The official blog of BNP Paribas Asset Management

Reflation? Inflation? Both?

Global equities rose over February as a whole, but this masked recent investor concerns. Leading indices touched new highs by mid-February, but by the end of the month, markets had seen a nervous sell-off in the wake of rising US bond yields.

Equities – and commodities – rose over the month as a whole as expectations of a cyclical recovery in 2021 persisted. WTI crude oil became 17.8% more expensive, rising to back above USD 60 a barrel – its highest since the start of 2020.

Investors now appear to focus more on the notion that the increasing pace of vaccinations will lead to a return to normal life, and are paying less attention to news about the pandemic (rising infections, more contagious variants) or the risk of more stringent health measures being (re)imposed.

Emerging market equities underperformed, gaining just 0.7% (MSCI Emerging index in US dollar terms). Their steep 6.3% drop in the last week of February confirmed that it was the sudden rise in US long-term Treasury yields that lay behind the month-end fall in global equities.

En route to overheating?

Expectations of a return to (more) normal economic activity has given rise to concerns that fuelled gains in long-term bond yields. Some observers worried about the risk of the US economy overheating on the back of massive budget support from the Biden administration. This cast doubt on the ‘low-for-longer interest rate’ mantra that has supported risky assets to date.

An overheated economy could move from reflation to accelerating inflation, causing the US Federal Reserve (Fed) to adopt a less accommodative policy.

The central bank's denials of such a move have yet to fully reassure investors, who are keeping a close eye on inflation data.

What has underpinned equities?

Solid Q4 2020 earnings reports and positive guidance from many companies allowed the main indices to book net gains in February despite the month-end decline: 4.5% for the EuroSTOXX 50, 3.1% for the Topix, and 2.6% for the S&P 500 (but only +0.9% for the Nasdaq Composite).

Sectors that benefit from higher rates recorded the biggest monthly rises; within financials, banks led the way. Utilities posted the biggest drop. Other sectors traditionally penalised by higher bond yields (telecommunications and healthcare) were among the worst performers.

Yields on the way up, in Europe too

US government bonds had a tough month. The yield on the 10-year T-note closed at 1.40% on 26 February, up by 33bp over the month and by nearly 50bp since the start of the year.

The yield on the German 10-year Bund rose to -0.23% on 25 February, its highest since mid-January 2020. It ended the month at -0.26% for a monthly rise of 26bp.

The Italian BTP market outperformed thanks to the strong run spurred by the appointment of Mario Draghi as head of a cross-party government. Investors clearly see the former ECB president as the person most likely to kick-start the Italian economy, with European support, while providing political stability. The Italian 10-year government bond yield ended the month at 0.76%, up by 12bp from the end of January.

As in the US, the recent movements corresponded to a rise in real rates. Isabel Schnabel, a member of the ECB's executive board, said that too sharp an increase in real rates could compromise the economic recovery.

The ECB repeated that it intends to maintain favourable financial conditions. Chief economist Philip Lane made it clear that the ECB is carefully taking into account several criteria and will not hesitate to use all the flexibility allowed by its purchasing programmes to avoid a tightening of financial conditions.

Other board members raised the possibility of taking action on policy rates and of tolerating inflation above 2%, even if that is not how the ECB defines its inflation target.

The path to normal life

Investors are looking at when normal social and economic life can return. At the same time, while all-out government support for economies has been praised, some observers are foreseeing risks.

Short-term inflation data will likely remain volatile and fuel these concerns, particularly in the US, where the fiscal effort has been huge. We are convinced that the scenario of low inflation should eventually prevail, even if there are challenges in the short term.

Against this background, the rise in real rates may weigh on risk assets in the short run. However, in the medium term, the prospect of a cyclical recovery that will continue to be supported by accommodative monetary policies remains a key support for equities.

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. The views expressed in this podcast do not in any way constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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