Markets react to concerns over spike in global inflation and rates
Indian equity markets had attained all-time highs amidst a sharp rally driven by the pro-growth budget, continuing loose fiscal and monetary policy, rising pace of vaccinations, clear signs of an economic recovery, and sufficient liquidity. However, in the past few days, markets have taken a pause and we have seen a minor 5% correction due to increasing investor concerns regarding a potential rise in inflation and yields globally. In addition, a sharp rise in COVID cases in some states in India is leading to fears of another round of lockdowns which is also impacting sentiment.
On the global front, the US Congress is expected to pass President Joe Biden’s USD 1.9 trillion stimulus package. The Fed has also reiterated that it will maintain an accommodative monetary policy till at least 2024 to support growth. The rollout of vaccines and falling COVID-19 case levels has also continued to stoke hope for an acceleration in economic activity this year in the US.
The US bond market appears to be pricing in strong economic data and GDP gains ahead, driven by increased consumer and business activity, and further pushed by more expected government stimulus. Hence, bond yields have spiked given the expectation that aggressive rounds of fiscal spending on top of extraordinary loose monetary policy by the Fed, as well as faster-than-expected growth, will stoke near-term inflationary pressures in the US as spending power comes back. Consequently, the US 10-yr treasury yield has risen to above 1.3%. In India too, we have seen the 10-yr yield rising above 6%.
This rise in yields is leading to some nervousness amongst market participants which has led to a near term correction both globally and in India. If US 10-yr yields rise further to 1.6-1.7% levels, we may see a further correction in the market due to risk off sentiment in the short term. A case in point is that during the taper tantrum in 2013, global and Indian equity markets had seen a sharp correction when yields rose sharply by 130 bps when the US Fed announced a roadmap for a faster-than-expected increase in interest rates.
Current jump in bond yields reflects confidence in economic recovery
However, as equity investors, we should bear in mind that the current jump in bond yields reflects a sign of growing confidence in the economic recovery. The taper tantrum in 2013 was in an environment of slowing growth, especially in China whereas the global economy is firing on all cylinders at this time. Also, current moderate rise in inflation is being driven by supply side due to the reflation in economy with low interest rate and high liquidity. Commodity prices can ease in the second half of this year and we don’t see a structural spike in inflation which could lead to higher bond yields. Overall, moderate inflation is good for Equities.
When the economy picks up, typically inflation rises leading to a gradual increase in interest rates. In common scenario, a combination of high inflation and rising interest rate can impact participation in equity markets. High interest rate can also increase cost of capital for businesses and thus have an impact on earnings. It’s only when policy makers start hiking rates aggressively that the stock market typically reacts negatively. In that context, the US Fed has reiterated that they will maintain their accommodative policy till the end of 2024. It is possible that this could be pulled forward and we could see a rate hike in the middle of the next year if growth and inflation are higher than expected. However, interest rates will still remain well below historical levels and for the market to peak out, rates need to reach much higher levels. For example, during the market peak in 2007, US interest rates were near 5% and in 2018, they were above 3%.
Investors are advised to use market corrections to add equities to their portfolio
As long as a gradual increase in yields is driven by growth and moderate inflation, it is fine. And stocks should be able to absorb higher rates amidst strong earnings. Hence, the rise in yields doesn’t alter our medium or long term outlook on the market and we continue to have a positive bias on Equities. Given that we are in the early stages of an economic recovery, monetary and fiscal policy remains supportive, the earnings rebound has been sharp, and relative valuations are still favourable, we maintain our overweight to equities. Our view remains that the rally in equity markets should continue in the longer term.
Many investors may have missed the recent rally. And the ongoing correction can give them a good opportunity to add equities to their portfolio. In an environment of rising yields, we are seeing a rotation out of the technology sector into cyclicals and investors can consider better quality cyclicals. Commodity outlook also looks good and the rally in commodity stocks can have more legs.
The views and opinions expressed are those of Mahesh Patil, CIO – Equity and do not necessarily reflect the views of Aditya Birla Sun Life AMC Ltd (“ABSLAMC”) /Aditya Birla Sun Life Mutual Fund (“the Fund”). ABSLAMC/ the Fund is not guaranteeing/offering/communicating any indicative yield on investments. ABSLAMC or any of its officers, employees, personnel, directors make no representation or warranty, express or implied, as to the accuracy, completeness or reliability of the content and hereby disclaim any liability with regard to the same. Recipients of this material should exercise due care and read the scheme information documents (including if necessary, obtaining the advice of tax/legal/accounting/financial/other professional(s)) prior to taking of any decision, acting or omitting to act. Further, the recipient shall not copy/circulate/reproduce/quote contents of this interview, in part or in whole, or in any other manner whatsoever without prior and explicit approval of ABSLAMC.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.