5 July, 2021
It was late March when the yield on the US 10-year Government Bond rose above 1.7%, reaching a 14-month high. Since then, bond yields have cooled off, with the yield on the 10-year falling to 1.4% in the past week.
Many have interpreted this as trepidation regarding the strength of the US (and global) economy, however we don’t think that’s the case. Recent moves in the bond market appear to be the result of technical factors rather than concerns about economic growth.
What do we mean by technical factors? Consider the following.
Higher inflation in both bonds and equities became the consensus trade around May. The market ‘sold short’ bonds anticipating long-term yields would rise with higher inflation prints and bond prices would fall. Market participants then profit by buying back bonds at a lower price.
Fixed income managers run books with extreme leverage to maximise profits from small moves in government bonds, and this comes with tight limits over risk. As positioning in this trade intensified, fixed income traders locked in profits by buying bonds back, driving bond prices higher and yields lower despite the Fed revising inflation, growth and employment forecasts higher.
So, we continue to hold the view the US economy will be allowed to run hot in the near-term, supporting cyclical (or economically sensitive) businesses. Moreover, we think real yields remain on the rise and will respond to a backdrop of economic normalisation and higher inflation.
For investors, this is significant. It will force the market to reassess the price being paid for growth and defensive assets (or bond-like equities) given valuations remain elevated. This has important implications for diversification.
Bonds and equities usually move in opposite directions but when bond-like equities account for over half of the global market cap, bonds and equities will sell-off together. To ensure portfolios are adequately diversified, investors must be selective about the stocks they own. Rising yields are typically a tailwind for low multiple (or value) stocks.
Oil’s staggering rebound
We discussed inflation at length in a recent podcast episode, but if you had any doubt about the reality of inflation today, take a look at the staggering rise in the price of oil.
It was March last year when the oil price crashed to US$20 a barrel and oil futures contracts turned negative for the first time in history. Today, oil is back trading near 3-year highs at around US$80 a barrel.
This is a result of excitement around reopening and more disciplined supply. On a longer-term view, even with trends towards decarbonisation, we think the oil price can find a base at around US$50 – US$55 a barrel. ESG concerns will ration capital expenditure from oil majors, while demand will continue to be supported by non-OECD countries for some time.
Finally, a word on the Delta strain
We hope you’re coping well with the latest COVID restrictions imposed across Australia. As we’ve mentioned in previous updates, we’re still monitoring the spread of COVID-19 very closely, along with global vaccination rates.
Currently, it’s important to note transmission of the Delta strain has not translated into higher hospitalisations and deaths in countries where vaccinations are well-progressed. In the UK, 85% of adults have received at least one dose, in the US and Europe that number is now around 60-65% of the adult population.
For global investors, a critical consideration is the possibility of further widespread lockdowns. With Europe’s vaccination rate catching up over the quarter, it is our view that more widespread lockdowns across the northern hemisphere appear unlikely at this point in time.
We expect policy makers globally to continue to focus on the vaccine rollout, and progress in emerging markets is particularly important. Vaccination rates in emerging markets are central to a global pathway to herd immunity and widespread border reopening.
A stock in focus | Exxon Mobil Corporation
The outlook for oil remains finely balanced with supply from ‘OPEC plus’ and US production restrained, and demand increasingly looking positive with economic recovery combined with further tailwinds from normalisation in travel (aviation typically accounts for 8% of oil demand).
Exxon is well-positioned to capitalise on the oil market recovery thanks to continued investment post 2016. Additionally, the company is gradually unveiling a compelling decarbonisation strategy via carbon capture and storage (the process of removing and storing carbon dioxide emissions). This technology can be utilised in sectors difficult to decarbonise.
A 10% free cash flow yield amply covers the company’s 6% dividend yield.