These divergences have important implications for investment strategies and risk assessments. In the short term, there is less scope for inflation to pick up in the eurozone, given the delayed and less dynamic recovery — as confirmed by the recent inflation releases in the U.S. and the eurozone. The homegrown uplift to bond yields will be correspondingly weaker. This combination makes European fixed income less exposed to duration risk than U.S. fixed income, and more attractive at the margin; the slower normalization also suggests a cautious approach to the European corporate high-yield sectors more directly exposed to COVID-19 restrictions.
The ECB's less-convincing stance, meanwhile, flags an important tail risk. Eurozone yields will feel the pull of U.S. Treasury yields, particularly if the latter surprise to the upside on the back of a stronger-than-anticipated U.S. recovery. This might reawaken concerns on higher-debt periphery countries like Italy. Should government bond yields turn on an upward trajectory, these countries would face higher debt-servicing costs given their elevated debt levels; this fiscal pressure could raise their sovereign risk and cause the spreads of their government bonds to German bunds to widen. During the time of the eurozone debt crisis, then-ECB President Mario Draghi turned out to be the perfect person to meet the challenge head on. Mr. Draghi had both the domain expertise and the decisiveness to push the ECB to a very forceful stance, crystallized in the famous "whatever it takes" speech.
Current ECB President Lagarde, by contrast, has appeared much more concerned about building consensus and lacks the economics background of her predecessor. Both of these differences have been apparent in recent press conferences. A less-convincing, more divided ECB could find it a lot harder to allay market concerns. While we do not expect things to get as nerve-racking as in 2012, a bout of serious turbulence in eurozone government debt spreads is a tail risk worth monitoring.
A stronger U.S. rebound bodes well for emerging markets, especially when combined with the ongoing recovery in China and the fact that Asia overall has made significant progress in bringing COVID-19 infections under control and creating the conditions for normalization — with the unfortunate and notable exception of India.
The upswing in commodity prices shows that the global economic outlook is brightening, although supply constraints triggered by the COVID-19 crisis have also played a role. From an investment perspective, however, we have to weigh the improved macroeconomic outlook for emerging markets against the potential stress from higher U.S. Treasury yields. Higher U.S. bond yields would increase debt servicing costs for those emerging markets countries and corporates that have significant U.S. dollar-denominated debt; and it would make emerging markets bonds at the margin less attractive to foreign investors compared to U.S. bonds. Indeed, both hard currency and local currency emerging markets bonds have had a challenging start to 2021 as the reflation narrative pushed up benchmark U.S. yields. While U.S. bonds have taken a breather and stabilized in recent weeks, a strong U.S. recovery and highish inflation numbers have the potential to push them up again in coming months. Here, differentiation and security selection will be the name of the game. Emerging markets countries and companies that are better positioned to benefit from a pickup in global trade and less exposed to currency risk on the funding side should prove to be better bets. As ever, security selection will be key, and a successful investment strategy will require even more hard work than usual.
Another important factor to pay greater attention to is China's role as a direct investor and funding provider across emerging markets. As China balances economic and geopolitical considerations in its investment decisions, and in handling distress situation for its borrowers, understanding China's shifting priorities has become crucial for emerging markets investors.
Overall, we expect that the coming months and quarters will see a consolidation of a robust recovery in the U.S. and in the global economy at large, with Europe catching up as it proceeds with normalization. Together with vaccination programs, fiscal policy plays a key role in this recovery, notably in the U.S. Going forward, we believe markets will increasingly focus on whether this can be too much of a good thing — whether the massive fiscal stimulus, enabled by an extremely stimulative monetary stance, will cause the U.S. economy to overheat and inflation pressure to build beyond the central bank's expectations and desires. We do not expect inflation to get out of hand, but given that policymakers have now pulled out all stops, we suspect that managing their desired inflation rise will prove harder than they think and claim. This could easily bring heightened stress and volatility to financial markets where prolonged massive monetary easing has already contributed to stretched valuations across asset classes.
This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.