Markets: Electrified by Yields!

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The 1.9 Trillion $ US Bill is finally passed by the House! And equities have reacted nerviously!  The RBI saw a bond devolution and so did the Fed  – sparking a crisis across the board. So what lies ahead?

Equities react to bond yields negatively especially if the pace of increase is high – and for a wide variety of reasons including the fact that this brings the value of future cash flows down. As well as reduces the comfort with the struggler balance sheets overladen with debt- and most importantly, if it is the US that is experiencing higher yields, risk averse money would tend to travel back and cause a USD appreciation (versus the expectations of a weakening which have kept emerging markets booming last few months). So whats been causing all the scare suddenly?

Why the Scare

The House gave final approval on Feb 26, 2021, to a budget blueprint that included President Biden’s $1.9 trillion stimulus plan, advancing it over unanimous Republican opposition as Democrats pressed forward with plans to begin drafting the aid package next week and speed it through the House by the end of the month.

Apart from this humongous stimulus , which can lead to massive inflation in core commodities and asset prices generally, global economic indicators announced recently for the final quarter of last year have confirmed the view that economic recovery is still gaining momentum. Fourth-quarter GDP, compared to the previous year, in China, Japan, the United States, Thailand and even the euro zone continued to recover from the strongest contraction in decades in the second quarter.  More than 80% of the companies on the S&P 500 universe beat expectations and the beat in India was even much larger – and smaller companies in the BSE 500 outperformed on sales versus their larger counterparts after several quarters.

As a consequence, and for the full year, the global economy shrank by around 3.5%.- much better than what the International Monetary Fund (IMF) had expected in the second quarter, when it forecast a 4.8% contraction. This evidence brought china back to focus – Resumption of normalcy in metal imports by China has caused metals to do extremely well creating and inflationary prophecy via dependent industries and Q3 comments by many auto and metals majors point to the need to raise prices eventually if such pressures persist.

U.S. stimulus checks themselves could unleash a $170 billion wave of fresh retail inflows to the stock market, according to Deutsche Bank AG strategists!

The Other View

However,  there is a very strong community of market specialists out there which believes that fears of damaging inflation look premature in 2021 and the outlook remains subdued as long as economic slack persists which is borne out by the US unemployment numbers. The US economy lost at least 4.5 million jobs during the pandemic and would need to create more than 100,000 jobs per month just to keep pace with population growth. In addition, as the pandemic’s effects start to ebb, economies re-open and global trade accelerates, supply-chain issues should ease, stabilising price pressures.

President Biden, speaking just before the House acted on the stimulus vote, cited a weak jobs report in justifying the use of a procedural device, called reconciliation, to ram through the measure if Senate Republicans oppose his effort to speed aid to families, businesses, health care providers and local governments. Mr. Biden’s comments came as the Labor Department’s reported on Friday that the economy added only 49,000 jobs in January, and just 6,000 in the private sector. The labor market remains 10 million jobs below its pre-pandemic levels.

The Federal Reserve chair Jerome Powell said on 10 February that it may be “many years” before the damage of high and persistent levels of unemployment is behind us.  The European Central Bank’s minutes, released last week, suggest a determination to communicate a clear distinction between a short-lived jump in inflation and a more enduring rise. “A temporary boost to inflation should not be mistaken for a sustained increase,” read the minutes. As last month’s ECB minutes say, there is a “risk of a cliff-edge effect from a premature removal of fiscal stimulus.”

Treasury Secretary  Yellen pointed out recently that one has tools to deal with overspending but not underspending.  And that means the US politico monetary establishment is voicing the same thing across the board – the risk of US inflation is further than markets think!

The Impact

We have already seen the carnage (?) in global markets over the past week or so as yields increased across the board. An abrupt rise in 10-year bond yields . FPIs would normally be expected to be sellers in this condition UNLESS the USD also weakens – and that’s whats been playing out.

“History shows however that bond markets often project their expectations for inflation well beyond levels that are justified by the trends in the actual inflation rate,” says John Stoltzfus Oppenheimer Asset Management chief investment strategist.

Growth With Inflation

Pimco, one of the world’s largest fixed income managers, said in a research note that the additional stimulus could “contribute to 2021 real GDP growth of over 7%,” a level not seen since “the great inflationary episode of the 1970s-1980s.”. A similar  optimistic view abounds across global commentators. At any rate, the Fed’s recent adoption of an “average” annual 2% inflation target would allow the U.S. economy to “run hot” for a while before tightening its policy. And that buys us all a lot of time. As long as real growth exceeds inflation, its heaven!

One doesn’t know whether inflation expectations are correct or not – and whether it is just reflation – the kind that’s good for sectors overburdened by years of low realisations and overcapacity.  These sectors will gain pricing flexibility especially if aggressive growth follows inflation – the kind that we saw in the middle to late 2000s – where inflation was moving higher but still outpaced by earnings growth and markets rejoiced this phenomenon until the Lehman meltdown.

Inflation induced by growth is different from inflation pressure caused by supply side shocks – and therefore sooner or later the markets may cease to panic as one is possibly faced by the first prospect of a universally aligned growth situation globally. This would be key to a rally like one has never seen earlier

Also remember that a lot of the stress on balance sheets is cleaned out – and a whole lot of new competition awaits in the wings for everything from pins to planes globally. High growth means availability of alternatives or near substitutes as well as digital arbitrage – this itself may cause pricing pressures to remain much lower than one fears even as growth continues over the next 4-5 years.

Meanwhile, all eyes will be on the Fed during their March FOMC meeting. It remains to be seen what they do next.

What should you do

Remember that stocks are for the longer term – and the opportunities in the US and Indian space are unlimited. Remember you are buying not a bank when you buy an SBI – but a huge commercial bank, a large insurance player and most important, a large fintech (Yono) rolled into one. Similarly, when you buy Reliance, you are buying not an oil and gas player (in profit terms) but a huge retail and telecom player (apart from the owner of multiple apps that can be listed on their own like Zoho!) and so on! And when you buy an IRCTC, you are buying into a superb monopoly with multple levers of growth (except the rail service shutdown risk) that it will leverage over the next few years! Why would you be worried about yields?

In any case, if a view on the Nifty is what excites you, then you would love to read the latest report from our Head of Research, Amnish , who puts a substantially higher Best Case scenario target on the Nifty than you would imagine.

Talk to our RMs and Officers for mutual fund recommendations to profit from this bump up in yields or for stock recommendations that will make you participate in wealth creation opportunities for the next decade!

So Keep watching this space!

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