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The implications of rising inflation should not be underestimated.

  • Tuesday, April 27, 2021

NEW YORK CITY - Times SquareFinancial markets have been making strong gains so far this year on the back of the expected economic rebound particularly in the second half of 2021 and into 2022. Equity markets have hit new highs in the US, UK and Japan.

The S&P 500 hit a high of 4185 on 16th April having grown 48.8% over a 12-month period. The Nikkei 225 broke through 30,000 points, up 52.5% over a 12-month period. The FTSE 250 hit a high of 22,522 points on 16th April while the FTSE 100 broke through the 7,000 mark. Both up 42.5% and 19.7% respectively over the past year.

Overall equity markets continue to be supported by ultra-low interest rates, massive government spending, most of which is still to hit the real economy, and by earnings growth as the global economy opens. As far as performance going forward is concerned, we feel that this will be impacted by the roll out of vaccination programmes and infection rates, the speed of any rise in future levels of inflation and the Federal Reserve’s management of interest rates and inflation.

Markets have priced in all the good news so have been prone to exhibit days of volatility when bad news is prominent, like the worsening of the Covid 19 situation in India, the Philippines and Brazil. This raises doubts as to whether the recovery is really secure. Subject to an improving roll out of the vaccine across just the developed world, we would expect a good recovery.

One feature of a strong recovery is the outlook for inflation. Having been dormant for long periods of time, recently the US bond markets reacted to the expected onset of inflation. The US 10-year treasury yields rose sharply up to 1.75% in mid-March but fell back to 1.56% by late April as immediate concerns abated. The forward indicators show that yields are likely to rise further over the year ahead with some analysts suggesting 2.5%.

There is evidence that price rises have started to emerge. Annual US inflation was recorded as 2.6% in March. This is a significant rise from February’s 1.7%. This increase was however a result of current oil prices which 12 months ago were exceptionally low. If oil and food were taken out then the ‘core’ inflation rate has not moved very much. The general feeling is that the US is heading for ‘core’ inflation over the Federal Reserve’s 2% target.

Even with recent US 10-year treasury yields rising to 1.75%, real yields will offer little compensation against inflation expected over 2%. Bond markets are still being influenced by massive central bank purchases so any mis-step on policy or even the communication of policy could cause a correction.

The Fed’s current position is to maintain the current 0.25% interest rates until 2023 and manage any inflation increases through the tapering of the Quantitative Easing (QE) programme. Fed Chairman Jerome Powell has gone on record as saying ‘that price pressure is not expected to be particularly large or persistent this year’. The rise in the oil price and the pressure linked to growing demand is seen by the Fed as transitory and not permanent. The Fed have said it is likely to be years before inflation and unemployment conditions are back to the level that meets the criteria for raising rates. Any suggestion of tightening early would create a problem that the world should avoid.

Up until late February, interest rates had stayed low relative to growth and inflation expectations. Equity prices were supported by historically high multiples of corporate earnings and by ultra-low bond yields. The companies that flourished were growth stocks particularly in the tech sector. Since late February, equity markets became more volatile and those with high PE ratios and indebtedness came under greatest pressure due to the spike in bond yields. With growth stock being more impacted by the rise in rates our portfolios suffered more at this time than the national averages.

Stock markets recovered from late February and early March’s correction as concerns over US inflation and the Feds policy subsided somewhat resulting in 10-year treasury yields falling to under 1.6%.

The bond market concerns are focused on the USA, where fears that the Biden US$1.9tn Recovery Plan is too large, especially coming after last year’s US$3.1tn stimulus programme and the awaited US$2tn infrastructure and clean energy plan. On top of these three federal stimulus packages, the market senses that pent up private demand is enough not to be easily absorbed into the economy and could create supply chain constraints.

Accelerating global demands are putting pressure on stretched supply chains. Producers are struggling with shipping and port handling delays, while manufacturing surveys across the world show longer delivery times and rising prices. In some sectors such as semi-conductors there are outright shortages holding back car manufacturing. Against this backdrop, we expect firms to pass on these costs to customers. There is some expectation from fund managers and economists that US inflation could hit 3% by the summer and average 2.6% in 2021. While these price increases may only be transient due to the considerable slack in the labour market, the implications of rising inflation and interest rates should not be underestimated. For this reason, we will be adding inflation protection into our portfolios.

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Chris Davies

Chris Davies

Chartered Financial Adviser

Chris is a Chartered Independent Financial Adviser and leads the investment team.

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