In the May issue: we explain why inflation may run hotter for some time, but should move back later in the year.
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Year-to-date, MSCI All Country World Index (ACWI) total equity returns (including dividends) are up 8% in sterling terms, buoyed by the vaccine rollout and reopening from lockdowns.1 Of the major economies, the UK leads the way with over 70% of the population having received at least one vaccine dose and non-essential stores now being allowed to reopen, in England at least.2 Globally, the picture is mixed, with the US only just behind the UK, but the slow pace of vaccinations in Europe has seen a third wave and more lockdowns, while the pandemic is spreading rapidly again in India.
On balance, very accommodative fiscal and monetary policy, as well as easing lockdowns (outside of Europe), provide a backstop of support for the global recovery during these uncertain times. Moreover, fiscal policy could be eased further in the US, where the Biden Administration has proposed a new infrastructure plan worth $2.65trn and a further $1trn directed to healthcare and education to be spent over eight years that is being debated in Congress.3 Some commentators are starting to voice concerns about too much stimulus. Another potential disconnect is that while the world’s largest economy continues to add to what are already the most stimulative policies in history (outside war times), the authorities in China, the second biggest economy, are tightening policy, including guiding banks to control credit growth for the rest of the year. This has already seen some stretched firms, like bad debt manager Huarong Asset Management, get into financial difficulty. Can both sets of policy makers be right?
Looking forward, the IMF recently forecast global real GDP to grow by 6.0% in 2021, which if achieved would be the fastest rate since records began in 1980, and another strong print of 4.4% is expected in 2022.4 This potential rapid economic growth is leading to overheating concerns. For example, in the US annual Consumer Price Inflation accelerated to 2.6% in March, the fastest pace in nine years, from a low point of just 0.1% last May.5
Higher inflation is exactly what the Fed wanted when it introduced its new Average Inflation Targeting in September 2020. However, given the unprecedented global stimulus combined with pandemic-led supply disruption, inflation risk is likely skewed to the upside.
Some early warning inflation indicators include: i) annual global food prices rising by 25% in March6; ii) crude oil prices are back at pre-pandemic levels; iii) March used car prices in the US are 26% higher than a year ago7, following car production disruption and a shortage of computer chips; iv) US lumber futures prices have more than quadrupled over the past year to record the biggest increase in 50 years of data.8
The Fed is essentially betting that there is sufficient slack in the economy to take away pricing power from companies so that any inflation will prove transitory. However, some pricing surveys show that this may not be the case. In March, the National Association of Independent Businesses, a body that represents small firms, showed that surveyed companies expected selling prices to reach their highest level in 13 years.9
Businesses are rationally taking the opportunity to raise prices amid low inventories, weak competition and pent-up demand, while incomes have been boosted by stimulus cheques.
Even if inflation continues to accelerate in the US over the summer, Fed officials expect that short-term interest rates will remain at zero until “maximum employment” is achieved and “inflation has risen to 2% and is on track to moderately exceed 2% for some time”. These targets are not likely to be met in 2021. The March unemployment rate was 6.0%, well up from its pre- pandemic level of 3.5%, and it will also take time to determine whether there is any follow-through after the expected initial inflation spike.10 The Fed futures market currently does not expect the first full interest rate hike before 2023.11 However, it is possible for the Fed to consider reducing its accommodative policy alternatively by scaling back its current $120bn monthly pace of asset purchase (i.e. tapering) later in 2021, but this could lead to market volatility, as we saw in the so called taper tantrum of 2013, when the then Fed chairman Ben Bernanke first talked about reducing Quantitative Easing.
The Fed is aware of this risk, however. For markets, the longer the Fed continues to run loose monetary policy, the more difficult it may be to control inflation and longer-term interest rates. Moreover, low interest rates justify higher equity valuations, and the MSCI ACWI equity index is currently trading on 19.5 times forward earnings, compared to its pre-pandemic peak of 16.8x.12 Also positioning is already very positive, investors have poured $569bn into global equity funds over the past 5 months to end-March, compared to $452bn in the past 12 years!13 Should the Fed be forced to tighten policy aggressively, it could lead to a correction in equities from elevated levels.
To conclude, the vaccine rollout, favourable policy and strong economic recovery is likely to drive company earnings and thus equities up further over the coming months, even though inflation risks have risen. At some stage the global economy will have reopened. It remains to be seen what impact the permanent economic changes caused by the pandemic will have on the growth and inflationary outlook.
1, 2, 4, 5, 6, 7, 8, 9, 10, 11 Refinitiv, data as at 4 May 2021
3 RenMac Policy: No Bridge to Republicans in Biden Infrastructure Plan, 6 April 2021
12, 13 BofA, Flows Booming in Spring, 6 April 2021
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
Please remember investment involves risk. The value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.