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Market Outlook: Rising yields challenge risk appetite

Stock markets began March on a positive note, after last week's downturns based on worries about rising long-term bond yields. One factor behind the upturn was FDA approval of another coronavirus vaccine and progress towards enactment of the latest American fiscal stimulus package.

Rising bond yields challenge risk appetite

After a long absence, worries about rising inflation and bond yields are back. This contributed to a downturn in most stock markets by the end of last week. With the United States and other countries launching large fiscal stimulus packages, while COVID-19 vaccination campaigns have begun and economic growth is expected to accelerate, investors are starting to calibrate the risk of overheating.

Rising bond yields are a normal development when financial markets anticipate economic growth. But as we wrote last week, rising yields may also put a damper on growth, since they make it more expensive for companies to borrow while making share valuations more uncertain. In late February this affected growth and technology stocks in particular. These equities are especially sensitive to rising yields; their valuations depend largely on future earnings, whose estimated present value falls as bond yields become higher. For example, the tech-heavy Nasdaq Composite index in the US lost 5% after 10-year Treasury yields spiked at above 1.6%. The Nasdaq index bounced back by 3% on Monday, March 1 once the 10-year Treasury yield had retreated lower again. But on March 2 the Nasdaq fell nearly 2%, pulled down by Tesla, Apple and other high-valuation stocks.

Central banks will need to tread carefully on the late winter ice in order to preserve balance: that is, provide the right amount of support to economic growth without fanning the flames of inflation. What financial markets are wondering is when and how central banks will eventually begin to withdraw their stimulus programmes.
This was one reason why US Federal Reserve (Fed) Chairman Jerome Powell confirmed in congressional testimony last week that the economy remains in a situation that requires continued stimulus and that the Fed is in no hurry to tighten monetary policy even if inflation should rise. According to Powell, it may take three years for average inflation to reach its 2% target. He also said that the Fed has the tools to deal with any unexpected inflation surge.

There were similar statements this past week from policy makers at the European Central Bank (ECB), which is carefully monitoring the trend of long-term bond yields and can buy assets as needed to preserve favourable financial conditions.

Some positive COVID-19 vaccine news

Last weekend the US Food and Drug Administration (FDA) issued an emergency use authorisation for the Janssen COVID-19 vaccine, developed in partnership with Johnson & Johnson (J&J), which may be administered in the United States starting this week. J&J expects to deliver 100 million doses in the US by the end of June. The single-dose vaccine is also expected to receive European Union (EU) approval in March.

The pace of COVID-19 vaccinations in the US also set a one-day record of 2.4 million this past week, well above President Biden's target of one million per day.

At last week's EU summit, there was mixed support for a proposed "vaccine passport" that would enable more people to travel. For tourism-dependent countries like Greece, it could help kick-start the tourism sector by this summer. Meanwhile other countries such as Germany are sceptical towards a system that might lead to discrimination against non-vaccinated people at a time when vaccines are not yet available to everyone.

European Commission President Ursula von der Leyen nevertheless confirmed that the EU still plans to vaccinate 70% of its adult population, about 255 million people, by the end of this summer.

American Rescue Plan moves to the Senate

Last Saturday the US House of Representatives approved Joe Biden's American Rescue Plan, a stimulus package worth USD 1.9 trillion (equivalent to about 9% of gross domestic product, GDP). The bill is also expected to win approval in the US Senate and to be signed by the president within a week or so, but no later than mid-March, when previously approved extra federal unemployment benefits will expire. Later this spring, the Biden administration is expected to propose a second stimulus package focused on infrastructure.

TINA, FOMO and looking back at a 300-year-old bubble

Stock market valuations are the highest since the dotcom bubble. Despite an ongoing pandemic, investor risk appetite is high. A lack of alternatives to equities when bond yields are low is one explanation, but how long can we expect TINA ("There is no alternative") to prop up stock markets? Aside from TINA, there is also FOMO ("Fear of missing out"), the psychological stress of standing on the sidelines as prices surge higher. This is a classic warning sign of a bubble. Yet bubbles are hard to identify in advance and it is even harder to predict when they will burst. What can we learn from history? Read more in the latest issue of Reflections

Our market view

Recovery will support stock markets

A continued rise in long-term US Treasury yields is creating some stock market turmoil. This led to downturns on most major exchanges last week. In itself this is not surprising, since last year's sharp stock market recovery provides reason for caution. We are sticking to last week's cautiously optimistic view of stock markets.

In our main scenario, we anticipate a clear economic recovery starting this spring or summer, with solid growth at least well into 2022. Due to a combination of continued large stimulus measures and an accelerating economy, inflation risks are emerging on the agenda and thus also worries about a continued climb in government bond yields, especially in the US. We expect only limited upturns in yields, but if they turn out to be faster and larger than this, they are likely to have a negative impact on the stock market mood.

In an economic recovery, cyclical value companies should be able to regain lost ground, but looking further ahead the digitisation trend will continue to benefit growth companies. Sizeable worldwide investments in sustainability suggest that last year's strong performance for companies with this type of strategy may continue.

Share valuations today are undoubtedly high from a historical perspective but can be justified by lower interest rates and bond yields as well as a strong earnings outlook. These high valuations limit upside potential in the long term, but they are rarely a good signal to sell in a short-term perspective.

Continued potential, though a lot has been priced in

Given today's low interest rates and yields, it is hard to find good alternatives to stock market returns. Meanwhile, central banks and governments have established a floor by promising continued stimulus.