Investors see a risk that the bond market is completely wrong about inflation

For now, the US Treasury bond market appears to be moving along with the Federal Reserve’s view that inflation will remain largely under control, even after several months of dazzling results. Beneath the relatively optimistic surface, however, is an undercurrent of concern.

The concern is that 10-year Treasuries yield TMUBMUSD10Y,
1.293%,
currently hovering around 1.30% – along with break-even rates that suggest annual price increases of around 2.3% over the next decade – underestimate the risks of a prolonged period of higher inflation in the US.

And if those risks materialize, pushing long-term yields higher and steepening the yield curve, as it did in the first quarter, “that could lead to significant volatility between asset classes” as bonds sell, credit spreads widen and stocks fall, portfolio manager said. Scott Ruesterholz of Insight Investment, which manages more than $1 trillion.

Recent comments from prominent investors such as BlackRock Inc.’s Larry Fink and DoubleLine Capital’s Jeffrey Gundlach serve only to underline the concern that the market is too complacent.

Two consecutive months of aggregate US consumer price index gains at or above 5% have left parts of the financial markets jittery. And pointed questions from lawmakers during Fed Chair Jerome Powell’s semi-annual testimony to Congress last week may have contributed to fears that the central bank has misjudged the ongoing price pressures unleashed by the pandemic, even though it acknowledged the chairman “go through a shock through the system that accompanies the reopening of the economy.”

A painful ride

“There is definitely a risk that the market is getting it wrong here,” said Mark Heppenstall, chief investment officer of Penn Mutual Asset Management, which manages $33 billion from Horsham, Pa. The CIO sees the possibility of key consumer price readings coming in between 3% and 4% in the next six months as gross domestic product, or GDP, hits 7% to 8% for the year, pushing the 10-year treasury back to 2. % is pushed. If, on the other hand, higher inflation and slower economic growth occur, it could create “push-pull dynamics in interest rates that make the bond market suffer more”.

Much depends on the outlook for bond investors for the remainder of 2021. Fixed income is hit hardest of all asset classes by higher inflation, which erodes fixed value bonds, and some investors are unable to sustain losses for long. “There will be some tension in other asset markets,” Heppenstall said in a telephone interview. “But it could be a painful ride for long-term bond investors.”

A new Fed confab looms

Investors are largely looking beyond the US economic reports due for the coming week, including housing-related data from Monday and Tuesday; weekly unemployment claims on Thursdays; and monthly purchasing managers indices for production and services on Fridays. Instead, they’re focused on the July 27-28 Fed meeting in Washington, where policymakers are likely to continue their discussions about tapering bond purchases while adopting what Powell calls a more “humble” mindset about inflation. .

Fed officials will find themselves in a traditional speech blackout period for the next week ahead of that meeting.

Inflation forecast

Meanwhile, some forecasters are already bracing for months of high price polls well above the Fed’s 2% target. Economists at Fannie Mae predict that consumer prices will remain around 5% yoy until the end of 2021. Those at Barclays Plc expect total CPI to come in at 6% YoY in December, while Wells Fargo & Co. expect a percentage of 4% for the whole year, which means that readings should remain around 5% until the end of December.

Ruesterholz of Insight Investment sees a chance that inflation will remain above 3% through the second quarter of next year amid strong economic growth in the US, before falling to 2.25% to 2 by the end of 2022, 5%. That’s because price pressures from hotel reopenings, increased consumer travel and used car sales should eventually dissipate, while disrupted supply chains are likely to “repair themselves,” says the New York-based portfolio manager.

Ruesterholz says Insight invests in “high-yield, growth-sensitive assets” with lower credit quality and collateralized loan obligations, or CLOs, and sees Treasury Inflation-Protected Securities, or TIPS, as an “interesting” way to build a scenario with higher inflation.

Checking out: As inflation rises, BlackRock’s iShares investment strategy says clients are ‘confused by the movement in interest rates’

“We need to be aware that the forces that keep inflation up are much stronger than expected, and we run the risk that the longer that happens, the more likely it is that inflation will trickle down to other categories, investor psychology and expectations.” , he says. .

The stock outlook

Last week, the Nasdaq Composite Index COMP published,
-0.80%
ended the week lower for the first time in about a month and the small-cap Russell 2000 index RUT,
-1.24%
fell more than 4.5%, the worst week since October 30 and the third consecutive weekly decline.

In other words, in absolute terms, neither growth stocks, which were highlighted in the tech-rich Nasdaq, nor the value sector, reflected in the Russell, performed well in July.

What works? The biggest of the greats outperform the Nasdaq Composite Index COMP so far,
-0.80%
up about 1.2% over the month. That dynamic also helps the S&P 500 SPX,
-0.75%
and the Dow Jones Industrial Average DJIA,
-0.86%
made a profit so far this month.

“The S&P 500 is up 4% since June 3, but ~80% of that movement can be attributed to the top 5 stocks,” Larry Adam, CIO at Raymond James’ wealth management unit, wrote in a weekly research report.

That said, Adam said he’s not too concerned about the limited size of winning stocks.

“Narrowing width is a sign of internal weakness and can sometimes precede relapses. We are aware of this, but not overly concerned given the strong medium term technical background and market tendency
for sector rotation later,” he wrote.

Peak earnings?

John Butters of FactSet Research says 85% of S&P 500 companies have reported positive surprises for second-quarter earnings per share so far.

“If 85% is the final percentage, it will be the second-highest percentage of S&P 500 companies reporting positive EPS surprises since FactSet began tracking this metric in 2008,” he wrote on Friday.

He said mixed earnings growth, including actual results and estimates, for the second quarter of 2021 for the S&P 500 is 69.3%, which would be the highest year-over-year earnings growth the index has seen since the fourth quarter of 2009. (109.1%) reported. keep numbers.

Adam says better-than-expected quarterly results from US companies are “attributable to the surprising resilience of the US economy; however, as the reopening is fully realized, much of the uncertainty clouding analysts’ estimates will diminish, and with it the magnitude of the gains.”

Raymond James will look for more guidance from CEOs and CFOs on how business is developing for the next three months and the full year.

EARNINGS REPORTS EXPIRE JULY 19-23
MONDAY: IBM, Tractor Supply, JB Hunt
TUESDAY: Netflix, Chipotle
WEDNESDAY: Coca Cola, United Airlines, Johnson & Johnson, Verizon, Texas Instruments, eBay, Anthem, Baker Hughes
THURSDAY: Intel, Snap, Twitter, American Air, AT&T, Domino’s, Biogen, Abbot, Equifax
FRIDAY: American Express, Schlumberger

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