Financial market bubbles are quite concentrated, we noted recently. But more and more market segments seem to be overheating. Government bonds, on the other hand, strongly disagree with the stock markets.
An anecdotal example of this bubble-forming is the price of wood (lumber), which has risen even faster than the Nasdaq since the beginning of this year. Just take a look at the graph below:
Investors are looking for real assets that cannot simply be printed by central banks, ending up with a commodity with limited supply such as gold… or indeed lumber.
It’s a point to note that while technology firms continue to dominate markets and indices, the average share of the US S&P 500 index is still in loss since the beginning of the year.
Meanwhile, the combined value of the FANGMAN (Facebook, Apple, Nvidia, Google, Microsoft, Amazon, Netflix) stocked has reached a new historic high of $8 trillion. The sharp increases in the index should therefore be taken with more than one grain of salt. There is a shift in value from local smaller companies to the giants of this world. Gigantism, as it can be called.
Jackson Hole
Equity markets are gradually starting to price in higher inflation, and are looking forward to the meeting in Jackson Hole on Thursday. Fed chairman Jerome Powell will then present the Fed’s policy during a virtual session. He is expected to give an overview of the most proactive efforts the central bank has ever made to sustainably raise the level of inflation. Thus, by aiming for “average inflation”, the Fed will allow inflation to be higher than normal during a given period. The Fed considers an inflation rate of 2% to be ‘normal’. This is quite the opposite of the mission former Fed president Paul Volcker undertook in the 1980s, when inflation was sky-high.
However, there is a risk of a prolonged overshoot. For equities, this need not be an immediate problem. After all, they are in a ‘sweet spot’ with an inflation of 2-4%. The current stock market rally may also get an extra boost because investors are looking for protection in higher-yielding assets, including equities.
Different vision
In the meantime, the bond markets have a completely different opinion. The 10-year US Treasury is currently yielding 0.63%. Nominal interest rates reflect expected nominal GDP growth plus an inflation rate plus a certain risk premium. The bond markets rather expect a period of very low growth and inflation, or even deflation. If deflation actually occurs, which is by no means ruled out after a period of high debt accumulation, nominal US Treasuries are still an interesting investment, especially those with long maturities.
Jim Leaviss, CIO of M&G Public Fixed Income, is not negative about developed country government bonds either, and told Investment Officer: ‘Despite the huge government spending, it is difficult to be bearish about government bonds now given the current environment of yield control. And government bonds like bad news: although they are clearly very expensive, they offer opportunities for profit should negative sentiment return in the second half of the year. Since inflation is unlikely to rise significantly in the short term, I don’t mind owning long maturities.’
In Europe, the planned recovery fund and the continued Pandemic Emergency Purchase Programme (PEPP). helped Italian BTPs and other peripheral bonds to outperform.
‘I am not convinced that BTPs will outperform significantly after their major rally. Flows are decreasing as spreads narrow, so demand is likely to shift to other high-yield government bonds in the region that have so far been less aggressively bought by the ECB and investors,’ says Leaviss. ‘That is why I find, for example, Dutch 10-year government bonds attractive now.’
EMD
Leaviss does see value in emerging market bonds too. ‘First, they offer higher real yields than developed market bonds. In addition, the depreciation of EM currencies has slowed the recovery of these bonds, which means that some local currency bonds do still offer attractive value now.’
Emerging markets clearly face challenges as a result of Covid-19, in particular as a result of the slowdown in world trade. But unprecedented central bank interventions in emerging markets are helping and there are regional opportunities of relative value.
‘For example, I expect Asia to outperform other EM regions because high real rates here generally make the currencies attractive to investors. Moreover, many of these economies are net exporters and should therefore also improve their current account balances,’ he concludes.