Investors’ views on the outlook for growth have gone from acceleration to anticipation of the coming peak, while on inflation, expectations have moved from a pickup – transitory or otherwise – to concern that central banks might appreciate an overshoot of their targets less than previously thought, even as medium-term inflation expectations have remained anchored.
Assessing the outlook at the mid-year point, we find the rally in US Treasury yields has been overdone and foresee modestly higher nominal yields through the rest of the year. The outlook for equities remains good thanks to solid economic and earnings growth. There will, however, be more variation in returns across styles and sizes.
The pandemic, of course, is not over and a Covid variant that is resistant to current vaccines, and the re-imposition of lockdowns that could entail, is one of the key risks to our outlook.
Two factors determine the path of US Treasury yields: the persistence of recent inflationary pressures and the timing of steps by the US Federal Reserve to taper its support for the US economy.
A more hawkish Fed would reduce inflation and term premia on longer maturities and raises the odds of limited rate rises at the shorter end. Nevertheless, we feel it is too early to position for a flattening yield curve. Our third-quarter target for the 10-year Treasury yield is 1.50%, and 1.75% at end-2021.
In the eurozone, slower asset purchases by the ECB amid improving economic activity should cause yields to rise, but net negative bond issuance, thin trading liquidity and growing concerns about the spread of the Delta variant should cap yields. Overall, we have turned neutral in eurozone duration.
Overall, US equities should modestly outperform European equities through the rest of the year, even if Europe has the Next Generation EU funds to look forward to. The recovery in European earnings has lagged that in the US, leaving room for European equities to catch up.
More cyclically oriented countries such as Japan and emerging markets should outperform. As vaccination rates rise, a fuller reopening should allow corporate earnings growth to accelerate broadly across emerging markets.
