Risk assets stabilized late last week alongside a respite in yield-driven volatility as the US 10-year Treasury yield was mostly range bound between 1.50% - 1.60% over the week.
While we see more upside in yields given our forecast for the 10-year Treasury yield to be at 1.90% in 12 months, this reflects our baseline expectation that the large part of the move up in yields in the near term is likely behind us, and the odds for another 40 basis point move up from current levels in March is less than even.
Our view has been that a post-crisis steepening of the yield curve driven by improved growth expectations is a largely healthy phenomenon typically seen in the 24-month period after a recession and that yield increase driven turbulence is unlikely to derail the long-term equities bull market.
Broadly, we continue to see equities as relatively attractive and expect equities to outperform bonds in this phase of the business cycle given that equity earnings yields still far exceed real yields, with the spread still significantly above the 30-year average.
Barring crisis years, history shows that the higher the spread between equity earnings yield and real yields at the start of the year, the higher the outperformance of equities versus bonds over the year.
During this initial phase of recovery, earnings of cyclical stocks, such as energy, commodities, industrials and financials, tend to benefit more from the pick up in economic growth and rise in yields, and on the other hand, high growth stocks such as tech typically face headwinds in valuations as their future earnings are more heavily discounted with higher rates into net present value.
We have been advocating for clients to position for the equity cyclical rotation for some months now, and continue to hold this view.
Abundant liquidity (with significantly more to come from the USD1.9 trillion US stimulus package) tends to exaggerate marketmovements – as we have seen from the sharp V-shaped rebound from March 2020 – and the rotation into cyclicals this year could be surprisingly violent in our view.
In particular, we believe that the energy and materials equity sectors are attractively valued and would further benefit from the White House’s subsequent focus on its infrastructure bill to rebuild the United States’ aging fixed assets in line with long term decarbonization and sustainability goals.
Note that the size of the recently passed US stimulus bill with a headline of USD1.9 trillion has exceeded consensus expectations, and this speaks to the impact of the Democrats’ control of the Senate after the Georgia runoffs.
At this very early stage, the US infrastructure bill is tentatively touted at a very broad range of USD2-4 trillion, and while there are good chances that the eventual bill could come in at a lower figure, the figure would likely move the needle given that the current value of government infrastructure in the US is about USD6 trillion.
Finally, the Chinese equity market has suffered in recent weeks from a sharp correction in high flying tech and baijiu stocks, and clients have asked if the Chinese equity market have passed a major top.
In our view, while Chinese equity turbulence could continue over the near term as authorities seek to normalize monetary policy and as some sectors have been significantly over bought, the structural bull market is still intact.
First, China’s fundamental economic outlook remains positive and we expect its recovery to continue solidly into the remainder of 2021. There is scope for private sector capital spending and household to further drive the growth rebound, and export demand would likely be boosted by a recovery in the global economy.
Second, the ongoing National People’s Congress (NPC) underscores the authorities’ intent to normalize monetary policy in a calibrated manner. For instance, the announced 2021 quota for local government bond issuance is only marginally lower at CNY3.65 trillion (versus the 2020 NPC target of CNY3.75 trillion) and this came in above consensus.
The authorities are likely also keeping a close eye on market stability, as seen from the national team’s buying of equities last week to support markets.
Third, despite the fact that Chinese markets do not appear outright cheap, we believe that valuations at the broad market level are not in bubble territory.
China A-shares are currently trading at about 17 times forward earnings which is in the ballpark of their Emerging Market peers, and supportive factors for the Chinese equity market include a positive earnings outlook alongside a firm economic recovery and the scope for the bull market to broaden out from high growth into cyclicals sectors which are more attractively valued.
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