Inflation fears lingered throughout March, driven by hopes of an economic rebound and consumers spending with abandon, but this genie seems to have returned to the bottle for now, with figures yet to show any meaningful rise.
In fact, the UK’s CPI (Consumer Price Index) fell in February to 0.4%, from 0.7% in January, with clothing and footwear seeing the sharpest price declines in more than a decade. US consumers, however, will soon have another stimulus cheque in their hands, courtesy of President Biden’s $1.9 trillion package, and much of this is expected to flow into the service side of the economy as people more feel comfortable leaving their homes. With oil prices also higher this year, pressures on inflation are rising at the margin and if we do see higher figures in the spring, concerns about another taper tantrum could easily rise to the surface again.
The month featured the anniversary of global markets bottoming on 23 March 2020, with two of our favoured areas – small caps and high yield – leading the way in the recovery since. Technology’s recent sell-off continued into March but the sector quickly rallied and, as we have become used to, markets were soon back at all-time highs, with the S&P 500 close to hitting the psychologically significant 4000 level.
In the face of sell-offs in government bonds, markets were waiting to see whether central banks would blink and Federal Reserve Chair Jay Powell did everything he could to be at his reassuring best following the March meeting. Powell said the Fed would wait until the economy has ‘all but fully recovered’ to pull back monetary support and will be patient in the face of any temporary rise in inflation. This ‘temporary’ is key, with Powell suggesting there will likely be a step up in March and April, but this one-time bulge will wear off quickly and not change the longer-term outlook. As he put it, ‘You can only go out to dinner once per night, but a lot of people can go out to dinner’.
Powell also refuted concerns that higher employment could spark a rise in inflation, signalling a demise in the Phillips curve. While there is still a link between wage inflation and unemployment, Powell said that when wages rise because unemployment is low, firms have been absorbing it into margins rather than raising prices. As a final positive, the Fed announced an upward revision in growth forecasts for 2021 (to 6.5% from 4.2%), reflecting progress on vaccinations and fiscal policy and pushing stock markets back towards highs.
Many took Powell’s comments to mean the Fed is comfortable with higher longer-term interest rates, with Biden’s stimulus package theoretically enabling the Bank to normalise the long end of the yield curve without choking off economic recovery. While the relief Bill got through the House and Senate in March, highlighting the unified Democrat government, not a single Congressional Republican voted in favour and this shows a widening gulf between the two sides on Capitol Hill. This may signal difficulties if Biden needs Republican support for proposals and we could see that imminently as he tries to pass a $2 trillion package of infrastructure spending, paid for by a substantial increase in corporate taxes. Proposals include raising corporation tax rates to 28%, with his predecessor reducing the level from 35% to 21%.
In a busy month for central banks, the Bank of England’s Monetary Policy Committee voted unanimously to keep interest rates at 0.1% and maintain quantitative easing at £895 billion. Despite the fall in CPI in February, the BoE also expects inflation to move quickly back towards 2% in the spring, due in part to increases in energy prices, but said there are no plans to tighten policy until there is ‘clear evidence significant progress is being made in eliminating spare capacity and achieving the 2% inflation target sustainably’. Meanwhile, the European Central Bank (ECB) attempted to put a floor under eurozone government debt by announcing an acceleration of its programme of bond buying but left interest rates and its suite of monetary policy tools unchanged. Given the level of reliance on central bank stimulus and the slow progress of the vaccine rollout on the Continent so far, concerns are rising that economic reopening and growth may be considerably slower and lower than predicted. An ugly argument with the UK over ‘vaccine nationalism’ is hardly showing either side in the best light – especially with Boris Johnson chalking up the success of the UK rollout to greed.
We remain broadly positive about stock markets outside of US large-cap technology stocks but believe there are a few more things for equity investors to consider. Rising chatter about pent-up demand is one additional factor to bear in mind, with excess personal savings in the US standing at $2 trillion at the end of February. Some of this money has already flowed into markets via increased day trading – some may say gamification of markets – and stoked huge asset price inflation in areas like Bitcoin and the usual suspects in the tech sector.
Another question is where we are in terms of central bank stimulus, with huge amounts borrowed and spent to keep economies moving. Data on the G4 (US Federal Reserve, Bank of Japan, ECB and Bank of England) shows central bank balance sheets expanded massively during 2020, rising from around $15 trillion to breach the $25 trillion level, with borrowing in the UK exceeding GDP for the first time since the 1960s. While central banks continue to reassure markets they are not going anywhere, it is valid to ask how far this largesse can continue. Interest rates, at least, look anchored at low levels for some time to come: Powell has said ‘a strong bulk’ of the FOMC committee are not expecting a rise before the end of 2023 and urged against focusing on when the first hike might come, pointing out the state of the US economy in two or three years’ time is highly uncertain.
Equities have also benefited recently from the so-called TINA (there is no alternative) effect, with little value in government bonds, although rising yields, at least in the US, have brought 10-year Treasuries back above the yield on the S&P 500 in recent weeks for the first time since the pandemic hit. While many bonds are still negative yielding, particularly in Europe, there are signs of a slightly improving situation, particularly for income seekers.
A final consideration – and the most important one for investors – is valuations and this is a large part of why we remain broadly bullish on equities. Apart from the expensive US, where there remains a dislocation between a fairly mediocre short-term economic outlook and a 12-month forward P/E above the long-run average at close to 23 times, markets such as the UK and Europe are much cheaper and their return on equity is recovering from a lower base.
With consensus (and apparently the Fed) moving towards higher longer-term yields, conditions are increasingly shifting against the speculative tech trade – although most predictions are for a slow grind lower over the months ahead rather than a 2000-2002 like crash. To be clear, this is not expected to encompass every tech name and may even exclude the FAAMG giants, with those expected to suffer the most being names like Tesla and the various SPACs that have made investors such huge short-term gains. Higher long-term rates hit high- growth, high-multiple stocks harder than value and cyclical companies. Despite recent corrections, the market cap differential between speculative names and companies best placed to benefit from economies reopening is vast and there is a huge amount of capital that could find its way to cyclicals and value stocks as their earnings continue to improve.
If tech does suffer further selloffs, we highlight the UK market as an attractive option amid the reflation trade, with plenty of cyclical upside, cheap valuations and structural overweights to sectors such as financials, energy and materials, which have been outperforming so far this year. Saying this, no one will be surprised to see figures released in March showing the UK economy back in reverse gear during January, with GDP estimates highlighting a 2.9% contraction. This was better than the near 5% decline predicted by many, with the service sector hardest hit under renewed lockdowns but increases in health services from vaccine rollout and increased testing partially offsetting declines in other industries.
While there was no mention of the Brexit effect in the GDP report, separate ONS (Office of National Statistics) data revealed the largest monthly fall in goods imports and exports for the UK since records began in January 1997. It charted a 41% decline in exports to the EU during the month, valued at £5.6 billion, alongside a £6.6 billion fall in imports from the euro bloc. As we have written, the UK is benefiting from Brexit being in the rear-view mirror but the full ramifications of leaving after close to 50 years will only become clear in the months and years ahead.
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