AUGUST 16, 2021
Toby Sturgeon, Global Head of Fiduciary Investment Services at ZEDRA shares his thinking on the economic outlook
- The transitory period for inflation
- The Fed’s targets of returning to full employment and inflation at 2%
- The Fed’s fight to avoid a repeat of the tapering events of 2013 which induced considerable volatility
- The outlook for treasuries in the US and UK
- The gradual lift of travel restrictions
- The transition from recovery to expansion
Excuse some poetic license here, all 6 Ts have been widely referenced this quarter but not all have been swinging. Inflation has been influencing a number of markets as investors asked just how transitory is the transitory period for Inflation? The first quarter of 2021 was one of the worst for bond markets and whilst the second quarter saw positive returns, bond markets continued to react to every comment from central banks on growth or inflation. The knock on effects were seen in equity markets, tech companies were the worst hit, as they reacted to the potential of central banks hiking rates as early as 2023.
It is widely accepted that many of the base effects of low prices during 2020 will fall away in the coming months, however which factors will persist? The US saw the largest monthly jump in core CPI since 1982 as a result of a falling US Dollar and rising prices in numerous financial assets and commodities such as copper and gold which was up 4.1% in Q2. The wider commodity index rose 13.3% in Q2 and is up over 20% in 2021. Consumer prices rose to 5.4% in June (year on year) which is the biggest 12 month increase since August 2008. The Federal Reserve (‘Fed’) believe that current inflation is transitory and that they would not stop providing support until it makes “substantial further progress” towards its targets of returning to full employment and inflation at 2%. The US still “has a ways to go” in terms of a full recovery as it has thus far been a jobless recovery with the unemployment rate at 9% if you include those who have dropped out of the labour force since Covid. This is significantly higher than the headline number of 4.7%. There are some who feel that the Inflation story is really a US story. US inflation may be at a three-decade high however we should note that the Eurozone, for example, has seen price growth barely touch the 2% threshold. The UK remains modest at 1.5% in May also. It is interesting to note that many have referenced a surge in 2nd hand car prices as a factor. This partly reflects a wider factor where there has been supply disruption for elements such as semiconductors which are needed for new cars. 2nd hand car prices have soared not only because fewer cars were manufactured a year ago but also because people are less keen to use public transport.
Targets – Central bank targets / base rates
The Fed may target inflation over a full economic cycle and reference the 7 year average for US Personal Consumption Expenditure Core Price Inflation which is 1.63%. The Fed does want inflation to go up and may be looking to make up for the missing inflation of the past. This, in turn, could impact the outlook for base rates and the Fed surprisingly indicated that there could be two hikes in interest rates in 2023. Against a backdrop of rising interest rates government bond holders will likely suffer capital losses over the medium term. Whilst the Fed remain relaxed on inflation there are some commentators cautioning us against this complacency. They believe that moderately higher inflation coupled with near-zero interest rates should create additional funds for governments to increase spending on health, education and infrastructure which can help rebalance the economy.
You may recall that the Fed stepped into bond markets last year to provide liquidity and prevent the cost of borrowing rising. It continues to purchase $80bn of US Treasuries and $40bn of Mortgage Backed Securities every month. This has to end but the Fed will do its best to avoid a repeat of the tapering events of 2013 which induced considerable volatility as it took markets by surprise. This resulted in a jump in US Treasury yields and a drop in the US equity market. It is interesting to note that the Central Bank of Canada has announced tapering of their asset purchase programme.
Thanks Treasuries recovered after a quarter to forget in Q1
In the US, 10 year Treasury yields dropped by 30bps falling to 1.45% but remain more than 55bps higher than they were at the end of 2020. 10 year UK Gilts have a real yield of minus 1.2% and you need to drop down to BBB rated issuance to achieve a modest positive real return. The Bank of England unanimously agreed to leave rates at 0.10% unsurprisingly following the US in agreeing that inflation is likely to be temporary. Encouragingly they noted that global GDP growth has been stronger than anticipated supporting equity markets. They increased their estimate of UK GDP for 2021 to 7.25%. The commodity heavy UK market has benefitted from the rally delivering strong returns this year. The UK will likely rebound further than most but primarily due to having fallen further in the first instance.
Travel restrictions and the transition from recovery to expansion
Travel restrictions are gradually being lifted around the world and there are signs that we are beginning to transition from recovery to expansion. The first sign to support this transition is that global growth has exceeded the previous peak reached in Q4 2019, indeed global real GDP is expected to grow at its fastest rate since 1973 this year. Growth thus far in 2021 has been incredible both in terms of economic output and company profits. Whilst global and US GDP are likely to have recovered to pre-Covid levels, not all are recovering at the same rate however. The US posted annualised growth rate of 6.4% in Q1 but the Eurozone contracted by 0.6% over the same period. It should be noted that leading indicators point to optimism in the region and it appears that there has been strong rebound in the Eurozone economy in Q2. Some surveys suggest that employers in the region are hiring at the highest rate for 20 years and economic sentiment is at a 21 year high. Travel restrictions have been impacted by a number of countries being on target for vaccination rollout especially in the UK and the US with the Eurozone catching up after a somewhat slow start. The region is likely to be 3 months behind therefore there is potential for strong returns there, mirroring those of other regions albeit with a 3 month lag.
There are those who ask whether we have come too far already, well Q2 earning season is underway and it is widely expected that companies will deliver growth of around 60% compared with last year. Q1 earnings were 21% stronger than forecast and US earnings have exceeded pre-Covid levels. US earnings have beaten forecasts by around 20% for each of the last four quarters
So where does this put us? There appears to be strong growth, ample liquidity support, low interest rates, comfortable levels of inflation and elevated equity multiples. There are also some lingering effects putting upward pressure on inflation. The rises in commodity prices, supply chain disruptions, unemployment benefits and labour shortages are causing an increase in wages. With a typical non-financial company having 65% of their total cost base being labour costs this could yet impact. This has already been seen in China where it has been reported that producer prices going into factories are climbing at 9% per annum!
There will likely be some volatility along the way and lets not forget about other factors. We have already seen authorities in China tighten policy in order to crackdown on financial risk. The heightened scrutiny of technology companies in the region has impacted on their share prices massively. We would caution against being over complacent and also about feeling that markets have come too far.