Client Update - 19th March 2021
I am not sure it feels like a happy anniversary quite yet, however I should acknowledge that it is now a full year since I started writing weekly updates to our clients. And what a 12 months it has been. Having recovered strongly in 2020 on the expectation of an economic recovery, investment markets are now trying to front-run the next phase of the cycle. As I have written numerous times, the twin drivers of huge policy support, and expectations grounded in the belief that vaccines would come, propelled market valuations in the latter part of 2020. Now there is some attempt to front-run what many think is the next stage of the cycle – higher inflation and monetary tightening.
In doing so they have priced in higher inflation and are testing the timing of the beginning of a new rate hiking cycle. The US Federal Reserve (FED) is likely to reiterate that 2023 is the most likely start date. It needs to be a strong message because inflation is going to be higher in the next few months and demand straight out of lockdown could surge. I expect it will be quite a game of brinkmanship between the markets and the central banks. The European Central Bank will need to do more to resist contagion. They are already, but they are also making their policy framework more rigid. This will make for an interesting June meeting.
One can be forward-looking and short-sighted at the same time. Indeed, even 10-year inflation expectations are very sensitive to the current underlying state of the economy, as influenced by business surveys. The February manufacturing survey index (PMI) was its highest since 2008. These surveys can be pretty good at predicting inflation a few months ahead and we agree that consumer prices will accelerate into 2021, but it is premature to see in these indicators signals of a shift to a new inflation regime.
However, inflation expectations also take on board judgment calls on the policy stance. The FED’s pledge to tolerate inflation overshooting is an important shift. We think the FED will maintain a dovish communication mode during the imminent acceleration in inflation, thus strengthening the credibility of their “Average Inflation Targeting” framework. This should push inflation expectations further up. We think it will be transitory, but it is one of the reasons why we continue to think that even at 1.6% - the level reached last Friday – 10-year yields in the US still have room to climb further.
Our current economic cycle is marked by vaccine development and deployment (even in the face of new variants), rising immunity and falling infection rates, and a sequential lifting of social mobility restrictions and the commensurate increase in economic activity. The nuances are provided by differences in the speed at which this all happens between countries, the additional policy support that goes along with it and the extent to which the pent-up demand accumulated is realised in actual spending. The US is leading the way on most counts of a recovery, with the UK (delays in vaccine supply from India not withstanding) driving vaccinations forwards. Other countries are in their wake. The passage of the $1.9trn COVID-19 recovery stimulus bill in the US is a huge reason for the expected acceleration of the US economy. Joe Biden’s stimulus package hands out $1,400 cheques per adult, with $350bn for city development, $170bn for schools and $100bn for public health. A middle-class family of 4 will be around $12,000 better off from all this stimulus. There is no precedent for this in American history.
Some transitory increase in inflation is likely. We have had disruptions to supply and demand in the last year and the expectation is that demand will come back quickly. So, in some parts of the economy – travel and hospitality – prices could rise a lot. This hump in inflation in Q2 will coincide with a boost to US household income coming from stimulus checks and with the further re-opening of the US economy as vaccinations are rolled out rapidly across the United States. The transfer of wealth from global savers to American consumers via the guarantee of the US federal government should be tremendously powerful. Some of the cash might go into savings plans, some of which will go into equities (and not just the reddit betting type). The US is certainly looking quite attractive right now.
This is all speculation. What is clear is that central banks are loath to run the risk of snuffing out a recovery in order to counter early signs of inflation. They seem much more likely to wait for a sustained shift up in inflation before tightening. This is one reason why I have become more confident about the recovery – and more wary of inflation in the longer term.