This is an extract from our Asset allocation monthly - Removing the crutches
In September, the main issue affecting long-term bond yields in the US and Europe was major central banks beginning to talk of a gradual end to the emergency monetary policy measures, put in place to protect economies from the consequences of the pandemic.
These measures included massive asset purchases: EUR 1 337 billion from March 2020 to the end of August 2021 under the ECB’s pandemic emergency purchase programme (PEPP); USD 120 billion per month since March 2020 for the US Federal Reserve. The message from both leading central banks is now clear: Tapering is coming.
US Federal Reserve: More hawkish
The Fed’s long awaited monetary policy meeting on 22 September generated no major surprises, but did raise some questions. As expected, chair Jerome Powell indicated that the criteria required to start reducing (tapering) the pace of asset purchases had been met, at least on inflation. The trend on employment is somewhat less clear, but the drop in the unemployment rate from 6.7% in December 2020 (when the criteria were first laid out) to 5.2% in August (the latest data point) brought it sufficiently close to the equilibrium unemployment rate, estimated at 4.0%.
As a result, if the economy progresses as expected, tapering should be announced at the 2-3 November policy meeting. Powell said that tapering should end sometime around mid-2022.
The Fed’s inflation forecast for 2021 has risen sharply from 3.0% to 3.7% for the core PCE. The Fed now expects its preferred measure of core inflation (personal consumption expenditures excl. food and energy) to remain slightly above 2% from 2022 to 2024. Powell has defined this as a ‘very modest overshoot’ of the Fed’s 2% target. However, the dot plot, which shows the level of the policy rate deemed ‘appropriate’ by Federal Open Market Committee members, indicated a split committee: Six members expect a rate rise next year, while the other nine are pencilling in a later ‘lift off’ in rates.
The initial reactions of financial markets after the 22 September meeting suggested that the Fed chair had communicated his intentions clearly. In the days that followed, it appeared that the FOMC was divided not only over the date of the first rate increase, but also, more fundamentally, over the interpretation of the flexible average inflation targeting framework. Some members believe that key rates can remain low (at around 1% in 2024) with inflation slightly above 2.0%, while others, such as Fed Vice-President Richard Clarida, believe that much of the path towards the longer-run rate will have to be travelled by 2024.
These divergent views could partly explain the upward pressure on US long-term bond yields since the FOMC meeting and the renewed expectation that key interest rates may begin rising next year. Furthermore, even if the pre-announcement of tapering went well, there is a difference between the notions of the Fed reducing its purchases and having to accept that it will happen soon.
European Central Bank: Beyond September adjustments
Following the Governing Council meeting on 9 September, ECB President Christine Lagarde said that “favourable financing conditions can be maintained with a moderately lower pace of net asset purchases under the pandemic emergency purchase programme than in the previous two quarters”. The PEPP envelope remains at EUR 1 850 billion and the programme is due to end in March 2022. The ECB has not communicated yet on the future of the PEPP nor on changes to its asset purchase programme (APP). Investors will have to wait for the December policy meeting.
In the meantime, the ECB, like the Fed, risks being faced with upward pressure on long-term bond yields. In Q4, the monthly rate of PEPP purchases will be reduced to between EUR 60 billion and EUR 70 billion from EUR 80 billion in Q2 and Q3. However, uncertainty over the amounts that will be bought after March 2022, while government bond issuance remains significant, are beginning to worry investors.
Recent weeks have been marked by statements from several ECB members who want to distance themselves from the inflation forecasts released in September, which they consider to be too low. In particular, one press article referred to a private meeting between ‘German economists’ and ECB chief economist Philip Lane, in which he mentioned an internal scenario showing the return of inflation to 2% after 2023. Although partially denied, this story fuelled the idea that the mood may soon become a little more hawkish within the ECB.
While bond markets appear to have finally accepted that the recent acceleration in inflation is ‘transitory’, discussions at the central banks on this theme now seem to be giving rise to further upward pressure on long-term yields. Furthermore, although the Fed and the ECB are cautious in their official communications, other institutions have spoken out more clearly. For example, the Central Bank of Norway, which recently raised its key rate from 0% to 0.25%, indicated that a further increase was likely in December and that the rate could rise to 1.25% by the end of 2022 as home prices have risen sharply in recent months. The Bank of England, for its part, has indicated that recent developments reinforce the need for a ‘medium-term’ rate rise and multiple hikes rate next year are now priced in. Meanwhile, several emerging market central banks have already had to raise policy rates in the face of accelerating inflation.
As William McChesney Martin, Fed chair in the 1950s and 1960s, put it, the time has come for the chaperone to consider removing the punch bowl; bond investors seem upset about having to leave the party.
Is the reflation trade back?
Perhaps one way to look at recent events is to consider that central banks are removing the crutches that carried economies through their gradual recovery from the Covid crisis. The Organisation for Economic Co-operation and Development (OECD), the International Monetary Fund (IMF) and others have already pointed out that the exceptional recession of 2020 will leave deep scars, notably on employment, and that emergency treatment does not heal those scars.
For that to happen, it is up to governments to implement structural fiscal policy measures. Such decisions depend on the legislative timetable and will take longer to show their effects – longer than financial markets have patience for. Moreover, while parliaments had no hesitation in voting for one-off support for households and companies in 2020, further action could be trickier, which in turn could worry investors. Discussions in the US Congress on the ambitious infrastructure investment and major social reform plans proposed by President Joe Biden are taking longer and are more difficult than expected, even among Democrats.
While the White House announcements on the large-scale plans at the start of the year fuelled the reflation trade, the reality of the protracted debates in Congress has now taken some of the shine off this theme. At the same time, economic indicators have shown that the peak in the global growth recovery has passed. Although supply chain bottlenecks have limited industrial production, and services are suffering as the pandemic persists, demand remains high. The resolution of both these issues should lead to a strong recovery in both the services and the manufacturing sectors and the expansion should resume at a robust pace. However, investors do not seem to be focusing on this positive prospect, but rather on the short-term risks.
The current edginess could be heightened by the upcoming debt ceiling debate in the US, but once it has passed, the reflation trade could return. Our analysis of market dynamics indicators shows that technical configurations on many assets already reflect this
The autumn of 2021 is likely to remain a transitional phase, making predictions more difficult. It was easy to foresee the recession that followed the first great Covid lockdown and governments’ subsequent measures to help economic activity recover. The large-scale roll-out of effective vaccines should allow many economies to return to pre-pandemic levels of activity. The lockdowns of spring 2020 triggered a supply and demand crisis. Demand has recovered strongly, sparking persistent supply difficulties that are putting upward pressure on commodity and other input prices.
In response, major central banks are cautiously considering ‘normalising’ their monetary policy, reflecting reasonably optimistic economic growth scenarios. The recent announcements by the Fed would seem to largely explain the upward pressure on bond yields, which in turn led to erratic equity market movements in September.
Investors, too, need to accept that policy rates and bond yields will return to levels more in line with the fundamentals, while acknowledging that the medium-term economic environment remains supportive of equities. The elimination of supply bottlenecks should enable companies to meet strong demand.
Our asset allocation reflects these convictions: we are long equities, short bond duration, but in this transition phase, we reduced our risk exposure on these two major asset classes in September. These adjustments to our core positioning, and other changes, reflect our constructive view on risk assets.
For a full analysis of our latest asset allocation and the positioning in various asset classes, click here
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
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