US growth is now predicted at 6.5% for 2021.
- Thursday, March 25, 2021
The fixed interest bond markets are usually seen as ‘safe’ investments, but 2021 has become a problem year for bonds with expectations over rising inflation hitting real yields and values.
In the past three months UK gilt funds have fallen -5.16% while UK corporate bonds are down -2.92%, US government bonds down -3.8% but high yield non-investment grade bonds are up 0.62%. The reason being that high yield bonds have greater capacity to soak up inflation unlike government bonds whose yields are now historically very low. It is for this reason we recommended moving all our UK gilts and long dated credit to short dated high yield bonds at the end of February. These moves protected portfolio assets. Longer dated bonds are hit harder by inflation as the longer the fixed interest term the greater the long-term impact is upon the real value of the coupon.
The threat of rising inflation is a real one, due to the huge financial stimulus being placed into the global economy and the success of the vaccine role out in the US, UK and Asian countries. As a result of expected inflation, the yield on US 10-year treasury bonds rose to over 1.75% over the past two weeks. This shift in bond yields started a migration of capital from equity to bonds and particularly from high value US equity and tech stock.
The US Federal Reserve has just updated its forecast for US growth this year and is now predicting growth of 6.5% for 2021 up from their 4.5% forecast in December. This increase in economic growth comes on the back of President Joe Biden’s US$1.9tn stimulus package and the US’s rapid vaccine roll out. The Fed is expecting the American economy to grow beyond its pre pandemic size quite quickly. At his recent press conference Fed chair Jerome Powell argued that the recovery would take time and that policy needed to remain accommodative. It was too early to talk of adjusting asset purchases (QE). In the meantime, he is prepared to run the US economy “hot” to meet the central bank’s objectives. This news has helped US stock markets recover from their recent corrections. All three main indexes; Dow Jones, Nasdaq and S&P 500, have made gains over the past two weeks. On the back of this so have markets in general other than Japan.
The Office of National Statistics confirmed that the UK economy shrank by -2.9% in January and is expected to fall by -2% in Q1. This is however better than the -4% Q1 prediction by the Bank of England in mid-February. In his recent budget, Chancellor Rishi Sunak predicted 4% growth in UK GDP for 2021 and 7.3% in 2022. After our Covid related downturn, the UK is set for a strong recovery.
The growth in economic activity is expected to result in global inflation, firstly in the US, then into Europe and Asia. Rising inflation can be very helpful in reducing the real value of public and private sector debt. Stock markets will respond well to reasonable inflation but over 4% inflation can hurt business investment and result in higher borrowing costs.
The Fed has indicated that it does not expect to raise US interest rates before the end of 2023. The recovery needs to be well established before any rate rises are considered. The forecast for US inflation this year is 2.2% and currently stands at 1.7%, while UK inflation is 0.7% so the UK has quite some headroom before hitting the BoE target of 2%.
Oil prices are an indicator of demand within the economy and a barometer for inflationary pressure. Brent crude oil prices have risen from US$50 to US$69 in the past three months, while gold, a measure of uncertainty in the economy has fallen from US$1,825poz to US$1,725poz over the same period. These two movements would suggest a growth phase ahead.
Inflationary and volatility concerns are leading us to make a further change to our holdings in order to position the portfolios for the months ahead. We are anticipating that equity returns will recover from the recent correction and remain positive so we intend to maintain our current equity allocations. We will keep these under review due to the continuing threat of Covid returning in part of the world less vaccinated than us.
The increase in bond yields and interest rates in time will impact the cost of global borrowing. The UK has borrowed £400bn to fund the cost of Covid with our national debt now at the size of our annual economy. The Office of Budget Responsibility estimates that for every 1% rise in 10-year treasury bonds will add £25m to the annual cost of paying our debt interest costs.
Greater levels of quantitative easing could be a central bank strategy to push down the yield curve but QE in itself is further borrowing. The challenge to all central banks is how to manage bond yields and remove ourselves from the dependency on QE. The BoE currently own nearly half of all the UK governments gilt issues. This level of holdings should mean that the BoE would have control on yields but yields are primarily driven by US 10-year treasuries.
Federal reserve Chairman Jerome Powell and Treasury Secretary Janet Yellen will be sensitive to the measures available to the Fed to push down on the US yield curve but are unlikely to take action until they think intervention is required. Dr Yellen has stated she views employment rates as a key measure of inflation ahead of bond yield rises. There are levers that governments can pull to reduce the threat of inflation and push down on bond yields. We expect the Fed to continue with its US$80bn per month bond purchasing programme.
2022 will witness a big expansion of UK gilts with £214bn of new UK gilts issued. As gilts are put out to auction it is expected that yields will rise to attract investors unless the BoE buys up the majority. Global interest rates are however predominantly determined by the yield on 10-year US treasury bonds.
World-wide indebtedness will exceed US$230tn this year. This is the total of all government, corporate and household debt and exceeds 2.5 times global GDP. The enormous scale of these debts has ensured that central banks cannot raise interest rates without implications. Regularly both government and corporate debt needs to be refinanced at the end of the set term. These refinancing requirements ensure that QE programmes will remain along with global liquidity and low interest rates.
We are planning an earlier than usual rebalance and portfolio update and review this year. We are planning this for April and May rather than June and July this year.
Chris DaviesChartered Financial Adviser
Chris is a Chartered Independent Financial Adviser and leads the investment team.