• Recovery of the global economy and strong determination of governments to carry out the structural plans for the relaunch set up an objectively favorable scenario
• The rally in the Treasury, despite rising inflation expectations, nevertheless signals a contrasting feelings. Three critical factors: a Q3 not as intense as the previous one, the peak reached by liquidity in the US, uncertainties around Chinese political developments.
• In a scenario of equity markets still around the peaks and without a precise direction, the risk of corrections is real
• In the light of a lasting global economic growth we look at the markets with optimism and look for the optimal purchase level for our strategies.
The economies of the world are reopening and the governments of the main blocks show strong determination in carrying out structural recovery plans. There are solid reasons, being at the end of July, to evaluate the prospects of the markets with optimism. There are also red flags well represented by the anomalous evolution of the US Treasury.
In the last two months, a strong rally of the bond has accompanied the greatest growth in inflation in over a decade, breaking a pattern that seemed unchangeable (inflation up, Treasury down). Inflation, in general, erodes the future value of the fixed coupons and makes it likely that central banks will respond with interest rate increases. However, between May and July, at least for 30 years, this did not happen: the long Treasury started to rise again and other government bonds followed the trend. Why is that?
To answer we have to take a step back and go back to the end of last August when the Fed modified its mandate and to set an AVERAGE inflation target of 2% (with the option of temporarily exceeding it), convincing the markets that a new inflationary season had begun while it failed to pass the 2% for decades. From that moment, as per textbook in case of actual inflation, Treasury prices began to suffer, hitting lows in March and sailing smoothly for another couple of months.
Expectations of a rise in inflation, fueled by the robust American economic rebound since the beginning of the year, authorized the forecast of a new raise in yields and eventually rates. There was no shortage of signs from the Fed in this direction: the publication, in June, of the Dot Plot, the document containing the interest rate projections made individually by the members of the Fed Committee, suggested the possibility of a tightening of monetary policy or at least the end of the expansionary stance.
Fed chairman Jay Powell had urged the market not to focus too much on those forecasts though. He also acknowledged that the Fed may have to respond to higher than expected price pressures. A statement to read alongside the recent admission that Fed officials were beginning to discuss scaling back $ 120 billion in monthly purchases of Treasuries and MBS. The combination of these news thus suggested that the Fed would have not tolerated the risk of galloping inflation. The Treasury, therefore, should have continued on the downward path and, instead, the trend has reversed. Other factors, evidently, were stronger and acted in the opposite direction. Which ones?
There are three, in all likelihood. The first is that the recovery of the American economy seems to have reached a peak. So far, company data has been more than good but growth will probably not be a straight line and the third quarter could easily be a hiccup. At the same time, the spread of the Delta variant (Delta Scare) has generated fears that the global economic boom will be less than the optimistic forecasts made at the beginning of the year or, at least, will happen later. Although the number of deaths (Case Fatality Ratio) has fallen sharply in developed countries, there is fear that some governments will react with new lockdowns.
The second factor is liquidity. Central banks have in several circumstances made it clear that the purchase programs (especially the extraordinary ones for Covid) will not go on indefinitely.
The third factor concerns China, where the government seems to be oriented towards stricter regulation of certain businesses will lead to a slowdown in the Chinese economy or at least uncertainty. A 1% slowdown in the Chinese economy is estimated to cause a slowdown in the rest of the world of at least 0.3%.
In short, the anomalous evolution of the Treasury is not without fundamental base: it signals that doubts are mounting among investors not so much about the intensity of growth as about the trajectory.
What to expect at this point? In the last newsletter, we warned of the risk of a market that proceeds without leading ideas. This situation has not changed but, on the other hand, the reasonable forecast that the global economy will continue to grow (even with the recalled limits) authorizes us to look to the markets with confidence.
There are upcoming opportunities beyond the so called “reopening trade” and make the case for particularly selective purchases. In the equity sector, it will be necessary to focus on companies with high dividend yield and on sectors, for example oil or steel production, where either cash flows structurally exceed capital expenditures or secular trends are strong and go beyond the uncertainty of Covid-19.