Despite the economic environment remaining supportive, asset market volatility has risen as central bank liquidity is being withdrawn Concerns over the effects policy changes will have on fixed income markets are likely to be exacerbated by inflationary scares A less accommodative policy backdrop The economic backdrop of positive, synchronised global growth and subdued inflation has continued in early 18. However, there has been a notable pick-up in asset market volatility, with global equities entering a correction in February after a record fifteen consecutive months of gains. This was catalysed by a sell-off in US treasuries, with the benchmark ten-year treasury yield having now risen to a key break-out level around 3%. Should yields stabilise above this sentimental threshold, it may cause some investors to question whether the multi-decade fixed income bull market that has been underway since the early 198s has ended (Figure 1). Increasing inflation expectations have been a key driver of the recent rise in treasury yields (Figure ), with the sell-off appearing to have been triggered by stronger-thanexpected US wage growth data released in early February. However, the global shift from quantitative easing towards quantitative tightening has provided a broader headwind to asset markets, with investors now focusing on downside risks more quickly than The ten year treasury yield, trend break or continuation? 5 Developed world equities and treasury yields.7 15 5 1971 1975 1979 1983 -year treasury yield 1987 1991 1995 1999 3 7 11 15 Fed Funds Rate Figure 1: Ten-year treasury yields are at a key juncture of around 3%. This is the precrisis low reached in 3 and the level at which yields topped out in 14. It also represents the level above which the falling trend line from the late 198 s would be broken, indicating a change of trend..5.3.1 1.9 1.7 1/16 7/16 1/17 7/17 1/18 US inflation expectations Figure : Inflation expectations have moved higher since the start of 16 and the Federal Reserve (Fed) has raised US interest rates in response. 1.5 1.5 Federal Funds Rate (RHS)
when the central bank put was effectively putting a floor on valuations in recent years. What has changed is that the Fed has ended its quantitative easing programme (in October 14) and begun reducing the size of its balance sheet (in October last year). Meanwhile, the European Central Bank has started tapering its own asset programme and looks set to conclude it later this year, while the Bank of Japan has reduced the value of its monthly asset purchases as a result of technical factors involved in its goal of maintaining its policy stance. Although these changes have been the result of improved economic fundamentals, they are reducing the liquidity inherent within global fixed income markets. Higher government debt issuance could add to the upward pressure on sovereign bond yields While investors are concerned about a potential acceleration in inflation, it could also remain subdued Governments are set to begin issuing more sovereign bonds to finance expansive fiscal policies. In the US, the Committee for a Responsible Federal Budget estimates that the recent tax reforms will require financing equivalent to just over % of US GDP over the coming decade. Furthermore, the US government is expected to implement a large infrastructure stimulus plan, which will require additional spending. In Europe, elections have shown that voters have become tired of austerity programmes, which is forcing incumbent governments to consider more expansive fiscal policies. Meanwhile, the Japanese government continues to run a large deficit in support of its economy. Together with the shift in central bank policy away from quantitative easing and towards quantitative tightening, increased sovereign bond supply will put upward technical pressure on yields. We note that the value of developed world government debt issuance is expected to exceed that of central bank government debt purchases in 18, for the first time since the Global Financial Crisis. Despite a supportive economic environment? Although some economic data suggests that inflationary pressures are building, wage inflation is edging up only slowly. Even the stronger-than-expected February data release that catalysed February s equity-market correction was subsequently revised lower in March (Figure 3). Given the reduction in labour force participation that has occurred over the past decade, there is some uncertainty over how much slack still remains in the labour force; the lack of wage growth indicates that there may be more than the current rate of unemployment indicates (Figure X working age participation rate). Meanwhile, the structural headwinds that have kept inflation subdued in recent years should persist in 18; these include demographic changes, technological developments, high household debt levels and regulatory factors that are containing the rate of credit creation. In any case, wage growth remains a key variable that both the Fed and investors are watching for signs that further policy tightening is necessary. US wage growth, initial readings revised lower US unemployment low, but labour-force participation increasing 3.5 1.5 85 84 83 8 81 8 79 11 9 8 7 6 5 4 1 11 1 13 14 15 16 17 18 Actual release Revised number Figure 3: While US wage growth has moved higher as the labour market has strengthened, it has plateaued between.5%-3% since mid-16. Even the strongerthan-expected initial reading that catalysed February s asset market correction was subsequently revised lower. 78 198 1985 199 1995 5 15 US labour force participation rate, prime age (5 to 54) US unemployment rate (RHS) Figure 4: The US labour force prime-age participation rate declined to multi-decade lows following the turn of the century as a result of demographic shifts. However, it has been rising in recent years. This raises uncertainty as to how tight the US labour market has actually become, despite the unemployment rate (which only accounts for active workforce participants) having fallen to cyclical lows. 3
Our base case is that central banks will tighten policy gradually amid positive growth and controlled inflation Escalating protectionism or higher oil prices could drive inflation higher in the short term, causing policy to tighten more quickly than expected A deterioration in the growth outlook could cause the trend of policy tightening to reverse Treasury yields have adjusted to price in the prospect of more normal monetary policy and the up/downside risks are now more balanced than when rates were extremely low just a few years ago The headwinds facing fixed income markets will also weigh on equity valuations, but equity markets are continuing to benefit from valuation support Global growth remains positive and the US economic cycle is likely to be extended by the government s recent fiscal measures. There also appears to be room for the economic expansions in Europe, Japan and the emerging markets to continue in the medium term. As such, our base case is that global growth will remain positive in 18, which will allow central banks, most pertinently the Fed, to continue to tighten their monetary policy stances. Our base case is that inflation will remain contained and this should prevent treasuries selling off too quickly. However, there are various tail risks that could change this view. In recent weeks, there has been an up-tick in protectionist political rhetoric and investors have become concerned that a trade war could develop between the US and China as President Trump pushes his America First agenda. The implementation of trade tariffs or other measures could have significant inflationary and anti-growth consequences, with follow-on implications for global monetary policy; however, the measures announced to date should have only limited impact and we are encouraged that both sides appear to be keen to avoid action that would cause significant economic damage. We remain cautiously optimistic that the US and China can reach a trade agreement, but we are cognisant that the sudden staff changes Trump has implemented within his administration potentially support the view that he may take a harder line on protectionism in the future. Despite the current positive trajectory of global growth, there is a risk that it will slow. Some of the world s major economies, including the US, are progressing further through their economic cycles and will begin to experience cyclical slowdowns at some point. We note that demographic changes over the past decade, such as a reduction in labour force participation, have added uncertainty as to how much spare capacity remains within the US economy. Meanwhile, China s economy could slow more quickly than expected as its government seeks to reign in the rate of credit creation. As was the case in early 16, this could raise concerns over the sustainability of the global economic expansion, causing risk sentiment to deteriorate meaningfully. We will be watching closely for signs that such trends may be developing. Implications for asset markets There will always be a level at which investors will judge themselves adequately compensated for bearing the risk associated with holding treasuries and we recently upgraded our view on international sovereign bonds (from negative to neutral) on valuation grounds, with yields having increased significantly over the past year (albeit currency-hedging costs remain prohibitive for most sterling-denominated investors). However, we expect strengthening growth and the trend towards less accommodative policy, particularly in the US, to continue to act as headwinds against fixed income markets in the coming year. If growth were to remain strong and force interest rates higher, we could become more pessimistic on the sector in the future; however, if growth and inflation were to decelerate, this could lead us to become more optimistic towards developed world sovereign bonds, given their status as safe haven assets. We note that it was inevitable that the ten-year treasury yield approached the key 3% psychological level as the Fed raised rates, but what is important is whether it stabilises around this level as it did in 14 or whether we see further immediate selling. Investors have become more wary of the risk that higher treasury yields pose to equity markets, given the ten-year treasury yield s role in asset valuation calculations and the likely effect of a move significantly above the key 3% psychological level on investment sentiment. However, equity earnings yields are still far higher than those of their equivalent corporate bonds (Figure 5), which is providing a floor for valuations. Equities should also benefit from robust earnings growth and technical support provided by share buyback activity, which have both been boosted by the recent US tax reforms and changes to the rules surrounding the repatriation of corporate capital held overseas (Figure 6). Overall we are marginally overweight equities as we continue to favour the asset class relative to fixed income, but we will look to shift our exposure within equity markets as higher yields have various implications for sectoral, geographic, quality and stylistic allocation decisions.
US equity earnings yields exceed corporate bond yields 1 Global equity valuations have improved Yield (%) 8 6 4 1988 1993 1998 3 8 13 US equities' earnings yield US corporate bond yield Figure 5: Equities earnings yields remain superior to the equivalent corporate bond yields, suggesting the former still present value in relative terms. Price-earnings ratio 18 16 14 1 5/16 8/16 11/16 /17 5/17 8/17 11/17 /18 US Emerging markets UK Europe Asia ex-japan Japan Figure 6: The recent US tax reforms have boosted corporate earnings, thereby making equity valuations more attractive. This has been one of the key factors supporting our ongoing preference for equities over fixed income, with the latter having also become more attractively valued as yields have risen. How do treasury yields affect equity valuations? The Discounted Cash Flow model is an asset valuation methodology that estimates an assets value by calculating the total current value of all the cash flows it is expected to generate over the course of its life. When estimating the current value of a future cash flow, investors will discount the nominal future cash flow value by a discount rate. In practice, the rate that analysts use is often linked to a risk free-rate, which is in turn generally assumed to be linked to the yield of ten-year treasuries. When the discount rate, or treasury yield, rises, the current value of future cash flows falls. As such, the value of the asset also falls, and vice versa.
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