Equity markets were generally flat over the past week. But, the more noticeable action occurred in the bond markets, where an increase in yields has gained steam of late. This left investors wondering whether they should be reassured as it’s another sign of growing confidence in the economic growth outlook, or instead concerned as it may foreshadow some inflationary headwinds, which could prove problematic for equity markets. We discuss this more below and provide an update on the virus front.

 

Coronavirus Update

North America continues to see a meaningful decline in infection trends. In Canada, the 7-day average rate of new daily infections fell over the past week, with the figure now standing at close to 2900 new daily cases versus the 3500 from the week ago period. Many provinces and territories experienced declines, with the exception of Manitoba and Newfoundland. The latter has been noteworthy and should serve as a reminder of why health officials across the country remain so cautious. The province entered a lockdown over the past week after officials confirmed that the “UK variant” of the virus is responsible for the province’s recent outbreak. Meanwhile, in the U.S., the 7-day average rate of new daily cases fell to nearly 60,000 versus the 95,000 from the prior week.

 

Bond yields on the rise

Global bond yields have been moving higher for a few months after the lows reached last year. But the increases of late have attracted much investor attention.

 

Bonds are debt instruments, whereby borrowers pay a recurring amount of interest before ultimately repaying a lender – an investor - at a future date. Many investors buy and hold bonds – or invest in fixed income products like mutual funds or ETFs that do so - as part of a well-diversified portfolio. And as with stocks, investors can both buy and sell bonds that they no longer want to hold. When more investors want to sell rather than buy bonds, the prices decline. A bond yield represents the interest income relative to the price of a bond. As the price of a bond falls, its yield rises, and vice versa.

 

Stocks and bonds have been negatively correlated through much of the past decade, and through other periods as well. This means that as one moves up, the other moves down. In recent months, bond prices have been under pressure (bond yields are rising), suggesting there are more sellers than buyers. That in itself is not surprising given the current backdrop. The prevalent view that a durable economic recovery will fuel robust earnings growth for stocks has likely contributed to investors shifting some of their exposure away from defensive asset classes such as bonds into riskier assets such as equities. In other words, the move higher in bond yields may simply be further validation of the growth recovery that investors expect to soon arrive.

 

But, the move in bond yields has been noticeably sharp in recent weeks and broad based, with yields increasing across the globe. This may suggest that some investors are growing anxious about future inflation. More specifically, some may be questioning whether the combination of an eventual opening of economies, massive fiscal and monetary support from governments and central banks, and pent-up demand from consumers and households could lead to sustained inflationary pressures going forward.

 

Inflation is a key risk for bonds and fixed income assets in general as it can erode the principal, or value that is repaid upon maturity of the loan. But, it presents a risk for stocks too. Such a scenario may force central banks to shift their stance and raise interest rates earlier than otherwise expected. Stock prices can be very sensitive to the level of interest rates, particularly when valuation levels are elevated as they are today. The potential for an earlier than expected increase in interest rates would be a new and meaningful headwind for stocks. As a result, any large and sustained move higher in inflation could present a risk to both stocks and bonds.

 

We understand the rationale above, but are less concerned at this juncture. Inflation will undoubtedly rise this year as a function of an economy normalizing - moving from partially to more fully open. Moreover, supply chain bottlenecks will exacerbate the upswing. But the Federal Reserve – the U.S. central bank – has repeatedly indicated it is very willing to tolerate a rate of inflation above its long-term target, at least for a little while. We expect other central banks to remain similarly accommodative. The more interesting question will be whether the pricing pressures that surface this year will prove to be temporary or persist into next year. Investors will have to wait to find out. In the meantime, the strong earnings growth anticipated to begin in the later part of the year should help offset some of the concerns around rising bond yields and inflation.

 

Should you have any questions or concerns, please feel free to reach out.

Thom