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An investment chief at a $1.4 trillion asset manager outlines 3 different ways the drop in Treasury yields could affect the stock marketand explains why there could be 1970s-style inflation in the second half of 2021

Published by Business Insider on Thu, 15 Jul 2021

<p><img src="https://static5.businessinsider.com/image/60f04b1bd1026600182c5b35-1200/desai_sonal_cmyk.jpg" border="0" alt="Sonal Desai" data-mce-source="Franklin Templeton Investments" data-mce-caption="Sonal Desai, fixed income chief investment officer for Franklin Templeton Investments"></p><p></p><bi-shortcode id="summary-shortcode" data-type="summary-shortcode" class="mceNonEditable" contenteditable="false">Summary List Placement</bi-shortcode><p>US Treasury 10-year yields have plummeted in July, dropping to 1.35% from 1.52% at the end of June.</p><p>Analysts have struggled to explain the falling yields, pointing to concerns about the Delta variant of COVID-19 and the Fed's increasingly hawkish outlook as potential contributing factors.</p><p>There is also little consensus over how the decline in bond yields might affect markets. Low yields often support higher stock prices, but bonds and stocks also tend to move in the same direction in the aftermath of a recession.</p><p>"I don't have a crystal ball," said Sonal Desai, CIO for fixed income at the asset manager Franklin Templeton. "But I would not bet on the dream constellation of strong policy-supported economic growth, low and stable inflation, loose monetary policy, and ever-rising asset prices that markets seem to hope for."</p><p>She added, "Something has to give."</p><p>Desai, who has a Ph.D. in economics from Northwestern University, has led Franklin Templeton's fixed income investing team since 2018. The firm is the world's 16th-largest by assets under management (AUM), holding $1.4 trillion as of July 2020.</p><p>Desai discussed how the fall in bond yields could help analysts predict market movements over the next six months, and shared three possible scenarios.</p><p>"Regardless of which scenario plays out, something in the current constellation of asset prices doesn't add up," she said. "Over the next six months, most likely, we will find out what does."</p><p>First, Desai speculated about a return to "secular stagnation". In this scenario, the fall in yields points to a future where growth fizzles out, perhaps due to a lack of fiscal stimulus or further restrictions to curb the spread of the Delta variant.</p><p>"After a strong, brief rebound in growth and a sharp short-lived jump in inflation, we quickly get back to a long run of slow growth, low inflation and low interest rates," Desai said. "This, by the way, is the view implicit in the official growth forecasts of the US administration."</p><p>In this potential scenario, stock markets would experience a dip, with lower earnings leading to repricing.</p><p>Desai's second prediction is far more optimistic: She imagines "a productivity renaissance." In this timeline, concerns over the Delta variant subside and American politicians reach a consensus on government spending.</p><p>Workers would return to the labor force, companies would spend more on research and innovation, and the stock market would boom.</p><p>"Markets will have to start pricing in higher rates. Stock markets will be supported by the tailwind of productivity on earnings, corporate bonds will benefit from a healthier profitability outlook, but long-duration 'safe-haven' assets will look markedly less attractive," Desai said.</p><p>Lastly, Desai said she feared that the economy could be set to experience "classic overheating". She said that most economic data currently points towards this being the most likely of her three scenarios.</p><p>"In this classic overheating scenario, loose monetary and fiscal policies feed sustained inflation. Not necessarily a return to the 1970s, but a persistent 3% to 5%," Desai said. During that decade, oil-supply shocks jolted inflation and the Fed raised interest rates to 20% in response.&nbsp;&nbsp;</p><p>In such a situation today, stocks would enjoy an initial boom before becoming more volatile as the Fed introduces measures to curb inflation.</p><p>"Market rates will move up faster than the Fed, punishing duration exposure in fixed income," Desai said. "Stock markets should be initially well supported, but then increasingly nervous as the Fed gets ready to tighten."</p><p>Desai's three differing predictions point to rising uncertainty in US stock markets ahead of the second half of 2021. The fall in bond yields will make investors even more nervous.</p><p>"The unusual degree of uncertainty in the current macro environment allows for a wide variety of views on how things will play out," Desai said.</p><p>"Place your bets, and get ready for more volatility," she added.</p><p><a href="https://www.businessinsider.com/stock-market-outlook-investing-bond-yield-predictions-impact-sonal-desai-2021-7#comments">Join the conversation about this story &#187;</a></p> <p>NOW WATCH: <a href="https://www.businessinsider.com/kosher-passover-coca-cola-bottles-yellow-cap-bottle-soda-retail-food-drink-jewish-jews-2017-4">Why some Coca-Cola bottles have a yellow cap</a></p>
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