The reflation trade has culminated in an 80 basis point jump in 10-year US treasury yields since the US elections. Three factors have been driving this surge in bond yields. The first, namely expectations of an interest rate hike by the Federal Reserve at its December meeting, was exerting an influence even prior to the election. The second is the anticipation of President Donald Trump-driven fiscal stimulus and its potential impact in adding growth to an already fully-employed US economy. Finally, expectations that the European Central Bank would taper its asset-purchase programme have recently come to fruition.
In respect of the first factor, markets are currently pricing in a Fed hike in December and two more in 2017. This is hardly an aggressive view given the current implied 10-year US inflation rates of about 2.0% and the durable US economy. The risk is that the Fed will prove more hawkish, perhaps hiking on three, or even four, occasions in the new year. We are therefore taking a cautious approach to bond markets in the belief that yields could rise further from here, particularly should US inflation accelerate as it is already beginning to do.
In an environment of rising bond yields, global equities are typically challenged, but benchmark indices have surged to new highs in the US and advanced strongly in other parts of the world. This reflects not only expectations that US growth will accelerate in 2017, but also the stronger growth numbers coming from Europe, China and even Japan – meaning that the outlook has brightened on the corporate earnings front.
Rising bond yields are therefore something that equity markets can manage. However, the big story is not the overall levels of equity indices, but the rotation within them. Investors have rotated away from equities offering compelling yields in favour of those that are more cyclical in nature. At the moment, emerging markets are lagging this process, as they often do when bond yields rise and the dollar strengthens. Once that process is complete, however, we anticipate that emerging market equities will also join the bull market in global stocks.
Best wishes for the holiday season and 2017.