerous challenges for capital markets. Various macroeconomic data put the ”Goldilocks“ scenario to the test. In particular, consumer prices in the US rose sharply by historical standards, clearly exceeding even analysts' estimates. It was therefore hardly surprising that the pressure on individual market segments has increased noticeably in recent weeks and highly valued shares came under considerable pressure, especially on the US technology exchange Nasdaq. In the current second quarter, the macroeconomic data for the US economy no longer exceeds investor expectations to the same extent as they did in the previous three quarters. In our view, this could create additional headwind in the coming months.
We do not see a similar development in Europe at present. However, worth mentioning in the Eurozone is the upward pressure on long-term government bond yields, which are slowly starting to move higher. As a result, the volume of bonds with negative yields is shrinking: while the aggregate global value stood at USD 18.4 trillion in December 2020, today, five months later, outstanding bonds yielding below zero amount ”only“ to USD 12.3 trillion.
Inflationary pressure in the US has risen steadily in recent months, as reflected in the 10-year breakeven inflation rate. The Federal Reserve has anticipated the rise and classifies it as ”transitory“. Of note is the very close correlation between ten-year Treasury bond yields and the ten-year break-even rate. However, a gap has opened up in recent months, and this despite the fact that inflation expectations have risen and the wave of issuance of US government bonds has been enormous because of the gigantic government deficit.
We believe that, on the one hand, the interest rate hike in the US from the first quarter of 2021 had to be digested and, on the other hand, the Federal Reserve is by far the biggest buyer of Treasuries at the moment, thus limiting upward pressure on the yield curve at the long end. However, it remains to be seen how long interest rates will remain at the level of 1.6% to 1.7% before the pressure increases in the direction of 2%. We expect the gap to close in the coming months – this increase could put additional pressure on the technology sector, at least in the short-term.
In modern portfolio theory, which was founded by Nobel Prize winner Harry M. Markowitz, the focus is not only on the risk and the expected return of asset classes, but also on the correlation between the individual asset classes. As a rule, a very low – close to zero – or even a negative correlation is preferred. This is advantageous because if investors were to lose money in one asset class, those losses would be mitigated or even offset by gains in the other asset class.
However, in recent months the correlation between the two largest asset classes, equities and bonds, has risen sharply and now stands at 0.53, a level not seen since the late 1990s. The probability has thus increased that bonds and equities will move in the same direction. If inflation expectations continue to rise, this would seem to make sense, as both, long-dated bonds and equities, are likely to come under pressure in the short-term.
The big challenge in the coming weeks will continue to be the development of inflation. How long is ”transitory“ exactly? Will the core inflation rate overshoot? And will the Federal Reserve remain relaxed should inflation numbers continue to clearly exceed expectations over the summer, as they did in April? Investors will certainly have to be patient, and they should stick to their chosen investment strategy even in the event of emerging turbulence. This means that despite stretched valuations, equities should continue to be preferred over bonds, with selection being the winning factor in almost all asset classes. We also recommend increasing the quality within each asset class and refrain from experiments. This means, for example, increasing the allocation to consumer staples – a sector that we believe is attractively valued relative to the overall market by historical standards.
Publisher: LGT Bank (Switzerland) Ltd., Glärnischstrasse 36, CH-8027 Zurich
Author: Thomas Wille, Head Research & Strategy, Email: email@example.com
Editor: Alessandro Fezzi, E-Mail: firstname.lastname@example.org
Source: LGT Bank (Switzerland) Ltd.
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