The hike in US inflation looks short-term for now but the risk to US 10-year treasury bond yields is to the upside, which should favour risk assets and cyclical sectors, says JPMorgan Asset Management (JPMAM) Asia chief market strategist Tai Hui.
Speaking at JPMAM’s market briefing for 2Q2021 on April 8, Hui expects strong headline inflation over the next two to three months, though he says markets have already factored this in.
The real question will be whether inflation growth is going to sustain into 2022 and 2023. Hui admits this is hard to predict, no thanks to the combination of quantitative easing programmes by the US Federal Reserve and stimulus packages introduced by the government, including the most recent cheque of US$1,400 ($1,877.71) given to millions of qualifying Americans. Whether or not this massive quantum of easy money will trigger the return of inflation is unclear for now, he says.
“Frankly there is no clear answer to what will happen at this point in time. If we think about the magnitude of the US fiscal stimulus and the spike in household savings rates in the US, we don’t know if that will be saved or spent. If the money is used to pay down debts, inflation pressures may not be as intense as expected,” says Hui.
In any case, warnings have come from some big names, such as former US Treasury Secretary Larry Summers. “There’s a real possibility that within the year, we’re going to be dealing with the most serious incipient inflation problem that we have faced in the last 40 years,” Summers, now a Harvard professor, told Bloomberg News in February.
The US Fed’s current projection is for near-zero interest rates through to 2023 supported by inflation forecasts, which are then seen to resume to its long-term target of 2% by 2022 and 2023. In the meantime, the Fed sees a spike from around 1.7% now to 2.4% by the end of 2021, revised from an earlier projection of 1.8%.
Hui believes that the Federal Reserve will stick to its accommodative policy. “On the supply side, we don’t expect an ongoing inflation spike in commodities. Job market improvement driving inflation may take longer to manifest. So we think the Fed will hold [rates] stable for the next few years,” he says.
At the Federal Open Market Committee (FOMC) meeting in March, the central bank also voted to keep asset purchases steady with at least US$120 billion worth of bonds purchases a month, although Hui believes that the Fed may start signalling a reduction by 2021.
“I think we could see the Fed starting to signal its intention to reduce asset purchases towards the end of this year, and actually implement the reduction of asset purchases by the first quarter of next year, and gradually winding down,” says Hui.
Where will bond yields go from here?
Hui believes 10-year US Treasury yields will hover around 1.6% in the near term as the bond market waits and observes inflation rates, as it enters into what can be best described as a consolidation phase.
For the longer run, however, he expects yields to have some way to go, driven by the pick-up in long-term inflation rates to 2%.
More importantly, yields are expected to be supported by the improving US economy.
“We have seen a pick-up in real yields related to the economic recovery and we expect them to continue to rise over time due to the ongoing economic improvement. When the economy is in full swing, real yields tend to hit around 1%, so we could have another 50 basis points or so to go over the next 12 months or so,” says Hui.
However, he warns that rising bond yields will create pressure for fixed-income investors due to concerns over liquidity, which in turn puts pressure on risk assets and equity investors. Nevertheless, he views that in this case, the rising yields are an indication of a strengthening economy rather than one that’s overheating.
“Imagine you have a swimming pool. In a recession, that pool would be freezing cold. But if the economy is warming up, the temperature gets more attractive. Now, of course, if it overheats and runs too hot, it becomes intolerable. We think for the next 12 months, we’re still in that middle stage with the temperature being just right,” he says.
Sector allocations
With this macroeconomics backdrop, investors might be keen to know that Hui is maintaining his preference for equities, emerging market debt, and high yield corporate credit, given what he views as a low and rising inflation regime. “Historically, if we look at past inflation cycles, typically we see that equities, corporate credit, and emerging market debt tend to perform best in this environment,” he says.
Based on data between 1989 and 2020 during periods where average inflation was below the median and rising, these asset classes provided nominal annual returns between 10% and 15%, he notes.
JPMAM’s preference for equities over fixed income stems from the fact that current yield levels of government bonds or other low-risk fixed-income assets are still too low to adequately make up for the duration risk that investors have to bear.
“For 10-year US treasury bonds, if real yields were to rise 50 basis points, that could equate to approximately a 4% reduction in bond prices, which is not sufficient to compensate investors,” he reasons.
To that end, Hui prefers shorter-duration emerging market debt and high-yield corporate credit over government bonds. “If we look at US high-yield and emerging market debt, spreads are approaching pre-pandemic levels, suggesting there is limited room for compression, but really the income component will offset the duration risk,” he says.
In addition, Hui points out that rising yields do not necessarily threaten equities, as historical S&P 500 data shows that equity market performance actually tends to be positive when bond yields are rising from low levels.
He attributes this to an improvement in companies’ pricing power when inflation starts to pick up, resulting in better earnings per share. “That’s particularly important right now given equity valuations are above average, so we can’t rely on valuation re-rating to deliver performance — we need actual earnings growth,” he argues.
While tech stocks dominated the bull run over the past year, Hui now sees a rotation to more cyclical sectors in what can be dubbed a “value rally” this year. Financials, energy, industrial and materials are sectors that tend to outperform in rising rate environments, he says.
For investors looking to diversify portfolios or hedge against inflation, alternative assets such as infrastructure and real estate that generate income with low correlation to public equities will be attractive as well.
In terms of geographies, US and China remain JPMAM’s top picks for equities, though Hui says investors should diversify portfolios as recovery progresses, with tactical opportunities present in Europe, Japan and other parts of Asia.
For China, while there are concerns over potential monetary policy normalisation, Hui points out that China’s economy is on a stronger footing, enabling the People’s Bank of China to take a more neutral approach while also remaining flexible.
In addition, he notes that China’s money supply and credit growth do not show a strong correlation with equity market performance, further reinforcing a positive outlook for the market supported by healthy earnings growth expectations in the near term.
Supportive Chinese government policies towards certain sectors and industries will help attract investors’ interests there too. For example, China’s target to be carbon-neutral by 2060 is expected to drive sectors like electric vehicles, components suppliers and renewable energy. In contrast, traditional industries
such as coal-fired power generation are those that will be more challenged.
Over the longer term, shifts in China’s economy from manufacturing towards services will continue; local produce will enjoy support compared to substitute foreign imports. “As US-China tensions continue, we’ll see more self-sufficiency from China,” says Hui.
