Yields on US Treasury bonds have risen steadily since autumn 2017 and are currently trading close to a four-year high. Investors are particularly focussed on the yield on the 10-year US Treasury bond, which is fast closing in on 3%, which is seen as a key level.
The rise in yields reflects the fall in US Treasury bond prices that began in September 2017. US treasury bonds have declined in value as the growth outlook for the US economy has improved and the Fed has begun to unwind monetary stimulus. The decline in bond prices has also been driven by more recent concerns about a future rise in the US budget deficit resulting from President Trump’s tax bill.
While these factors have all impacted US government bond pricing, the rise in yields ultimately reflects the market’s view on interest rates and inflation. The Fed raised interest rates three times during 2017 to a current range of 1.25-1.50%. The Fed signalled its intention to raise rates a further three times in 2018 to 2.0-2.25%, with rates expected to reach 3% by 2020.
Investor sentiment has shifted rapidly since the autumn, in favour of rate hikes. Consensus currently expects the Fed to raise rates three times this year; recent polls reported that 92.8% of polled economists expect a rate rise at the March Fed meeting and a further 58.7% of economists expect the Fed to hike in June. In comparison, a poll conducted four months ago reported only 29.1% of economists expected rates to rise in March, with 11.3% expecting rates to go up in June.
The rise in US treasury yields also reflects the markets’ view on inflation. Inflation has been conspicuous in its absence since the financial crisis, in spite of the significant stimulus injected into many of the world’s major economies. The sustained pick-up in global growth has also so far failed to stir any meaningful inflationary forces.
The absence of inflation is noteworthy given unemployment in the US is at a 50-year low. As defined by the ‘Philips Curve’, economists believe there is an inverse relationship between the level of unemployment in an economy and inflation. In theory, declining unemployment means there are less workers looking for jobs, making it harder for employers to fill outstanding vacancies. This in turn should place upwards pressure on wages, feeding inflation into the broader economy.
The break-down in this historical relationship has caused many economists to state that the Philips Curve is dead. Critics have pointed to the fall in labour participation rate, as well as declining productivity levels as reasons for the failure. Others have pointed to the increasing role played by technology in the global economy, as well as an ageing population as reasons for the lack of inflation.
While inflation has been absent in recent years, we think that underlying inflationary pressures are starting to build. We identify four factors that are likely to drive inflation higher over the course of 2018:
Energy prices: We expect rising energy prices – principally driven by the higher price of oil – to drive inflation higher. Since bottoming out in February 2016, the price of a barrel of Nymex Crude Oil has risen more than 120% to US$65 currently. Almost every single sector of the global economy is – directly or indirectly – reliant on oil. We expect the sharp rise in energy prices to feed underlying inflationary forces over the next 12-18 months.
Wage Inflation: US wage inflation appears to be finally on the rise, with average wages rising 2.9% in January, the highest rate of increase since June 2009. The U-6 underemployment rate rose to 8.2% in January, with job openings remaining close to a record high. Anecdotal evidence from a range of US corporations adds to the wage inflation outlook, with Walmart recently raising starting wages for new employees from US$9 to US$11 an hour.
Synchronised global growth: The global economy continues to strengthen, with growth synchronised across all major geographies – the first time this has happened since the 2008 financial crisis. Strengthening economic activity equates to rising demand, which in turn will likely drive upward pressure on pricing, given much of the spare capacity in the economy has been eroded since 2008. Consensus expects global GDP growth of nearly 4% this year, an acceleration from an estimated 3.8% growth in 2017 and 3.1% in 2016.
Weak dollar: A weaker dollar – if sustained over a period of time - will likely result in higher US inflation. First, a weaker dollar places upwards pressure on commodity prices, as most commodities are priced in US dollars. Second, dollar weakness will also push up import prices in the US, adding further inflationary pressure to the economy. The US economy is particularly susceptible to the second effect, as it is a net-importer of goods.
The strengthening economic recovery in the eurozone has provided an additional kicker for global growth. Considering Europe’s underlying structural issues, the rate of economic recovery in Europe has been remarkable and presents a further upside risk to the global inflation outlook. Seasonally adjusted eurozone GDP grew at 2.7% in Q4 2017, versus the fourth quarter of 2016 – the fastest pace of economic recovery since the 2008 financial crisis.
The EU jobs market has also made steady progress, with the eurozone unemployment rate falling to 8.7% at the end of 2017, down from a peak of 12.1% in 2013. The eurozone U6 underemployment rate has also been declining at a steady rate since 2015, which is consistent with higher wage growth and core inflation, over the medium-term. The EU U6 rate fell to 17.3% in Q3 2017, the lowest rate since Q2 2009. The data likely strengthens the ECB’s expectation for EU inflation to pick-up in 2019-20.
Equity market performance is normally relatively unaffected during the early stage of rate tightening cycle. The lift-off in rates is usually seen as a sign of a central bank’s confidence in the strengthening economic recovery. The improving economic growth outlook is also theoretically positive for equity markets, as it indicates potentially higher levels of corporate profitability in the future. The improving outlook is also beneficial to confidence, both at the corporate and consumer levels, as individuals and businesses are more likely to invest when the economic outlook is improving.
While all these are positive factors, we cannot ignore the fact that equity markets have run hard since the beginning of 2016 and that a lot of the good news is already priced in. The S&P 500 has risen nearly 50% since February 2016, and is up nearly 250% since the post financial crisis low in March 2009. Equity valuations also continue to look full – particularly in the US – which leaves the market more vulnerable to policy tightening than it normally would do at this point in the interest rate cycle.
The current pull-back in equity markets is therefore not unexpected and is something we cautioned about in our update in January. High equity valuations, bullish investor sentiment and extreme positioning are not the necessary ingredients for further gains, especially coming off the back of the very strong performance seen in 2017.
On balance, we still expect global equity markets to rise this year. However, we expect the rate of increase to moderate, following the stellar performance seen in 2017. The risk of an outright bear market remains low, as bear markets normally coincide with recessions. We see a low risk of recession currently and expect growth in the global economy to continue gathering momentum.
However, we continue to think the market has under-estimated the scope for a rise in inflation this year – both in the US and globally. We also think the market has potentially misjudged the Fed’s desire to normalise interest rate policy. That said, rates should likely remain low, in absolute and historical terms. We also expect the Fed, along with other central banks, to raise rates at a measured pace.
Equity markets also stand to benefit from a potential rotation of funds out of the fixed income market, as a rising rate environment is normally negative for bonds. Renowned fixed income investor Bill Gross recently said that he now believes the bond market is in ‘mild’ bear market territory.
The main risk to market performance in 2018 is a faster than expected pick-up in inflation, which would likely prompt the Fed, along with other central banks, to tighten at a faster rate than is currently anticipated. Higher than forecast interest rates will likely negatively impact equity valuations.
Sectors that normally fare better in an improving growth / rising rate environment include financial stocks (banks and insurance), consumer discretionary as well as energy and commodity names. Value stocks also stand to outperform. Consumer staple, utilities and other so-called ‘bond-proxy’ stocks are at risk of underperforming when interest rates rise. Richly-valued high-beta tech stocks are also potentially vulnerable.
Recent high levels of investor sentiment and positioning are a risk to short-term performance and we expect markets to exhibit greater volatility through 2018. The easy money has been made in equity markets and we continue to expect 2018 to be a more challenging year than many are currently anticipating.
*Data sourced from Bloomberg as at 4 February 2018