Given the apparent acceleration in the US economy, many are wondering, where are bond yields headed, and what will this mean for the economy and markets?
This time on FS Insider, we spoke with Caroline Miller, Global Strategist at BCA Research, about her recent webcast titled, “Should bond bears come out of hibernation, or will they face extinction?”, to get her take on global growth, inflation, bond yields, the stock market, and more.
US Growth Based on Earnings, Not Fiscal Promises
The earnings picture in the US is still looking solid, Miller noted, and she expects more upside in equities.
Above-trend economic growth and the recent softness in the dollar is helping most corporations this year while wage growth is flat.
“The ability of companies to expand volume and find some pricing power in this environment is creating this reflationary window for equities,” she said. “This is happening in the context of what is still a fairly benign inflation environment, meaning that the risk of the Fed murdering the business cycle anytime soon is quite low.”
The recent health of US equities isn’t just a function of high hopes for a boost from fiscal policy, she added.
The broad-based nature of fairly strong sentiment in US equities is an earnings story rather than a fiscal policy story, Miller stated, and that at any credible pro-growth fiscal agenda would only be incremental to that earnings story.
“The earnings picture is still pretty solid at a time when financial conditions remain supportive for equities,” she said. “They may look expensive relative to history, but from our perspective, they don’t look expensive relative to cash and safe haven assets like bonds.”
Global Growth Picture?
The global picture is an important part of the story for risk assets. Whatever the cause, there’s been a distinct recovery and reflation in the global manufacturing sector, which is the most cyclical component of the global economy, Miller noted.
“We see that from our diffusion index … 85 percent of the 37 countries in our diffusion index are experiencing growth in this sector,” she said.
Forecasters’ global growth expectations for the past year have turned out to be too timid, and she expects to see upward revisions later this year.
Source: BCA Research
“Not only is momentum pretty solid; it’s accelerating,” she said. “What’s important to note is, we’ve seen a change in leadership.”
In the last year, it has become apparent that the rest of the world is looking healthier. It’s not that the US has faded. The rest of the world is showing signs of acceleration.
This is one of the reasons why the dollar has been softer, Miller added.
But that also means that if the US is on a stronger footing and growing above trend, the mechanism that transmits that upward thrust is not going to be the currency, she added.
“The fact that global growth is more balanced and positive everywhere now, not just in the US, means that we should see higher bond yields rather than a stronger currency, as a result,” she said. “The global growth picture is synchronized, and in our view still pretty sustainable over the next 2 quarters.”
Is This a Short Bond Call?
“We still have a preference for global equities over global bonds,” Miller said. “I don’t want to sound too ‘Pollyanna.’ I think a few trends will emerge over the next 9 to 12 months that will invariably cause us to once again get more defensive on equities.”
First, she expects to see valuations become more stretched and profit growth to peak.
We should see some recovery in developed market core inflation, given that global economic slack has largely been absorbed. This is going to push monetary policy slightly tighter, Miller stated.
Bond markets are reluctant to embrace this thesis for now, however.
“We’re still living with emergency deflationary-level settings for monetary policy … at a time when granted, the inflation outlook is not worrisome per se, but certainly the risk of deflation has receded,” she said.
There’s still a large gap between where she expects central banks to be headed in terms of removing accommodation, and government bond yields, which appear to be seeing benign inflation.
“That’s why, with yields where they are, from a total return perspective, we think that bonds certainly look more pricey than stocks,” she said.
When Will Inflation Tick Up?
As far as inflation goes, the US labor market is tightening. The unemployment rate has fallen below the updated estimates of the level of unemployment consistent with stable inflation, which should imply that wage growth and wage pressures are bound to emerge.
“We’re at an inflection point where any further declines in the employment rate should be putting upward pressure on wages,” she said. “To us, the relationship itself is intact.”
As a result, core inflation in the US should start to move back to the Fed’s targets, she added.
In terms of the fiscal picture, Miller sees some reason to be cautious about fiscal stimulus and tax relief.
“Theoretically, in an economy that’s already operating at capacity, as we believe the US is, it isn’t necessarily great for profits or growth long-term to apply a big dose of fiscal stimulus,” she said.
Such stimulus is more likely to overheat the economy and produce more inflation than growth if we’re already bumping up against supply constraints.
“A tax cut that just ends up being net candy for the economy is almost certain to invite a monetary offset — a cycle-ending monetary offset — faster than would have otherwise been the case,” she said. “An unfunded tax cut that pushes the deficit out is also going to flatter the view that bond yields have upside.”