"Boom! Here comes the boom!… ready or not"
- P.O.D., Boom
As regular readers will know, we have been positive on (US led) risk assets for many quarters. Indeed, our most recent commentaries have centred around the prospect of greater differentiation in the recovery from the covid pandemic (unlike the synchronised global recovery from the financial crisis). However, since the US employment report for March (which came in sharply higher than expected with the creation of close to 1 million jobs) and the CPI release this week (marginally above consensus at 2.6% y/y), there has been a widespread narrative that the US rebound is now ‘in the price’. I find it difficult to see how what has been described by Jamie Dimon as a multi-year ‘boom’ is now fully priced, when we have seen perhaps only the first two data prints that contain any relevant information. Further, what does ‘in the price’ mean? What price? 5-year US yields? US equities? USDDM? USDEM? Consensus GDP estimates? Inflation expectations?
Before the covid crisis, in Q4 2019, US 10-year yields traded in a 1.50% to 2.00% range, and the upper bound Fed Funds target was around 1.75%, having declined from as high as 2.5% that summer. These reference points highlight significantly more upside to US rates, particularly considering the amount of fiscal stimulus introduced since then. Some argue that the 5-year yield at 0.85% is fully pricing a bullish growth/hawkish rate scenario, or even that EDZ1/EDZ2 at 20bps is about as far as the front end can go (an approximate 80% chance of one 25bp rate hike in 2022). I’m not sure those arguments hold if the high frequency data really do start to accelerate.
Analysts appear to be fixated on the extent to which rising US yields are a tightening of financial conditions and as such should weigh on equities (particularly long duration assets). I am more inclined to view the current monetary policy settings as being at the lower limit of accommodation. Nominal growth is rising significantly faster than yields. As the Richmond Fed President stated this week, real-time indicators suggest the US is “in the midst of a boom”. Ultimately, the result will likely be higher sustained growth in the US.
Meanwhile, in the euro area, in Q4 2019, 10-year bund yields traded in a far lower -0.60% to -0.20% range (it is of course more complicated in the eurozone, as while there is clearly more upside potential in the yields of the periphery, this would likely come about / be seen as a negative progression – wider intra euro area spreads). Indeed, going into the crisis, the base rate in the euro area was -0.50% (having fallen from -0.40% in September 2019), where it remains today.
We can of course debate the impact of the Pandemic Emerging Purchase Program (PEPP) (not to mention the tiering on the targeted longer-term refinancing operations – TLTRO – programmes) on narrowing intra euro area spreads and providing liquidity. But in essence, the European Central Bank (ECB) action was focussed more on maintaining the ‘supply’ of credit, not the cost of credit (which was admittedly already very cheap) – maintaining ‘favourable financing conditions’. Furthermore, the persistent weakness of eurozone inflation (forecast for 2023 at just 1.4%), suggests that further accommodation or an unexpected pick-up in demand is needed for ‘current’ monetary settings to be appropriate.
Our central viewpoint of differentiation is the dominant factor in this debate – and by extension the fact that the global capital account is more important to pricing than the current account. For example, many argue that printing dollars and anchoring front end rates can only be negative for the USD. But if, as we expect, the US economy grows at a significantly faster rate than its developed market peers, then the US should generate faster earnings growth (even relative to rising nominal rates), and the US capital account should see significant inflows.
Furthermore, the argument for bonds pricing is more complicated in the near term. We continue to believe that the US growth trajectory drives a higher, steeper US yield curve, at least until we are back near pre-covid levels – at which point the economy will still have significantly more accommodative short rates to sustain growth. However, it is not clear that there will be a global exodus from US Treasuries. In fact, the yield differential has already made holding US Treasuries significantly more attractive than many negative yielding alternatives (even on a currency hedged basis). While many look at twin deficits (which we are also concerned about in the long run), in the near term capital flows are likely to be the dominant driver for US equities and in our view ultimately for the USD. This notion is supported by our Dollar Smile framework, which highlights the convexity of the USD pricing relationship, not just in relation to its safe haven status, but also when its growth outperformance is clear.
Differentiation will be key. European stocks tend to do well when the global economy is strong – they have the highest earnings beta to world growth. However, differentials may distort this correlation for the current recovery – we expect US (growth) stocks to outperform European (value). US banks earnings releases have been very strong so far – some releasing back loan loss reserves, reinforcing capital and growth support further. However, the level of loan reserves in the eurozone was minimal in comparison, as the ECB encouraged banks to run down capital buffers to maintain (in many instances nationally underwritten) loans to the real economy. This, combined with the prospect of a continued flat yield curve (and the hindrances of negative rates), suggests market valuation rebounds should be significantly less pronounced on average in Europe.
Furthermore, while the ECB factors in 0.3PP increase in eurozone GDP this year as a function of the US fiscal stimulus, growth forecasts for this year are being revised lower (German institutes cut 2021 GDP estimate to 3.7%, from 4.7%, just this week). While much of Europe is built on a global export model, it is clear that the Germany for instance (and likely others) are more reliant on China growth (as the correlated slowdown in 2019 attests), than US growth. If China is back to pre-pandemic growth levels, further acceleration from here will be closer to trend (even if y/y comparisons are flattered by the 2020 (Q2?) dip).
Innovation, investment and earnings growth will likely happen (and be dominant) in the US, and thus global capital will flow to the US (bonds, equities and even simply the USD). Nominal GDP growth in the US will be around 10% in 2021 and interest rates are not catching up; in fact, they are lagging by a bigger margin.
The move higher in US yields may be slower and more complex than the rally in Q1, but underlying growth pressures will likely continue to drive prices and rates higher through Q2. US equities will also likely start to outperform again, as the US consumer demand growth accelerates through the year – we expect forward looking earnings estimates from the tech sector to remain very strong. Ultimately, we feel that we are just at the beginning of a boom for US consumption and economic growth and, “ready or not”, that the boom is far from fully priced.
Bloomberg, Refinitiv Datastream and Eurizon SLJ Capital Limited, data as at 15th April 2021
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