Key points from the month:
- Markets able to shrug off September’s correction, with corporate earnings driving fresh records in S&P 500
- Marginal UK rate rise and tapering by Federal Reserve expected but we see these as positive early signs of global economy reaching escape velocity from pandemic
- Stagflation fears look overstated, with little sign of stagnating economy at this stage
Equities broadly moved higher over October, shaking off September’s correction despite lengthening shadows created by Evergrande, America’s debt ceiling and the risk of central banks moving sooner than expected towards policy tightening levers.
Strong earnings from US tech giants and consumer, travel and services firms in the UK towards the end of the month helped markets climb this wall of worry, with the S&P 500 back at record highs and investors seemingly confident equities can stay on their feet after central banks start withdrawing bond purchases. US Treasury Secretary Janet Yellen is among those counselling the inflation situation reflects temporary pain that will ease in the second half of 2022, while other optimists have highlighted the positive correlation between higher prices and corporate profits over recent decades.
After such a long spell of markets seeing higher interest rates as tomorrow’s problem, however, the prospect of a hike this year, on top of tapering in the US, has clearly spooked some investors. Wherever people sit – or possibly fly – on the hawk/dove spectrum, most would agree the Bank of England’s (BoE) communication around this has not helped, with different signals emerging day to day. While Governor Andrew Bailey has hinted at an imminent rise, for example, overturning indications that hikes were on the cards for next year, Monetary Policy Committee member Silvana Tenreyro has argued there is no need for a raise because markets have anticipated it happening and repriced accordingly.
The narrative on inflation also continues to drift, moving from transitory blip to higher for longer. Figures published over the month showed another 0.3% rise in the UK’s cost of living over September, due to higher fuel prices, but the annual rate of CPI actually eased slightly, based on distorting effects from 12 months ago. The BoE’s new chief economist Huw Pill upped the ‘4% by year end’ ante and suggested inflation could climb above 5% in 2022, an uncomfortable position for a Bank with a 2% target. He also urged markets to look at core underlying trends in the UK economy, which no longer requires rates on a record-low footing.
For our part, we echo that statement and suggest that while rate hikes and tapering might be concerning in the short term, they are ultimately a positive signal on the global economy reaching escape velocity and moving beyond the grasping tendrils of the pandemic. The economy has come faster to the current mid-cycle point than would be expected, in 18 months rather than the more typical four or five years, but no one should be surprised to see an accelerated cycle given the unprecedented levels of stimulus.
All the worry around higher UK interest rates also serves as a reminder that, while this dominates newsflow as people extrapolate local into global, we are running diversified portfolios on which the impact of hikes by the BoE should be limited. In any case, rises are likely to be minimal and even the most hawkish commentators are not suggesting we will have moved too far away from emergency levels in a year’s time.
As a counterpoint to concerns about inflation, it was interesting to see an argument for deflation from innovation-focused US fund manager Cathie Wood recently. She cited several deflationary forces that could overcome the supply chain-induced inflation currently troubling the global economy, with technologically enabled innovation the most potent. Wood cites declining artificial intelligence (AI) training costs, for example, with this technology likely to impact every sector, industry and company. This appears to support our argument against persistent long-term higher prices, that wage inflation is unlikely to become embedded, despite comments from our Prime Minister. Some might point to the great resignation currently occurring as a sign of a power shift from employers to employees, with so many people re-evaluating their situation post-pandemic, but, for now, that seems to be focused more on flexible working than higher pay.
Ultimately, the key thing to remember about inflation is that while headline figures are elevated at present, core levels remain fairly steady. On the former, we are seeing a kind of rolling base effect move through the system, with gas prices causing a spike one month and used cars the next, but none of these are likely to calcify into higher long-term core inflation.
One thing to keep watching is Evergrande’s potential bankruptcy, with more pessimistic commentators suggesting it could trigger another global financial crisis and a ‘great reset’. The property developer has accumulated around $300 billion in debt and a bankruptcy would significantly slow Chinese economic growth. Already-stressed supply chains would come under even greater strain as a result, which would do little to alleviate already-spiralling inflation in the UK and US. Highlighting the scale of the issue, recent data predicted a third of China’s property developers will struggle to repay debts in the next 12 months, as the sector deals with serious headwinds from falling sales, restricted access to credit and a wider downturn.
To complete the full -flation bingo, some commentators have voiced concerns in recent weeks about a return to 1970s-style stagflation, a demoralising combination of supply shock-driven inflation and stagnant economic growth. Part of this comes from worries that a consequence of quantitative easing (QE) and ultra-low interest rates has been rising prices with nothing extra produced, but we have to recognise the impact of the demand surge from restarting economies post-lockdowns. Back in the 1970s, stagflation came as growth and activity exceeded the global economy's productive capacity whereas today, we are running up against supply-chain bottlenecks. This should ultimately mean supply eventually rises to meet demand rather than vice versa.
To be in stagflation, economies need to be stagnating and there is little evidence of this; in the US, for example, Democrats are nearing agreement on President Biden’s multi-trillion dollar economic agenda, allowing a $550 billion infrastructure bill to pass.
Moving to our next stop on the monetary policy world tour, the Bank of Japan remains an outlier as counterparts start down the tightening path, keeping its benchmark interest rate unchanged at -0.1% and maintaining easing. Monetary policy is not a high priority for new Prime Minister Fumio Kishida’s economic plan and current thinking is that ‘normalisation’ may not begin until the retirement of BoJ Governor Kuroda in April 2023. After a solid third quarter, as markets said farewell to the unpopular Yoshihide Suga from the top job, Japanese equities had a slower October, with rising concerns around Kishida’s plans for wealth redistribution, including potentially higher capital gains tax. They rallied again as November began, however, as the Liberal Democrat Party secured an easier-than-expected election victory. This gives Kishida the platform to increase stimulus and he is set to implement a package worth trillions of yen to support the pandemic-ravaged economy in the coming weeks.
Meanwhile, President Christine Lagarde has done her best to convince investors of the European Central Bank’s ongoing commitment to ultra-loose monetary policy but markets continue to price in rate hikes next year. She also acknowledged surging inflation can no longer be deemed temporary and will likely last longer than anticipated before fading.
In terms of our portfolios and funds, we remain broadly positive on risk assets, albeit recognising we are moving into the mid-cycle phase and the period of everything rising as markets recover from the pandemic is over. The reflation trade that drove performance for the first part of the year has paused but we are well positioned if we do see another leg of a long-term value retrenchment via holdings such as Schroder Income, Man GLG Japan CoreAlpha and Fidelity Special Situations.
Key Risks
