Why are bond yields declining as inflation surges?
On the latest edition of Market Week in Review, Chief Investment Strategist for North America, Paul Eitelman, and Head of Portfolio & Business Consulting Sophie Antal Gilbert discussed the May U.S. inflation numbers and the puzzling reaction in bond markets. They also explored how the Group of Seven (G-7)'s proposal to establish a global minimum corporate tax rate could impact markets.
U.S. inflation speeds up again, May CPI report shows
U.S. core inflation accelerated by 3.8% on a year-over-year basis during May, Eitelman said, per the Bureau of Labour Statistics' consumer price index (CPI). Characterising the increase as a bit uncomfortable, he noted that May's reading marked the second straight month that core inflation exceeded economists' expectations. However, similar to April's spike, Eitelman said that last month's surge in consumer prices can also largely be attributed to supply-chain bottlenecks and the aggressive reopening of the U.S. economy as restrictions fade.
Two of the sectors with the highest price increases during May were the automobile industry and the airline industry, he explained. The surge in car prices is being driven by the well-publicised global shortage in semiconductor chips, Eitelman said - a problem which he expects will resolve over time. "There's a natural incentive for these companies to invest in expanding their production capabilities in order to take advantage of the higher prices and ultimately profit from them," he noted.
The increase in airfare, on the other hand, is largely a result of the pick-up in U.S. air travel this spring, especially when compared to last spring's very low numbers, Eitelman said. "At this time last year, with the country in lockdown, the demand for air travel had collapsed - in other words, the industry had no pricing power whatsoever. Now, with demand recovering, airlines are able to charge more normal prices," he explained. Amid this backdrop, Eitelman expects the rapid rise in airfare to be more of a temporary factor - one which he sees as very unlikely to persist year-in and year-out.
Eitelman believes the same will probably hold true for U.S. inflation on the whole, with the current spike likely proving to be transitory in nature. "As the calendar flips to 2022, my expectation is that inflation readings will gravitate back down to levels at or below the U.S. Federal Reserve (the Fed)'s 2% target. In other words, while inflation is running hot today, it's likely to turn lukewarm later," he concluded.
Why are global bond markets rallying in the face of rising inflation?
Zeroing in on the equity market reaction's reaction to the May inflation report, Eitelman said that the benchmark S&P 500® Index was unfazed, hitting a new all-time high on 10 June. He added that on a global basis, equity markets in general have continued to exhibit strength so far this June, which he called an encouraging sign.
What's been more puzzling, Eitelman said, is the recent behaviour in bond markets. Bond prices actually rallied the week of 7 June - with yields dropping fairly significantly - despite headlines around increasing inflationary pressures, he said. For instance, the yield on the U.S. 10-year Treasury note fell to 1.43% on 10 June - its lowest level since March - while government-bond yields also declined in the UK, Germany and Japan, Eitelman said. "The bond-market rally in the face of accelerating inflation is a global phenomenon, and it's certainly a bit mystifying," he stated.
So, what exactly could be behind it all? Eitelman believes there are a couple possible factors, with the first being that major central banks haven't responded to the surge in inflation by tightening monetary policy. "We saw examples of this play out again recently, with both the European Central Bank and the Bank of Canada standing pat on their accommodative monetary policies," he noted.
Another driver, Eitelman said, could be the crowded view among investors that yields would increase as inflation surged. "It's not abnormal for one-sided positioning to be disappointed," he noted. Lastly, Eitelman believes that the slow pace of negotiations between Democrats and Republications around U.S. President Joe Biden's proposed stimulus plans, including the infrastructure plan, could also be a factor. "These negotiations have been proceeding in a messy manner, and both the magnitude and timing seem to be moderating down a bit," Eitelman observed.
Potential market impacts of a global minimum tax rate
Turing to the G-7 summit in the UK, Eitelman noted that finance ministers from the seven participating countries recently agreed in principle to a global minimum corporate tax rate of 15%, meaning that large global companies would be subject to taxes in countries where they have business operations (and not just where they're headquartered). The idea behind this, he said, is to prevent multinational companies from shifting where they're domiciled in order to avoid paying taxes. European nations in particular have expressed a desire for mega cap U.S. tech giants to pay more in taxes in countries they do business in, he noted.
The implications of a global tax rate for investors would likely vary by sector, Eitelman said, with perhaps a one-percentage-point hit to U.S. earnings growth in 2022 for the aggregate market. Generally speaking, the information technology and healthcare sectors would be impacted the most, as these sectors are currently paying lower effective taxes and have a larger global footprint, he added.
"These tend to be areas of the market that the U.S. has more exposure to, whereas international equity markets' exposure is typically less. Because of this, I think a minimum global tax rate will lead to more of a tailwind for value strategies over growth strategies, and for non-U.S. equities over U.S. equities in general," Eitelman stated. Broadly speaking, the pendulum continues to swing toward more taxation, he said, which makes greater tax awareness among investors very appropriate in the current environment.