Investment strategy

Yield turbulence unlikely to derail equity bull

01 March 2021 • 3 mins read

As the vaccine rollout continues, major economies are slated to attain herd immunity over the next 12-24 months; our forecast is that US GDP growth would improve sharply from -3.5% in 2020 to 6.0% in 2021 whereas world GDP growth would rise from -3.4% to 5.9%.

A boost in the demand-side of the economy is anticipated to set off reflationary pressures, particularly due to supply chain weakness and lean inventories in the direct aftermath of the pandemic. As a result, higher inflation expectations are driving a steepening of the yield curve, and this is a largely healthy phenomenon that should not surprise investors in the initial recovery phase after a recession.

A disruptive move in Treasury yields, however, tends to cause turbulence in equity markets, especially for the valuations of high growth names that are more sensitive to interest rates as their future earnings are discounted at higher rates into present value.

While a further sharp increase in yields could portend more volatility in equities ahead, we do not expect this upswing in yields to derail the longterm post-pandemic bull market. To put things in perspective, real yields remain very low and the US 10-year real yield will likely stay in negative territory in 2021.

While we expect nominal 10-year US Treasury yields to gradually move closer to 2% over the next 12 months, the recent upswing has already been fairly sharp and if yields continue to move up rapidly from here, then a dovish shift in tone from the Fed seems likely ahead, which could take the form of explicitly ruling out any tapering of QE until 2022.

First, the rates market now reflects expectations of a first Fed rate hike in 2023 and four hikes by the end of 2024 – which seems aggressive given that the US will likely need to see full employment in the labor market before inflation levels can rise above 2% for a sustained period, potentially a year, before a first hike is justified.

Second, while higher yields driven by reflation is a healthy phenomenon at this stage of the cycle, a move that is overdone may not be consistent with the Fed’s plan in terms of progress towards full employment and inflation. Clearly, higher yields will also have an offsetting effect on the momentum of the property market recovery and also risk an overly disruptive correction in equity markets and sentiment.

We have previously discussed how this part of the business cycle where inflation is low and rising is beneficial for cyclical/value sectors, and have in our asset allocation strategy overweight positions in the energy, financials, industrials, materials and real estate sectors .

These sectors have outperformed the broad market since early February as inflation expectations and Treasury yields began moving upward sharply.

We do expect major technology stocks, such as FANG (Facebook, Amazon, Netflix and Google parent Alphabet), to underperform value/cyclical sectors over the next 6 to 12 months and have been advocating some moderate rebalancing from technology into value/cyclicals but we see this more as a tactical rather than strategic move.

We see the earnings potential of high growth sectors, such as technology, being the greater factor that would drive long term appreciation.

In particular, it will be important for investors to seek diversified exposure to structural growth themes such as e-commerce, rise of the cloud, AI, 5G, renewable energy, health tech, electric vehicles, smart cities and green infrastructure. The key question for many investors is what to do with their holdings in the technology sector.

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Eli Lee
Head of Investment Strategy
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