Many have been bullish on shares since the second half of 2020, so it is natural to ask, given the rise in bond yields, whether it’s time to go defensive and rotate away from shares. One short answer is that it’s probably too early. There is a bias, albeit a weakening one, towards shares and other reflationary assets over the short term. However, the upside in shares is considerably less than it was six months ago as the risk-return trade-off of these investments has deteriorated due to higher valuations and the significant risks posed by higher inflation and bond yields. For now, however, some considerations on the factors still favouring shares at this point in the cycle:
- The driver for higher bond yields is expected higher inflation, which is the result of stronger economic growth as the pandemic fades. Though the real US bond yield has risen, it’s still low by historical standards and financial conditions remain accommodative. In this regard, it is encouraging to note that the spread on corporate bonds has remained steady.
- Secondly, stronger economic growth is leading to earnings growth which should accelerate as economies re-open and normalise. In this regard, the US is leading developed share markets
On a longer-term basis, rising global bond yields do pose a significant threat to share prices and could have a negative impact on economic growth. The question is, how far away is this tipping point?
In this context, the current tug of war between financial markets and central banks on the timing of the interest rate hiking cycle is fascinating. Currently, markets have priced in a policy rate increase in both the US and Australia by the 2022 September quarter. But both the Fed and the Reserve Bank of Australia (RBA) have repeatedly stated that they don’t expect an increase in rates for some time. For instance, the RBA’s Governor Lowe has said that the “cash rate is very likely to remain at its current level until at least 2024”, while the policy rate forecasts of the Fed’s Federal Open Market Committee members suggest the policy rate will not increase until 2023.
So, which is correct: financial markets or central banks? Paradoxically, both sides may be correct. Markets may be correct in the sense that economic conditions will return to pre-pandemic levels faster than expected with somewhat higher inflation. However, this does not necessarily mean central banks will have to capitulate and increase policy rates before the end of 2022. If the RBA or the Fed are willing to tolerate somewhat higher inflation – say, close to 3.0% – to achieve their policy aims, they are able to as long as they’re willing to tolerate lower exchange rates. Under such a scenario, short-term interest rates (say, maturity of under three years) will remain low and well anchored, while rates at the long end of the curve will rise in volatile trading.
What does this mean for shares? The easiest answer is greater volatility. As market expectations adjust to new economic data and central banks’ messaging, prices tend to jump around. The March quarter is a prime example of this. It’s possible that the Fed’s narrative on the US economy will likely be challenged over the next six months given the possibility of significantly stronger economic data, higher inflation due to the base effect and the prospect of another major spending bill from the Biden administration which focused on infrastructure. The more difficult answer, however, is the timing of a re-allocation from shares. As long as higher nominal bond yields are driven by the expectation of higher inflation caused by stronger economic growth, share prices can be supported by higher expected earnings. Valuation matters and companies with lofty valuations, whether it’s Tesla in the US or AfterPay in Australia, will likely come under more pressure.
The main risk over the next six months is not higher policy rates but the main central banks, in particular the Fed, reducing (tapering) its purchase of bonds faster and earlier than markets expect. While this risk is real, such “tapering” is still some way off for two reasons. Firstly, while US inflation is expected to increase over the coming quarters due to the base effect and early signs of upstream price pressure, inflation is likely to remain well contained due to the large output gap in the US economy. Secondly, the Fed will be extremely careful in the unwinding of quantitative easing. Post-GFC history suggests that this will be a long and gradual process, starting with the suspension of the re-investment of coupons from its holding of bonds. In doing so, the Fed will try not to spook investors.