Over the course of February we have seen the ramping up of the rollout of Covid-19 vaccines across the world but particularly in the US. Joe Biden recently announced that he expects every American adult to have been offered their first jab by the end of May 2021. This is a huge positive development for the global economy. Once America is back on its feet and back to normal, we can all focus on everyone else. Vaccine approvals and production have been a rare bright spot in the last 12 months.
As immunity levels rise and hospitalisation rates fall, investors’ focus has shifted from epidemiological charts to the potential of some explosive growth numbers and its spillover effects. In particular there are a lot of questions being asked about inflation!
There is the expectation that we will see more jobs in the economy leading to lower levels of unemployment and upward pressure on consumer prices over the coming months due to the combination of US policy actions, rebounding demand, reduced inventories, and limited spare manufacturing capacity. The perfect storm!
On the back of these concerns and fears we have seen the US bond market sell-off throughout February. Yields hit a high of 1.6%! There is expectation that yields could continue to rise and people are even suggesting we could see them converge to pre-pandemic levels. The 10 year treasuries were at 2% pre-Covid.
This leads us to the inevitable question – what will the Fed do? Already we have seen a subtle shift in the Fed’s language – they moved the goalposts from a hard and fast target of 2% to the new idea of an average of 2% through the cycle. Could we really have a period of time where inflation is above 2%? Seems possible. This definitely gives Jerome Powell additional room and capacity to tolerate higher inflation over the coming months but it is a potential mistake to believe that they won’t take actions to curb it, such as reducing the amount of bonds the Fed actively buys through their QE program, sooner than expected? We have seen this historically, whenever we start to see inflation, it becomes difficult to manage. A lot turns into some more and that leads to even more and suddenly we have too much inflation. This is one of the key reasons inflation targeting has become a key central policy for banks. Though I guess you could argue this has changed somewhat given Powell’s last statement!
The rotation from growth to value stocks should continue and this could be a game changer for US equities as investors look to monetise their ‘Covid winners’ and add risk ‘Covid losers.’ Given the potential and likely mean reversion in treasuries to pre-pandemic levels, US equities generally continue to offer a refuge compared to bonds.
In response to this pandemic we are still seeing monetary and fiscal stimulus continuing apace. We saw record spending by the government last year and while Democrats are in the driving seat in the Senate we would expect more wide-ranging support to come throughout 2021. There is the potential for a huge uptick in nominal growth, helped considerably by the Fed’s uber-easy mode.This is where the Fed makes it cheaper to access cash, which it achieves through actions like lowering interest rates and quantitative easing.
The IMF now projects US GDP growth of 5.1% in 2021 vs -3.4% in 2020. Global growth of 5.1% in 2021 vs -3.5% in 2020. Inflation expectations have already rebounded significantly and are at above multi year averages.
Investors have really started believing that the worst of the pandemic is done and the global economy is on the mend and moving forward. We have seen extremely sharp and aggressive moves in the ‘Covid losers’, those hit hardest by the impact of pandemic and they are now outperforming the ‘Covid winners’. Losers include names in the oil and gas, aviation and banking sectors. While the winners are regarded as stocks in online retail and communication sectors.
There is still room for the ‘losers’ to continue to outperform the ‘winners.’
At the same time, there is also a rotation from growth to value, this is driven by the US’s improved growth outlook manifesting itself through upgraded earnings forecasts and a rise in UST yields from historically depressed levels. Markets had generally handled the trade-off between improved earnings and rising bond yields well but by the end of February there was genuine concern about the impact of rising yields. Growth stocks discount much of their earnings from the distant future and are thus vulnerable to higher yields. On the other hand value stocks get more of their worth from near-term earnings and are therefore less exposed. This rotation has further to go if yields keep rising.
Does CPI keep trending upwards?
CPI drivers include increased money supply, less supply of consumer goods & services and more demand for consumer goods and services. With each of these pulling in the same direction, there is an increased likelihood of inflation having a bigger impact on the economy.
Thanks to government cheques we have seen huge money supply growth. The US Treasury also plans to spend a huge amount of cash in the coming months. Tricky supply issues, where due to pandemic companies don’t have as enough level of inventories and are going to have problems meeting customer’s needs are likely to lead to price increase in the near term of products. There will be particular focus on rebuilding inventories.
As the US economy reopens, there should be an increase in job opportunities, thereby reducing unemployment. This could lead to a potential increase in US wages over the coming months, which could lead to a potential boost to consumer demand, also helping to increase inflation. It’s worth pointing out the stimulus bill itself has a minimum wage increase going through the Senate and so this should help a large part of the workforce.
What do treasuries do here?
Due to a combination of a better growth outlook, more government treasury issuance and no need for corporates to for deleverage there is a real chance that 10 year yields could easily hit 2%. The same level they were pre-Covid.
Real yields have been suppressed by the Fed buying up treasuries. This is ironic because the more effective the Fed is at reducing real yields the more likely the Fed will have to act – expect tapering! The lower yields make it cheaper to borrow money which (when invested) leads to a positive growth impact in the economy. At first glance this is great but then over time has the potential to cause inflation, which is something that the central banks are mandated to control. The best way it can achieve this is through tapering – slowing down or stopping it’s purchase of treasuries!
How long will the Fed accommodate?
The Fed said they are happy to run inflation ‘moderately above target, for some time.’ The Fed wants as much employment as it can get andusing this language has effectively given itself wiggle room. But will it be enough? The Fed still wants to keep LT inflation around 2%. Letting inflation get out of hand would also be terrible. This has led to consensus belief that 2.5% is the new upper bound on inflation expectations.
So what will US equities do?
Stocks should be able to handle the first jump in inflation, at least. Companies are able to benefit from the ability to pass on inflationary pressure to consumers but only for so long. The problem companies have here is that it is only a matter of time till the goods in their own supply chain become increasingly more expensive and so they themselves are forced to increase prices again. Then we all end up in a dirty inflationary spiral. There will always be the concern that the Fed will react and bring inflation expectations back to earth. These sorts of actions by the Fed will likely weigh on the stock market and cause prices to drift lower.
Over the course of the next month it will be interesting to see how markets react to the ongoing focus on inflation and treasury yields, especially with earnings season now behind us! [Earnings season is a quarterly four week period where companies publish numbers to represent their performance over the last three months. These numbers generally detail how they performed and also what their expectations are going forward. Both useful information in helping to value a company and therefore are very important for most companies.]
