Please see article below from Legal & General’s Asset Allocation team received yesterday afternoon – 19/04/2021
Our Asset Allocation team’s key beliefs
Questions of geography
We will address just two topics this week. First, looking at the global numbers, the pandemic is once again intensifying with cases and deaths sadly reaccelerating. But have markets become immune to bad news on the virus? Second, bond yields fell last week despite inflation and growth both surprising on the upside. We think a small island chain in the Caribbean holds a clue to the newfound resilience of the Treasury market.
Is the COVID-19 threat receding? It depends where you live
Looking at recent economic data, it is easy to conclude that the COVID-19 crisis is fast receding in the rear-view mirror. Last week, we learned that China’s GDP grew by 18% year-on-year in the first quarter and that US retail sales jumped by an extraordinary 28% year-on-year in March. Such annual comparisons are flattered by the base effects from the collapse in activity this time last year, but the sense of economic renaissance is palpable.
In the OECD, vaccination programmes have started to bear fruit. Even the EU, which has been infuriatingly slow to roll out its vaccine programme, is now getting its act together and vaccinating at roughly at the pace of the US in mid-February. The EU is on track to hit its target to inoculate 70% of the adult population by September. The main change is in Germany, where the country’s 35,000 GP practices are now permitted to administer shots, rather than just 430 centralised vaccination hubs. A little decentralisation goes a long way.
At the global level, however, there is sadly little sign of the pandemic slowing down. The virus is still raging in emerging markets, with Brazil and India suffering from their darkest days since the crisis began. Headlines of 150 million cases worldwide are likely only a few weeks away.
Does this matter for global markets? At the aggregate level, we think the answer is no. We’ve stuck to a positive medium-term outlook on equities despite these virus dynamics. It’s always important to remember that markets are a discounting mechanism. Notwithstanding the staggering death toll from COVID-19 (nearly three million and counting), investors are collectively capable of looking through today’s ongoing pandemic to the prospect of normalisation tomorrow.
Caribbean clue to the CPI conundrum
On top of the strong growth numbers mentioned above, US inflation rose by more than economists’ consensus expectations in March. Core CPI rose by 0.34% month-on-month (versus the expected +0.2%) and 1.65% year-on-year (versus the expected +1.5%). Several of the beaten-up components climbed slightly on the month, but still remain depressed with scope to rise significantly over the next few months as the economy opens.
In the coming months, we expect core inflation (on both CPI and PCE) to peak around 2.5% year-on-year. There are strong base effects which we believe make a rise above 2% inevitable. In addition, there are reopening effects with some prices normalising and supply-chain disruptions boosting components such as used-car prices. Finally, demand-pull inflation from stimulus spending could add to upward inflation pressure. It is plausible that core inflation could even reach 3%.
Despite that upside news, and the prospect for stronger inflation ahead, Treasury yields have fallen over the course of the past couple of weeks. One explanation comes from Treasury International Capital System data released last week, which revealed that investors domiciled in the Cayman Islands have made net sales of $400 billion of US Treasuries in the 12 months through to February. Not bad for a small island chain with a population of 70,000!
What’s going on here, and why is it relevant? It is estimated that over 80% of the world’s hedge funds are registered in the Cayman Islands and the size of the net sale suggests that a sizeable short base has built up in what is euphemistically referred to as the “fast-money community”.
The message on positioning from these data are matched by a similar story from the options market and surveys of investor sentiment. Having worried about COVID-19 for 12 months, institutional fund managers now say they worry most about inflation and a bond-market tantrum.
Yet in the words of General George S. Patton, “If everyone is thinking alike, then somebody isn’t thinking.” Consensus bets can sometimes pay off, but they are vulnerable to small changes in sentiment having an outsized impact. The size of the short base is now such that the reflationary narrative needs to be constantly buttressed by new information to keep yields moving up.
The bar for taking short duration positions just got that little bit higher.
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