Economic reflation, inflation and the rise of sovereign bond yields
Since the end of last year, reflation, reflationary policies, and reflationary trades have been hot topics of debate amongst economists and in financial circles. The markets are carefully monitoring the rise in inflation expectations and assessing the impact of the cyclical recovery on sovereign bond yields and central bank policies. But why is this important and what impact could the current macroeconomic developments have on markets in the coming quarters?
Reflation and inflation should not be confused
To fully appreciate why there is currently such a lot of focus on reflation, we first have to understand what it means, what a reflationary environment entails, and how it differs from an inflationary environment.
We can broadly define reflation as the initial phase of an economic recovery after a contractionary¹ or deflationary² phase. It also covers off the prospect of output and inflation progressively returning to their long-term trend after they have been hit by a recession or a deflationary shock (such as the one we experienced with the pandemic).
Although a reflationary environment does entail an increase in inflation, we generally consider it a positive development for the global economy, as it is associated with a return to normality. A reflationary environment is characterised by an increase in aggregate demand, progress towards full employment, and a price level progressively approaching the central banks’ 2% target.
This is different from an inflationary environment, which is normally associated with an incremental increase in the general price level at a time when the economy is operating at full capacity. So, while reflation is seen as a positive development, standard inflation is generally viewed as negative when price increases tend to overshoot long-term trends and central bank targets.
Following the 2020 pandemic, monetary and fiscal authorities around the world launched unprecedented policy support measures to reverse the deflationary forces caused by the pandemic and to prevent the global recession from turning into a depression. These reflationary policies, together with the development and progressive roll out of Covid-19 vaccines, have established the pre-conditions for the emergence of a global economic reflationary environment in 2021.
The medium-term prospects for reflation and inflation
In 2020, the global economy contracted by approximately -3.5%. Given the extraordinary policy support and the roll out of Covid-19 vaccines, the IMF now expects the global economy to rebound by around 5.5% in 2021. In the absence of further shocks or unexpected major setbacks, the reflationary environment should contribute to solid economic growth. However, in 2021 this growth will remain uneven across regions and will continue to be significantly affected by the development of the pandemic.
After the global financial crisis more than a decade ago, the inflation rates in advanced economies remained depressed for an extended period of time. Several countries have experienced bouts of negative price growth and inflation was only slowly recovering when the Covid-19 pandemic hit the global economy.
During the first half of 2021, inflation will tend to increase in the advanced economies, primarily due to higher energy and commodity prices, supply constraints, and a positive base effect. We expect that inflation will peak in the second quarter of this year.
That being said, overall, inflation should remain subdued for the foreseeable future. This is due to a negative output gap, headwinds from structural forces (such as demographics, globalisation, and technology), and a growing savings-investment imbalance. With inflation currently below target, central banks are likely look past any temporary inflation spikes and maintain their accommodative policies for a prolonged period of time - the so-called “low for long”.
What does this mean for financial markets?
A reflationary environment characterised by a cyclical economic recovery, extremely supportive macroeconomic policies, and moderately rising prices is considered positive for equity markets and risk assets in general.
The major equity indices increased by approximately 75% from the troughs of March 2020, reaching new highs in March of this year. This equity rally was driven by a flood of liquidity from central banks and an improved economic outlook. The election of Joe Biden, the prospect of additional fiscal support in the US, and the development of Covid-19 vaccines have strengthened reflation dynamics and fuelled so-called “reflation trades”.
Reflation trades tend to favour assets associated with faster economic growth and they usually foster a rotation into those assets that suffered most during the recessionary phase. Equity and commodity markets tend to outperform other markets, equity markets in emerging economies tend to outpace those of advanced economies, and small caps and cyclical sectors perform better than large caps and growth stocks. During a reflationary phase, growth prospects and rising inflation expectations cause sovereign bond yields to rise and high yield credit to outperform investment credit. Cyclical recovery and reflationary phases are also generally associated with weaker safe haven currencies (typically the US dollar, the Japanese yen and the Swiss franc), as investment flows are attracted to regions with better growth prospects and higher interest rates.
But we shouldn’t lose sight of potential risks on the horizon
Over time, a reflationary scenario also poses risks for the financial markets.
The approval of the USD 1.9 trillion US pandemic relief bill, together with the progressive reopening of the US economy and better economic data, have driven an increase in inflation expectations and a surge in sovereign bond yields. The yield on 10-year US Treasuries rose from 0.9% at the end of 2020 to 1.7% at the end of the first quarter of this year. Since then, the yield has eased back somewhat to 1.6%. European sovereign yields have followed similar trajectories, returning to near pre-pandemic levels.
Since mid-February, stretched equity valuations, combined with initial signs of inflation and a rapid increase in bond yields, led to market turbulence as equity markets digested higher rates. In the US, inflation concerns have investors worried that the Fed might have to tighten its policy sooner than expected.
Higher yields are currently viewed as one of the major risks for financial markets. A sustained and sharp rise in the US long-term interest rates could disrupt the fledgling cyclical recovery, derail the market’s upward move, and upset reflation trades. The risk of higher US yields could also strengthen the US dollar and encourage capital flows to move from the emerging economies back to the US. Although, so far, the reflationary environment remains intact, the avenue for further gains in risk assets has narrowed.
The reaction of the major central banks
We have seen differences in the manner in which the major central banks have responded to the tightening of financial conditions. This is due to their different situations and underlying structural characteristics.
In the US, the unprecedented fiscal support, a Covid-19 vaccination campaign gaining traction, and the progressive reopening of the economy have improved growth expectations and made the recovery more resilient to an increase in long-term yields.
From the Fed’s point of view, the steepening of the yield curve signals positive economic developments. As a result, it has recently upgraded its 2021 growth forecast for the US economy to 6.5%. The Fed has adopted a relatively relaxed attitude towards the increase in yields and, so far, has not committed to any action to drive yields lower. A moderate increase in long-term rates should not derail the cyclical recovery and the accompanying steepening of the yield curve. Instead it may encourage financial intermediation and contribute to financial stability. Nevertheless, the Fed has made clear that it will intervene to contain any sharp and unwarranted rise in sovereign bond yields that would create disorderly market conditions like the ones we experienced in March 2020.
Meanwhile, without any lasting inflationary pressures, and with the economy still a long way from full employment, the Fed has pushed back against any premature policy tightening and has reiterated that it will maintain an expansionary policy for the foreseeable future.
The situation is quite different in the eurozone. Although, based on the prospect of a cyclical recovery, sovereign bond yields also surged in 2021, the macro picture appears considerably weaker and the institutional framework is more complex.
The European recovery is being delayed by higher Covid-19 infection rates, renewed lockdowns, and much slower progress in the vaccination programme. Furthermore, as the eurozone’s fiscal stimulus is much smaller than the fiscal support approved by the US Congress, it will take more time to be disbursed and for its effects to be felt across the eurozone economies. Finally, regional divergences between countries and the risk of widening yield spreads between the EU centre and its periphery are particularly worrisome.
Therefore, it is not surprising that the ECB reacted forcefully to prevent any further increase in sovereign borrowing costs that could create a tightening of financial conditions and has recently pledged to step up the pace of its buying programme to keep yields in check. We expect the ECB to maintain a very accommodative policy stance for an extended period of time.
So, what can we expect going forward?
The reflationary environment is likely to push long-term yields up from the depressed levels reached last year. This progressive tightening of financial conditions could create further volatility and waves of market turbulence.
However, we expect that the reflation trades accompanying the cyclical recovery still have some way to go. Why? Well, firstly, the rise in long-term yields reflects a sharp improvement in the global growth outlook. Secondly, the unprecedented policy support also makes this recovery less interest-rate sensitive than prior cycles. Another point to consider is that inflation is likely to remain subdued and central banks will maintain extremely accommodative monetary policies for an extended period of time. And finally, yields remain historically depressed. Companies refinanced themselves with very favourable conditions and the economic upswing will foster stronger corporate profits.
We see a different growth picture between the US and Europe and the Fed and the ECB are following different approaches, both of which have contributed to a widening of the yield gap between US Treasuries and European sovereign bonds since the beginning of the year. Although the US dollar lost around 11% of its value in 2020, these developments have curbed the (widely anticipated) further weakening of the US currency. Divergences in the US and European growth paths and a further widening of the yield gap could reverse this trend or even strengthen the US dollar, which would further endanger some of the most popular reflation trades (for example commodity prices and the emerging markets cycle). Therefore, it seems certain that we are going to be hearing about reflation and inflation, and their impact on the markets, for some time to come.
¹ A contractionary phase is a period when real GDP declines consecutively for two or more quarters. It can also be associated with declining inflation rates and rising unemployment rates.
² A deflationary phase is characterised by a generalised decline in the prices of goods and services.
Positioning of our funds
April was a quiet month for bond markets. After peaking at 1.75% in March, U.S. Treasury yields took a breather in April and closed the month at 1.65%. In view of the strong economic upturn, we can only speculate on the reasons; presumably the buying interest of foreign investors – especially in Japan – pushed yields down somewhat.
The meetings of the two most important central banks, the ECB and the Fed, as expected, brought forth little news about a possible tapering. The European Central Bank reaffirmed that it would step up the pace of asset purchases under the PEPP programme this quarter in order to keep yields and financing costs down for European companies and governments. It is anticipated that EUR 20 billion will be purchased, compared with around EUR 53 billion in January. We then expect a moderate fall-off back to between EUR 50 billion and EUR 60 billion per month from the third quarter of 2021.
The Fed meeting did not hold any major surprises either. The necessity of maintaining an accommodative monetary policy until the U.S. labour market recovers from the pandemic was stressed. However, given the strong employment figures (916,000 additional jobs compared with 660,000 projected) and retail sales (+9.8% compared with +5.9% projected) last month, that message is becoming a tougher sell and could force the Fed’s hand in the medium term. Opinions on this vary greatly. While some analysts expect the first suggestions of the end of bond purchases to come as early as the upcoming June meeting, others think the Economic Symposium in Jackson Hole in August, or even December, to be more likely. The ECB is likely to follow suit a few months later.
After strengthening in March (31 March: EUR/USD 1.17), the U.S. dollar is now back at EUR/USD 1.21. This further weakness in the U.S. dollar can be explained by Jerome Powell’s dovish outlook after the last Fed meeting as well as the stagnation/slight fall in Treasury yields. With yields in the eurozone having risen slightly at the same time, especially on peripheral sovereign bonds (Italian BTPs +20 basis points since the end of March), the differential has decreased further. In addition, the U.S.’s lead over Europe in the vaccine rollout seems to be slowly shrinking and a reopening of the economy is thus edging closer in Europe as well or has already begun in many countries. Furthermore, the mounting national debt and the expanding trade deficit is weighing on the U.S. dollar. The enormous fiscal packages are intended to stimulate consumption; at the same time, however, the U.S. has for years been importing more and more goods and services from Asia and Europe. Both are likely to put the U.S. dollar under further pressure in the long term.
The Ethna-DEFENSIV gained 0.07% in April, bringing it to -0.35% year-to-date. In light of the sharp rise in U.S. yields in the first quarter, this is a very positive result. In April, too, bonds contributed around 60 basis points to performance, while there was hardly any change in sovereign bond yields. This shows that the bond portfolio is able to make a positive contribution to performance even in times of stable yields. Risk premia narrowed further, particularly for high-yield bonds whose premia are now below 300 basis points and thus close to their historical lows. In addition, we once again built up a 5% gold position in our portfolio. We believe that gold has bottomed out at about USD 1,700 and offers an attractive entry point. Moreover, given that equity and bonds markets have been doing very well for more than a year, gold acts as a hedge in more unsettled times.
As in previous months, April was also characterised by persistent risk appetite among investors. So it’s not surprising that many equity indices hit new highs for the year or even all-time highs, and credit spreads for corporate bonds were also close to their historical lows. Not just the very strong reporting season, but also the ongoing very supportive central bank policy and, of course, good momentum on the vaccination front created a brisk tailwind.
While ECB and U.S. Fed central bankers confirmed or raised their economic growth forecasts again, they didn’t even hazard to mention scaling back their supportive purchase programmes. However, we think it only a matter of time before we edge closer to a tapering. Even though central bank policy is currently being reduced to extreme capital market support without activating other transmission mechanisms, we consider it dangerous to continue this forever. The rapid economic recovery on the back of the stimulus measures and rising inflation rates could effectively force a policy adjustment earlier than priced in to date.
However, this assertion changes nothing about the current equity weighting in the fund, which is still high. It is just another argument that urges caution at the moment. Although we are also aware that the market environment at the moment is overbought, overvalued and, in some cases, euphoric, we must concede that this early bullish phase may continue for some time. However, to take these thoughts and also any seasonal headwind into account, we have diversified the equity portfolio a little further. We kept the weighting of foreign currencies that serve as a proxy hedge (USD and JPY) more or less constant, but used currency options to ensure greater participation in the event that the U.S. dollar strengthens. With just a few exceptions, such as the futures on Japanese and Swiss equity indices, our equity positions participated well in the market upturn in April. The currency positions in the Japanese yen and the U.S. dollar detracted from performance. There were not many changes on the bond front. The overall weighting remains about 30%, including sovereign bonds. The sovereign bond allocation of 9% was also diversified by investing in U.S. Treasuries. Its current duration means the fund’s positioning is relatively neutral. We still assume that we will see lower interest rates – in the U.S. as well – after the next, probably very brief, phase of rising interest rates. But for the next few months, we can imagine that slight rises in interest rates will continue, especially at the long end of the curve. We think it rather unlikely that the ECB will allow substantial movement in European interest rates, as, otherwise, the debate about peripheral debt would soon flare up again.
The long-term picture for equity markets remains positive: fiscal and monetary support has repeatedly been promised and global economic growth continues to gain momentum. The most recent reporting season, in which the majority of companies beat expectations for revenue and earnings, testifies to this development. Thanks to this tailwind, many equity indices reached new highs in April, too.
However, the short- and medium-term outlook is no longer untroubled. On the one hand, we are heading into the summer months, an historically weak period for the equity market. The “sell in May” adage stems from this seasonal effect. On the other, sentiment among some groups of investors has of late surged back to (excessive) euphoria. One indication of this exuberance is that bad news – e.g. the U.S. plans to increase corporation tax – is being absorbed by the market almost without a second thought. Forward-looking equity markets that have already priced in the best-possible scenarios are more prone to correction as soon as the real economy eases off the throttle.
This prospect of short-term fragility led us in April to reduce the equity allocation of the Ethna-DYNAMISCH tactically by taking two measures. Firstly, we successively scaled back some of our holdings and reduced the gross equity allocation by almost 10 percentage points to 70%. Some of those affected were stocks that had of late had a disproportionately high weighting in the equity portfolio (e.g. BlackRock), were already generously valued by the market (e.g. Demant) or recently surged in value based largely on individual (in some cases fragile) factors (e.g. the correlation between the Charles Schwab stock and the yield level. We still have confidence in these single stocks in the long term and see the reductions in the positions as a means to enhance the balance – including with regard to weighting, valuation and cyclicality – within the equity portfolio again.
The second tactical measure that we took in April was the addition of another hedging element, which reduced the net equity allocation to around 67%. This concerns put positions on the NASDAQ-100 that mature in September. This index is the most practical representative of some hyped-up technology stocks and growth themes, which we believe to be at high risk of a setback in the next few months.
Risk control is particularly important when it becomes secondary for other market participations. Thanks to our active management style, we are deft in treading the line between short-term uncertainty and long-term strength; i.e. between hedging and participation. We thus continue to offer investors in the Ethna-DYNAMISCH risk-controlled access to the equity markets.
HESPER FUND - Global Solutions (*)
In April, US equities climbed to new historic highs on the back of a weaker US dollar. Supported by strong economic performance, a high-speed vaccine rollout, marginally lower US Treasury yields, and the reiteration that the Fed intends to maintain an accommodative stance for an extended period of time, US equities apparently digested Biden’s proposal for tax increases to pay for the fiscal stimulus and, as a result, surged to new highs. For the month, the S&P500 rose by 5.5%, the Nasdaq Composite went up by 5.4%, the Dow Jones Industrial Average (DJIA) gained 2.7%, and the Russell 2000 increased by 2.1%. The Euro Stoxx 50 climbed 1.4% (an increase of 3.8% when calculated in USD) and the Shanghai Shenzhen CSI 300 index rose by 1.5% (2.7% in USD terms).
The global economy is clearly in a strong recovery phase, as evidenced by a sharp and broad rally in commodity prices. The IMF has just increased its global growth forecast to 6%. The acceleration of the vaccine rollout in Western countries and the unprecedented fiscal stimulus proposed by the Biden administration have improved the global economic outlook considerably. However, in light of the pandemic dynamic in emerging markets, we are still left with somewhat of a mixed outlook. As a result, the US dollar reversed its three-month rebound and weakened by 2.4% against the euro during the month.
The Biden administration recently announced another ambitious fiscal package to be funded entirely by taxes. Moreover, the Fed has repeated that it considers any spike in inflation temporary. Therefore, extensive fiscal and monetary stimulus continue to drive the US recovery.
The HESPER FUND – Global Solutions is sticking with its recovery and reflation trade scenario. However, in line with its macro baseline scenario, the fund has fine-tuned its portfolio in order to adjust to the sector and geographical rotation, changes in market sentiment, and the pandemic dynamics. Consequently, we have reduced the short on both US Treasuries and the USD exposure. Following the recent contraction of corporate spreads, the fund slightly reduced its corporate high yield portfolio and returned to corporate investment grade bonds. With regard to its equity exposure, the HESPER FUND – Global Solutions has tactically increased it again to 59%. We also maintained a diversified 10% exposure to commodities.
On the currency front, the fund reduced its long USD exposure from 27% to 18% but bought December options on the expectation of an appreciation during the final quarter of the year. We also maintained our 4% exposure to the Norwegian krone as a pure reflation trade. As pointed out in the last Market Commentary, the HESPER FUND – Global Solutions was in the process of rebuilding an opportunistic position in Russian roubles. However, in light of the deterioration in the relations between Russia and Western countries, which resulted in new sanctions, we swiftly closed the fledgling position with a small loss while keeping an eye on the economic and political developments in the region.
In April, the performance of the equity portfolio of the HESPER FUND - Global Solutions EUR T-6 increased by 1.23%, bringing the year-to-date performance to +4.05%. Over the last 12 months, the fund has gained 7.83%. Volatility remains stable and low at 6.9%.
*The HESPER FUND – Global Solutions is currently only authorised for distribution in Germany, Luxembourg, France, and Switzerland.
Figure 1: Portfolio structure* of the Ethna-DEFENSIV
Figure 2: Portfolio structure* of the Ethna-AKTIV
Figure 3: Portfolio structure* of the Ethna-DYNAMISCH
Figure 4: Portfolio composition of the Ethna-DEFENSIV by currency
Figure 5: Portfolio composition of the Ethna-AKTIV by currency
Figure 6: Portfolio composition of the Ethna-DYNAMISCH by currency
Figure 7: Portfolio composition of the Ethna-DEFENSIV by country
Figure 8: Portfolio composition of the Ethna-AKTIV by country
Figure 9: Portfolio composition of the Ethna-DYNAMISCH by country
Figure 10: Portfolio composition of the Ethna-DEFENSIV by issuer sector
Figure 11: Portfolio composition of the Ethna-AKTIV by issuer sector
Figure 12: Portfolio composition of the Ethna-DYNAMISCH by issuer sector
* „Cash“ umfasst Termineinlagen, Tagesgeld und Kontokorrentkonten/sonstige Konten. „Equities net“ umfasst Direktinvestitionen und das aus Aktienderivaten resultierende Exposure.
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ETHENEA Independent Investors S.A.
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The investment funds described in this publication are Luxembourg investment funds (UCITS / Undertaking for Collective Investment in Transferable Securities) that have been established for an unlimited period in accordance with Part I of the Luxembourg Law of 17 December 2010 relating to undertakings for collective investment (the “Law of 17 December 2010”). An investment in investment funds, as with all securities and comparable financial assets, carries the risk of capital or currency losses. The price of fund units and income levels will therefore fluctuate and cannot be guaranteed. The costs associated with fund investment affects the actual performance. Units should solely be purchased on the basis of the statutory sales documentation (Key Investor Information, sales prospectuses and annual reports), which can be obtained free of charge on the website www.ethenea.com or from the fund management company ETHENEA Independent Investors S.A., 16 rue Gabriel Lippmann, L-5365 Munsbach. All information published here constitutes a product description only. It does not constitute investment advice, an offer to enter into an agreement for the provision of advice or information or a solicitation of an offer to buy or sell securities. Contents have been carefully researched, compiled and checked. No guarantee for correctness, completeness or accuracy can be provided. All information published here constitutes a product description only. It does not constitute investment advice, an offer to enter into an agreement for the provision of advice or information, or an offer to buy or sell securities. The contents have been carefully researched, compiled and checked. No guarantee can be given for correctness, completeness or accuracy. The information includes past data which are no indicator of future performance. The management fee, custodian bank fee and all other additional costs are taken into account in the calculation of the unit price as stated in the provisions of the contract. Performance is calculated using the BVI method (German federal association for investment and asset management), which means that the calculations do not include an issuing charge, transaction costs (such as order fees and brokerage fees), custodian bank fees, or other management fees. Including the issuing surcharge would reduce performance. The performance shown is not a reliable indicator of future performance. Munsbach, 04/05/2021