John Husselbee is Head of the Liontrust Multi-Asset Investment Team
Just as Brexit and trade wars dominated sentiment in 2018/19 and Covid took the reins last year, the macro story of 2021 so far, beyond vaccination efforts, has been whether better-than-expected growth as the world reopens will spark inflation and how this might affect ongoing recovery.
At the mid-point of the year, our outlook remains positive on risk assets. Global stocks ended the month with a fifth consecutive positive quarter as reflation continues, although this is becoming more nuanced as some countries, especially in Asia, are falling behind in their vaccine strategies. One point to consider, and we make no apologies for repeating this from last month’s commentary, is that the S&P 500 has not seen a 5% correction yet in 2021 and, on average, these occur three times a year. With a large amount of good news priced in, including better-than-expected-earnings, and growing concerns about a taper tantrum and tax rises to come in 2022, we may see cooling off through the rest of the year as markets move towards a slower mid-cycle phase.
For now, however, the S&P and Nasdaq both hit record highs once again at the end of June, buoyed by news of a potential infrastructure deal in the US. President Biden celebrated the plan, which is expected to move through Congress alongside another bill purporting to spend trillions on ‘human infrastructure’, but there are no guarantees either will pass into law given the political splits in the US.
Broad bullishness continues, with the latest fund manager survey from Bank of America revealing a large majority expecting markets to continue climbing until at least 2024. Around 60% of respondents are overweight equities, with banks the most popular sector followed by ‘chunky cyclicals’, such as commodity-heavy UK equities, basic materials and industrials. Showing that a broad consensus still remains in place, despite some skittishness, 72% see fears over the impact of rising inflation on recovery as overblown.
As ever, the tactical opportunity for us as multi-asset managers lies in variation between markets, and while the US continues to look fully valued, the UK remains cheap despite a strong performance over the first half of 2021.
Central bank watching has become the markets’ favourite pastime and no comment or gesture, however miniscule, can escape forensic examination for the merest signs of hawkish or less dovish leanings. Speculation around the US Federal Reserve’s mid-month meeting was particularly high, as headline inflation had crept up to 5% year on year – and core to the highest level since 1992 at 3.8% – and there are growing calls to douse these flames before they get out of control.
According to JP Morgan, global core inflation is running at a 25-year high and despite their protestations, central banks are clearly walking something of a tightrope, working out the point at which inflation changes from a side effect of growth to a challenge to it.
Anyone looking for a more hawkish tone from the Fed saw exactly that in June, with higher expectations for inflation this year (some might say after the horse has bolted) and an earlier timeframe for potential interest rate rises. The Bank increased its headline inflation estimate to 3.4%, up a full percentage point from the March prediction, and admitted levels could end up ‘higher and more persistent’ than expected as reopening continues, with rapid shifts in demand plus bottlenecks, hiring difficulties and other constraints limiting how quickly supply can adjust. Meanwhile, its dot plot chart is now signalling two possible rate hikes in 2023; previously, this consensus forecast showed nothing on this front until 2024 at the earliest.
The pandemic remains the dominant story, however, and Fed chair Jay Powell advised investors to view the dot plot with a ’big grain of salt’, calling its forecasting capacity into doubt and claiming lift off on rates is well into the future. Even with the raised forecast for this year, the FOMC sees inflation trending down to its 2% goal and continues to claim it has the tools to stop things running too hot; the question, for many, is what exactly it would take for the Bank to actually use them.
Powell dismissed concerns about hyperinflation as very unlikely and attributes most of the recent spike in inflation to factors tied to the economic reopening, such as airline tickets, hotel prices and lumber, which he insists should resolve themselves in the coming months.
Tapering still remains a discussion for the future, with the Fed reiterating that the economy is not yet at the point where slowing asset purchases is appropriate. Highlighting the febrile atmosphere around his comments, Powell joked that markets could consider the Fed’s June session as the ‘talking about talking about’ tapering meeting, although this might suggest there will be more to say as the year progresses. Headway towards the Fed’s dual employment and inflation goals is clearly happening faster than anticipated, with 7% GDP growth expected in 2021 (up from 6.5%) and the unemployment estimate unchanged at 4.5%.
In the UK, inflation also climbed to 2.1% in May from 1.5% in April, exceeding the Bank of England's 2% target for the first time in almost two years, with upward pressure from transport, motor fuel and eating out costs. Economists had expected an increase of 1.8%, again leading to speculation over when policy tightening may be needed and, mirroring the Fed, the BoE also upped its expectations for inflation but insisted this does not pose a threat to growth. Short term, the Bank said CPI inflation could breach 3%, mainly due to developments in energy and other commodity prices, but – scoring top marks in central bank buzzword bingo – this should be transitory.
Overall, the Monetary Policy Committee’s central expectation is that the UK will experience a temporary period of strong GDP growth and above-target CPI inflation, after which both will fall back, and it does not intend to tighten policy until there is evidence of significant progress in eliminating spare capacity and achieving the 2% inflation target sustainably.
Figures showed the UK economy grew at its fastest rate since last July in April, giving a year-on-year comparison of +27.6% versus the same month in 2020, at the height of pandemic panic. This slightly meaningless parallel is more useful if we consider the latest growth spell puts the country just 3.7% below the pre-pandemic peak.
We remain in the transitory inflation camp although admit the latest statement from the US Fed jars slightly with previous assertions about a short-term spike. The situation appears to rest on how long we can afford to call the current run up in prices ‘positive reflation’ rather than ‘bad inflation’ and frame it as a return to more normal levels post-pandemic.
While this makes sense for items in the goods basket such as air travel and cars that saw a huge drop off from March 2020, inflationary pressure elsewhere is stemming from more serious supply-side issues, which might ultimately weigh on growth. Those former areas continue to recover at a pace and, anecdotally, Bloomberg’s Pret Index, showing the volume of business at a range of airport sandwich eateries, including Heathrow and Gatwick, is now at the highest level since schools reopened in March.
Within the Liontrust Multi-Asset portfolios, we added to index-linked bonds last year. While not expecting persistently higher prices, we felt that given the fact central banks are prepared to accept some inflation as a corollary of recovery from Covid-19, higher index-linked exposure is a sensible holding. We were also able to access it at more attractive levels than today, where higher inflation is now priced in. As ever, we want to prepare in advance rather than have to react.
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