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After the recovery, then what?
Growth, not inflation, is now the real concern: since July, the reaction of the bond markets to decade-high US headline inflation rates of 5%+ has been puzzling. Rather than seeing rising bond yields, as one would normally expect (because bonds reflect higher future expected inflation), long-term bond yields have fallen from their end-March highs. US 10-year Treasury yields have declined to 1.3% (as of late-August), down 0.4% from over 1.7% in March. Similarly, German 10-year bund yields have lost 0.3% from their recent peak.
Cautious bond market signals: what are the bond markets telling us? They are suggesting that future growth, not inflation, is now the principal preoccupation of the financial markets. This may seem odd given the strong economic recovery evident on both sides of the Atlantic.
Fading effects from pandemic-related stimulus: bear in mind that this recovery has been fuelled by an abnormally large helping hand from the European and US central banks (zero interest rates, bond buying programmes) and governments (unemployment support, “helicopter money”, infrastructure investment spending). This economic boost was a response to the pandemic-induced lockdowns, and thus largely one-off in nature.
Is weaker growth ahead? As we progressively return to something resembling more normal economic activity, post-lockdowns (subject to any fallouts from new COVID-19 variants), the impact from this extraordinary economic stimulus will fade. The bond markets are telling us today that there is a substantial risk of subpar economic growth ahead, post-stimulus.
Risk of premature tightening of monetary policy: the markets are also warning of the risk of a policy mistake by the US Federal Reserve, that the Fed will react to these higher inflation rates by tightening monetary policy too early, at a time when growth is already slowing down. In past cycles, the primary trigger of economic recession has been central banks raising interest rates in response to rising inflation pressures. Recall that the sensitivity of the global economy to interest rates is today far higher than in the past, given the very high debt levels. Any modest tightening of Fed policy could heavily impact the US and global economy.
Investment boom? Surging government and corporate investment is a new trend that we believe will be persistent, after a decade of under-investment in the wake of the Great Financial Crisis. Structural shifts in demand and consumption post-lockdowns, and the ongoing record-low cost of debt financing are following winds for corporate investment. Companies are investing for growth, in order to cut costs and generate long-lasting productivity gains, while governments are investing both to support employment, and to upgrade key transport, housing and communications infrastructure.
Focus on real assets for income and diversification: in a world in which cash, Sovereign bond markets and Corporate credit markets offer historically low (or even negative) income yields to investors, we advocate greater exposure to real assets with positive after-inflation yields. We see attractive income and diversification benefits from exposure to infrastructure, real estate and commodities. Pension and insurance funds are having ever greater difficulty in meeting their future expected return targets, given their historically heavy weightings to bonds and credit. We expect these institutional investors to step up their exposure to these real asset classes in the future, looking to match their long-term liabilities with these long-term assets which purport to offer far higher future returns than fixed income.
Refocusing on healthcare and medtech: healthcare benefits today from a resurgence in investment plus emergent revolutionary technologies. The challenge? To enhance healthy living years while controlling spiralling costs. Healthcare companies are better targeting treatments via more accurate diagnostic techniques, detecting health issues early via a focus on wellness and prevention, and advancing the use of telemedicine for prompter, more effective healthcare delivery. Acceleration in new drug approvals (especially for age-related and psychiatric conditions, e.g. Alzheimer’s/dementia and clinical depression) is boosting the drug pipelines of pharmaceutical and biotech companies, thus driving future profit growth.
Edmund Shing, Global Chief Investment Officer (PhD)