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Cross-Asset Quarterly Outlook

March 2021*

How Much Do Higher Yields Matter?

A temporary rise in COVID-19 infections during the winter notwithstanding, the rapid roll-out of vaccines in several countries and the sizeable US fiscal stimulus have fuelled a significant market rally.
A strong belief in the ‘reflation trade’ has raised inflation expectations, boosted government bond yields and driven a rotation in equity markets.
This has likely further to go but need not threaten risk assets as central banks are likely to cap any sharp rise in bond yields through further asset purchases.

The recovery and reflation narrative has become increasingly entrenched in markets, fuelling a sharp bond sell-off and affecting assets across the board. Increasing market optimism principally reflects progress with the vaccination roll-out after some initial teething problems (mostly in the US and UK) and the passage of another large fiscal stimulus bill in the US. Nevertheless, concerns persist. On the one hand, countries have experienced setbacks in their fight against COVID-19 with the appearance of more infectious variants and difficulties procuring and administering vaccinations. The fear is that recurrent lockdowns may be required as infections spread, new variants appear and the recovery fails to achieve escape velocity. There may also be a realization that there is no safety from the virus anywhere, until it is under control everywhere. On the other hand, concerns have also risen arisen over the US enormous fiscal experiment of injecting a 14% of GDP stimulus into the economy at a time when a recovery is already under way. This policy not only questions the ‘Washington Consensus’ regarding the role of fiscal deficits and public debt, but also challenges prevailing notions on how fast economies can grow without triggering inflation. It is a bet the Biden administration is willing to take, but which markets have faced with some trepidation.

Much has been written about the return of the ‘bond vigilantes’ but markets have so far not priced greater default risk into US government debt; they have simply ratcheted up inflation expectations. This has been most pronounced in Australia – a country at the forefront of the China-led economic revival – and the US. It has been more muted in Germany and more tame still in Japan. Nevertheless, the rise in headline rates has not been unusual in size: in the US, a 110bps rise since 10Y rates bottomed in August 2020 is typical for such periods of cyclical recovery. The other measure of how markets price reflation is the yield curve: in the US, it has undergone a 75bps shift within six months, unusual but not unprecedented. By and large, the recent shift in yields is well within the historical range and to be expected at this stage of the recovery, even if particular days saw accentuated moves. Similarly, the ca. 80% rise in equities (MSCI World) from the trough in March 2020 is not atypical for this stage of the cycle. Importantly though, equities are undergoing a significant rotation from momentum- to value stocks and from those viewed as insurance during the pandemic (tech, ‘new economy’) to those benefiting from a recovery and higher yields (leisure, banking).

While part of the reflation trade may still await confirmation from the real economy, surprise indices indicate that both activity and inflation data have significantly exceeded expectations recently. In addition, PMIs have firmed considerably across many DM economies.

Asset Allocation


  Chg -3 -2 -1 0 +1 +2 +3
Equities -              
Rates -              
Credit -              
Real Estate              
Commodities -              

Source: City of London Investment Management

*The publication reflects asset performance up to February 26, 2021, and macro events and data releases up to March 5, 2021, unless indicated otherwise.

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The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.

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© 2021 City of London Investment Management Company Limited.
All rights reserved.

City of London Investment Management Company Limited (“CLIM”) is authorised and regulated for the conduct of investment business within the UK by the Financial Conduct Authority (FCA), registered as an Investment Advisor with the United States Securities and Exchange Commission (SEC) and regulated by the Dubai Financial Services Authority (DFSA). Registered in England and Wales No. 2851236. Registered Office: 77 Gracechurch Street, London, EC3V 0AS, England.

© 2021 City of London Investment Management Company Limited. All rights reserved.