Return of the bond vigilantes

 

The term bond vigilantes was originally coined by economist Edward Yardeni in the early 1980s to describe how bond sell offs could force the hand of central banks or governments. In the recent decades of deflationary environment, central banks have dominated the fixed income markets and were successful at dictating benchmark interest rates without much challenge from the fixed income markets and bond vigilantes.

 

What spooked the markets in late February is when the 10 year Treasury yield jumped from under 1 per cent to 1.6 per cent. This move came despite central banks’ reassurances of their commitments to keeping benchmark interests low. The central reason for the higher bond yield is a positive one because most market observers have raised their growth forecast for GDP growth and corporate earnings given anticipated fiscal stimulus and pent up demand.  Strong demand driven growth means higher expected inflation and higher interest rates.

 

A measured, steady increase in inflation and interest rates driven by economic growth has been good for the stock markets historically. This virtuous cycle holds true for inflation measures below 4 percent. However, if inflation grows rampant and central banks lose control, that can be very bad for the markets and real economy overall. Historically, bond vigilantes see it as their job to bring order back to the economy when they believe central banks have become complacent on their inflation watch.

 

Earnings estimate rising

 

We believe the U.S. and Canadian economies will regain their pre-pandemic high-ground by late 2021, perhaps earlier. For Europe, the UK and Japan, it will likely be longer. China’s economy has already recovered all the ground lost as a result of the Covid -19 shutdown. Earnings could surprise to the upside in 2021 and 2022, especially for sectors most damaged by Covid-19. Anecdotally, Carnival cruise lines’ spring 2022 bookings are higher than for 2019.

 

The S&P500 consensus earnings forecast is $168 per share for 2021 and would represent roughly 20%y/y growth. If this is achieved, it would push profits beyond the pre-Covid-19 high of $163 per share reached in 2019. The stock markets are unlikely to rise 20% this year given that some of the growth has already been priced into the markets, however, if we are able to see healthy growth in 2021, this will make the valuation more palatable and healthier for future growth.

 

The U.S. economy is decisively in “early cycle” phase which bodes well for early cyclical plays in financials, materials and energy sectors.

 

U.S. business cycle scorecard

As at 02/03/2021. Darkness of shading indicates the weight given to each input for each phase of the business cycle. Source: RBC GAM

 

We do not see a recession on the horizon, unemployment claims and rates are lagging economic indicators and are skewed by Covid-19. Even though there is no recession or bear market in the forecasts, please keep in mind market corrections are normal and can be frequently observed. Since 1980s, the S&P500’s average intra-year drop has been 14.3%. Inflation concerns and vaccine headwinds can trigger more volatility and corrections in the markets.

 

Is there a market bubble?

While high market valuation is definitely a concern, most of the recent year fund flows have been going into bonds as oppose to stocks. Aside from the recent GameStop saga, we have not observed the level of exuberance in market sentiments that are often associated with a market bubble.

Source: Fidelity, FMRCo, Bloomberg, Haver Analytics, FactSet. Data as of 2/19/2021

 

Sector Rotations

 

The technology sector has done very well and rightly so. This is a sector with high growth, low overheads and high profit margins. The sector overall also invests the most in R&D spending. However, it is also most vulnerable to rising interest rates because of its high valuation multiples. In the past decades, it has been U.S. large cap growth that has outperformed value stocks and we are starting the see the trend reversing in recent months. The trajectory of interest rates is key to the strength of this sector rotation.

 

The rotation between value and growth still have room to run:

Source: Fidelity, FMRCo, Bloomberg, Haver Analytics, FactSet. Data as of 2/19/2021

 

 

 

 

Rita Li works with individuals and business owners and healthcare professionals to provide tailored investment advice, risk management and financial planning. Her team comprises of professionals with in-depth taxation, insurance and legal expertise, together, they deliver a high standard of service to clients. Rita is a Chartered Financial Analyst CFA® She holds her MBA from Richard Ivey School of Business.