In this week’s market update: inflation and rising bond yields remain the key focus; stimulus cheques are destined for the stock market; and it’s a big week for central banks.
Once again there’s no doubt what the big market story is this week. All eyes are on inflation, bond yields and what the world’s central banks are going to do about it.
This week sees rate-setting meetings from the Federal Reserve, Bank of England and Bank of Japan. Last week we heard from the ECB, which set the tone for this week’s announcements by promising to accelerate its €1.9trn bond-buying programme over the next few months in order to rein in bond yields which, like those in the rest of the world, are starting to rise on inflation fears.
Europe’s bond yields look particularly out of kilter with the reality of its subdued recovery from the pandemic as a relatively unimpressive vaccine roll-out and rising infection rates in places like Italy, Germany and France confirm that the region is far from out of the Covid woods yet.
It’s a slightly different story in the US and UK where rising bond yields don’t look like a wholly unreasonable response to an effective vaccine programme and the promise of herd immunity sooner rather than later thanks to a combination of jabs and anti-bodies.
A year on from the work at home orders that saw us all working out what this new Zoom thing was we are all still permanently out of office but the light at the end of the tunnel is getting brighter. The return to normality received a massive boost in the US this week as Joe Biden put his signature to a massive $1.9trn stimulus package. Among other things it will put cheques for $1,400 in the post to anyone earnings less than $75,000 a year. Much of that money is earmarked for investment in the stock market according to a survey by Deutsche Bank of online brokerage users - 37% on average with a higher percentage for younger investors.
The latest stimulus money follows similar cheques for $600 at the end of last year and suggests the US government has decided to pour fuel on an already smouldering economic recovery. With 100 million vaccinations already delivered in America and the proportion of hospital beds assigned to Covid patients falling from 19% to 6% since the beginning of the year, recovery is clearly already underway. An inflationary boom during the rest of the year looks possible.
Already, the number of passengers checking in for flights is running at more than 10 times the level last March even if it is still only half the level of 2019.
This is what the bond market is focusing on as it pushes the yield on 10-year Treasuries up from under 1% at the start of the year to over 1.6% today. If that looks like the taper tantrum of 2013 - when investors last worried that monetary policy was about to tighten significantly - that’s because there are many similarities. Both periods saw an economy recovering from recession.
Unemployment was falling but high. Inflation was subdued but there were concerns it could rise. Interest rates were at rock bottom and the Fed was buying bonds.
So, similarities but a key difference too. While there is a bond market tantrum again, there is no evidence of a taper. The Fed has been clear that it is targeting maximum employment and it has pledged to not raise rates until inflation has reached 2% and is on track to stay above 2%.
We will get some more clarity on the Fed’s view this week after the latest rate-setting meeting. But looking at market expectations of Fed policy running out five years into the future the latest move in bond yields looks total divorced from the likely path of interest rates. The futures market is pointing towards interest rates still well under 1% in five years’ time.
What that is saying is that the US authorities are determined to keep real, inflation-adjusted interest rates firmly in negative territory to stimulate the economy and to live with the inflationary consequences if these do indeed follow. It is a kind of unofficial yield curve control.
There is a saying that you should not fight the Fed. This makes complete sense. The US government and central have pretty much unlimited resources. The only constraint on them is the fear of inflation. But if they want inflation, because they see it as the only way out of the massive debts they have run up during both the post-financial-crisis period and the pandemic, then we shouldn’t stand in their way. That’s a recipe for getting crushed.
Inflation is likely. The only question is whether it is a short-term thing in response to stimulus and the re-opening of the economy or something more entrenched and longer-term because the inflationary genie is let out of the bottle and can’t be contained. It’s not a given but now is a good time to be thinking about ways in which portfolios can be protected from rising prices.
Value-focused shares are one possible solution. Gold, property, commodities, infrastructure, smaller companies are others. There are plenty of ways to navigate a more inflationary environment as long as prices do not get out of control. What it probably does mean, however, is that the kinds of shares which have benefited so much from a low-rate, low-inflation environment - those high-flying tech stocks - will continue to perform relatively less well as they have in recent weeks.
Looking at specific sectors, banks have enjoyed a significant resurgence of investor interest on expectations of higher interest rates which make it easier to strike a profit on the gap between the rate at which they borrow and lend. The MSCI index of global bank shares rose nearly 30% in the last three months of 2020 and has added another 20% so far this year.
Investors have also moved into sectors like materials, commodities, consumer goods and industrials, all areas that will do well as and when the economy picks up speed.
In terms of styles, the MSCI global value index has risen nearly 9% so far this year. Last year it fell by 3.6%, lagging the global growth index which soared by 33% as investors flocked to stocks like Tesla, Peloton and Apple. This year the winners are the likes of ExxonMobil, Caterpillar and Wells Fargo. Being caught on the wrong side of this rotation has been painful but fantastic for those who kept the faith with value through the long growth dominance.
The shift in performance has also been reflected in fund flows. Value funds in the US took in $6.3bn in February, up from $1.3bn in January. Growth funds, meanwhile, saw outflows of $18bn in January.
In terms of indices, too, the same effect is evident. The FTSE250 index is a classic re-opening trade with lots of financials, industrials and consumer businesses. It is up 5% so far this year having risen by 25% in the last three months of last year after the vaccine announcements in November.
Housebuilders, retailers, restaurants - all the businesses that need people moving around and spending freely - are doing well, and they are all heavily represented in the UK’s mid-cap index.
Another area to be cautious about might be emerging markets. This is because higher yields in the US could be positive for the dollar, and a rising US currency is often unhelpful for emerging markets especially those with a high exposure to dollar-denominated debts. That said, the long-term case for emerging markets remains intact. Demographics and a growing middle class are long-term positives. In the short term, as we saw this week with China’s strong industrial production data, the region is benefiting from being first in and first out of the pandemic. As ever the key is balance and diversification.
Here in the UK, inflation looks like less of an issue. For one thing the stimulus is nothing like on the same scale as in the US. For another, the UK economy is clearly suffering from the rupture with Europe at the start of the year. The most recent data for January showed a massive fall in trade in both directions across the English Channel.
But that said the Bank of England seems to have shifted its thinking away from its recent focus on the possibility of negative interest rates to a much more balanced view. The vaccination roll-out and the phased return to re-opening over the next three months is a positive counter-balance to both Brexit and the Chancellor’s much more orthodox fiscal approach than is being experimented with across the Atlantic. Again, we will get more of an insight this week as the Bank of England meets too to discuss rates.