Inflation is now a bigger threat to the bull market than Covid-19, a new survey of fund managers shows. It’s the first time since the pandemic began that investors have cited something more often than the virus.
Some 220 respondents with a combined $630 billion in assets under management took part in the BofA Securities survey, which ran during the second week of March. Less than 15% of the fund managers had the Covid-19 vaccine rollout as their top risk, down by about half from BofA’s February survey.
In March, higher-than-expected inflation was the most-cited tail risk, at 37%, and a taper tantrum in the bond market was second, with 35%. Higher inflation forecasts would mean higher bond yields. And a 2013-style taper tantrum spurred by expectations of Federal Reserve policy tightening would likewise increase market rates.
An all-time high net 93% of respondents expect higher inflation over the coming year. That’s a sign of a rebounding economy on its way out of a recession—91% of investors expect the economy to improve over the coming year and 48% said we’re in a “V-shaped recovery.”
But higher bond yields mean higher borrowing costs for businesses and consumers. That could hinder the economic recovery and weigh on corporate earnings. Plus, using a higher discount rate to value stocks produces a lower present value. And when ultra-safe Treasuries produce a decent enough yield, there’s greater competition for stocks in fund managers’ portfolios.
“Nobody believed that rates at 1.5% would cause an equity correction [a decline of at least 10%,]” wrote Michael Hartnett, BofA’s chief investment strategist. “But the move from 1.5% to 2% is critical as 43% of investors now think 2% is the level of reckoning in the 10-year Treasury that will cause a 10% correction in stocks.”
About a third of respondents said a 10-year Treasury yield of 2.5% makes bonds attractive relative to stocks, while just under 30% said a 3% yield would.
So far, rising bond yields haven’t halted the bull market. The Dow Jones Industrial Average, S&P 500, and Russell 2000 all set record high closes Monday, while the Nasdaq Composite has retraced more than half of its 10% correction in late February. The yield on the 10-year Treasury note is at about 1.6%, up from just over 0.9% at the start of 2021.
But the dynamics of the market under the surface have changed as bond yields have climbed. More value-oriented stocks and sectors have handily outperformed growth stocks this year, with far-off cash flows worth less today under a higher discount rate. By a narrow margin, survey respondents see that continuing: 52% say value will beat growth over the coming year.
“[The survey] shows consensus is ‘cyclical,’ with high exposure to commodities, industrials, banks, discretionary, [and emerging markets] relative to the past 10 years, which is a drastic 180 from a year ago when investors were heavily invested in ‘defensives’ like cash, healthcare, staples, and utilities,” wrote Harnett Tuesday.
Fund managers increased their allocations to sectors like energy and banks in March, while reducing tech exposure to the lowest relative level since January 2009. It remains an overweight versus fund managers’ benchmarks, however.
In any event, the rotation underway in markets still has room to run.
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