March 15th 2021
Investment Outlook March 2021
Bond yields rising: good or bad news? The largest moves in investment markets over the past few months have been in the bond market. Whilst yields remain low, relative to history, the jump in 10-year gilt yields from 0.2% to 0.8% saw the largest monthly decline for 20 years in the ‘risk-free- UK government bond market. Are yields rising good news in that they signal a sign to economic health, or bad news if higher bond yields raise borrowing costs across the economy and stall economic recovery.
Rising confidence in recovery With the growing confidence surrounding vaccines, the shortest month of the year quickens to a close. Markets are trapped between the negative force of higher bond yields and improving expectations around corporate profitability. Since the end of January, but for a minority of circumstances, investors in bonds have seen losses on their holdings as yields have risen globally.
Federal Reserve Chairman Jerome Powell calling the recent run-up in bond yields “a statement of confidence” in the economic outlook. This maybe a fair reflection on investor attitude as government bond yields have climbed from the depths plumbed in 2020 that were then discounting the prospect of long-term economic paralysis.
The ECB has pledged to keep financing conditions “favourable” through the crisis, a point that ECB Chief Economist Philip Lane reiterated. He said that term applies to “the whole transmission chain of our monetary policy - from risk-free rates, to government borrowing costs, to capital markets, to the terms and pricing of bank lending to firms and households.” This is vital. Whilst investors are typically focused on the 10-year government bond yield, companies that seek finance in the capital markets will be influenced by the yield in the corporate bond market. Financing costs for companies remain at record lows; the chart below shows current yields on investment grade debt at 2% and high yield bonds at 4%.
Despite rising government bond yields, borrowing costs remain close to record lows for companies which should enable corporates to fund their recovery plans.
Mortgage warning signs? In the U.S., the housing market is financed via the bond market, unlike the UK which is dependent on bank lending. The pandemic led housing boom was built on historically low mortgage rates. Indeed, the recovery in U.S. housing through spring and summer of 2020 provided confidence that an economic recovery was likely. The average for a 30-year fixed loan was 2.97% at the end of February, having climbed from the record low of 2.65% in early January. A fairly minimal change most would say.
But the impact of this small increase is already curtailing mortgage activity. Applications have fallen to a nine-month low as at the end of February, being possibly also impacted by the widespread harsh winter weather conditions.
The U.S. housing market may well be a bell weather for the broader economy and potential sensitivity to rising interest rates. If mortgage costs rise, the V-shaped recovery in the US housing market may stall.
The number of homes being sold eased back in January but remain at robust levels, and housing inventory appears low suggesting that the slowing of new mortgages may not trigger a wider reset of the economy as seen in 2007-09. The robust U.S. housing market of 2020 is showing up in the sentiment survey of the National Association of Home Builders. A sharp recovery in housing sentiment would normally be associated with continued falls in unemployment.
**Widespread optimism ** In the US, as elsewhere, most countries are registering buoyant surveys of business confidence. The US Institute of Supply Management (ISM) is suggesting a robust recovery in corporate earnings.
The key driver for equity markets in coming weeks and months is the trade-off between a modest rise in bond yields and rising profitability.
Rising yields shouldn’t derail the recovery Rising bond yields impacted returns through late February. Whilst we are watchful of the rise of yields, especially with respect to U.S mortgage activity, Central Banks are mindful of the need for interest rates to remain low to support the economic recovery. Strong survey data supports the thesis that the economic recovery remains resilient, with corporate profitability likely to continue to improve.
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