The official blog of BNP Paribas Asset Management

Weekly investment update – reflation trade on hold

Valuations of risk assets have marked a pause in the face of a number of headwinds. In our view, valuations remain underpinned by ample central bank liquidity and the prospect, in the US, of further fiscal stimulus.

Stricter lockdowns on the way in the eurozone

The pace of Covid-19 vaccinations has picked up further in the US to 2.7 million doses administered per day. President Biden confirmed a doubling of his goal to reach 200 million vaccinations within his first 100 days; the latest tally indicates 140 million doses have now been administered in the US.

In the UK, the number of doses administered appears to be peaking due to supply constraints. However, the number of new COVID-19 cases continues to fall.

In continental Europe the good news is that the pace of vaccinations is gradually rising with France and Germany both administering 250,000 doses per day, their fastest rate to date.

The bad news is that infection rates continue to rise, both in the eurozone and further afield (new COVID case numbers are rising in Japan, Sweden, Canada, Norway and Switzerland).

In France, daily new cases are now reaching 550 per 1 million, the highest since mid-November. Further lockdown measures are likely in both France and Germany in coming days with risk of further deterioration. Hospitalisation trends in continental Europe remain concerning, while they continue to improve rapidly in the US and the UK.

Markets are well aware of the ongoing challenges the pandemic presents. The week ending 26 March saw a notable pause in the reflation trade due in part to the COVID challenges in Europe and elsewhere. Long positioning in equities and commodities may also have contributed to the correction. Markets had been pricing in a lot of good news, notably on global re-opening prospects. Month-end rebalancing and the end of the Japanese fiscal year added to the noise, along with some preparatory risk reduction going into holiday-related low liquidity, with Easter coming up.

There is continued potential for volatility in market assessments of COVID risk – the primary risk being ‘new shocks’ that bring into question hopes of a gradual improvement in the outlook.

Bond yields continue to rise

US payroll data for March will be published on 2 April. Given the importance the Federal Reserve (the Fed) has put on closing the jobs gap the data will be of particular interest. The market consensus is for a strong report of around 650,000 in March as the US labour market recovery kicks into full gear. The expectation is for modest improvements in both leisure, hospitality and services, along with a rebound in construction hiring after its pullback in February. Federal Reserve officials will likely have their eyes on participation rates and marginalised groups’ relative gains.

The first details of President Biden's infrastructure-focused plans should be laid out in his Pittsburgh speech on 31 March. The administration plans to split the Build Back Better plan into two parts; the first focused on physical infrastructure and green energy to be released this week and the second focused on "human infrastructure" such as childcare and education to be released later. The first part may gain some more bipartisan support. Questions remain about how much this would be paid for with tax increases. The planned tax hikes could be a headwind for US stocks.

On 30 March the 10-year Treasury yield rose to 1.77%, the highest point since January 2020, before closing at 1.72%. US bond markets continue to lead the sell-off in government debt (see Exhibit 1 below) as investors fret that the Federal Reserve will allow the economy to run hot, with considerable amounts of government spending combining with monetary stimulus to pump up inflation.

Markets remain positioned for a steepening bias on the US Treasury curve. Our fixed income team are of the view that the yield curve will continue to trade with a steepening bias in the second quarter. A potential risk to this view is for the market to bring forward expectations of rate hikes, causing 2-year yields to rise and the front-end of the curve to flatten. So far, markets are pricing in the first rate hike in 2023, with six hikes being priced in by end-2024. Our fixed income teams remain underweight duration and overall government bond positioning versus their benchmarks.

One-off factors push inflation higher in Europe

The 5-year 5-year forward inflation rate has broken the highest level since January 2019 amid expectations for higher energy prices. Inflation in the eurozone has jumped to its highest level since the start of the pandemic. The European Central Bank insists the rise is driven by one-off factors, rather than underlying price pressure. The harmonised index of consumer prices in the eurozone rose to 1.3% in March, according to a flash estimate published by Eurostat on 31/03/2021 — in line with expectations and up from 0.9% last month. That is the fastest rate of price growth since before the coronavirus pandemic, but well below the ECB’s target of just under 2%. Core inflation, excluding the more volatile energy and food prices, fell from 1.1 to 0.9 %. We agree that the rise in overall prices reflects one-off factors such as the reversal of a German value added tax reduction at the start of this year, increasing energy costs, and changes to the weighting of products and services.

On 1 April it is likely eurozone and UK manufacturing Purchasing Manager Indices (PMIs) will confirm the strong preliminary prints. Manufacturing has been the primary driver of growth and has gone from strength to strength, with the output index in the eurozone at its highest level since the survey began (1997). Improvements in forward looking indicators, such as new orders and exports, suggest the recovery may have further to run.

The outlook

We continue to expect a vigorous global recovery over time, which should allow reflation trades to resume and we think that the Fed remains dovish. Among the potential catalysts that could reverse near-term caution are:

  1. Signs of peak pessimism on COVID concerns in Europe
  2. Further risk reduction in equities and commodities.

We remain constructive on equities as investors turn more optimistic on wider economic reopening with the vaccine rollout and extensive stimulus packages. Moreover, the extent of household and corporate savings point to significant pick-up in demand and investment going forward. This continues to fuel the reflation trade and we expect US inflation to move higher in the second quarter, which should increase pricing power and higher earnings. Europe lags on the earnings front. However, we see European earnings improving over time as the vaccine rollout gains ground

While we expect the economic recovery to be supportive for emerging markets, we see a very uneven picture. Rising inflation could bring forward rate normalisation for some countries. Commodity producers may continue to be supported by the ongoing commodity super cycle. However, a strengthening USD and rising US real yields would constitute a headwind for emerging markets.

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.

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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