In this week’s market update: new market records fall as America’s post-pandemic boom begins; Britain starts to re-open its economy; and Europe looks through the latest Covid wave.
Spring is definitely in the air as far as the stock market is concerned, with the S&P 500 breaking convincingly through the 4,000 mark for the first time just before Easter and moving further into record territory this week.
The leadership of the US market reflects the determination of the new Biden administration to match previous episodes of massive government intervention in the economy such as Roosevelt’s New Deal in the Depression years and Lyndon Johnson’s War on Poverty in the 1960s.
The Biden White House is holding nothing back in a spending spree that is cat nip to the stock market but is sounding alarm bells for fixed income investors. At the same time as shares are hitting new records, the bond market has just completed its worst quarter since 1980 before the four-decade bull market for fixed income was kick-started by Paul Volcker’s defeat of inflation 40 years ago.
Bond investors fear that the Biden boom will trigger a return of inflation just as big spending did in the past. A sharp rise in bond yields (and a consequent fall in bond prices) reflects fears that the US central bank will be forced into tightening monetary policy sooner than the market currently expects.
That fear was given weight this week by the latest edition of the World Economic Outlook form the International Monetary Fund. The spring issue of this widely watched twice-yearly report into the health of the global economy says the world economy will grow by 6% this year and a further 4.4% in 2022 following last year’s 3.3% contraction overall.
That compares with October’s prediction of 5.2% growth this year and 4.2% in 2022. The IMF said successful vaccine programmes, adaptation to the challenges of lockdown and Joe Biden’s stimulus package had been factors in its upgrade. Without $16trn of spending to counter the impact of the pandemic, the IMF said, the global economy would have contracted by 10% last year.
The expected growth will, however, not be evenly spread. The IMF said that rich countries would recover further and faster than the developing world. Thanks to its big spending plans, the US will lead the way with a 6.4% growth rate this year, 1.3 percentage points more than the IMF expected six months ago. The UK’s growth rate has also been upgraded, to 5.3% this year and 5.1% in 2022. Although Britain was hit hard by the pandemic last year, it is expected to be the fastest-growing G7 country in 2022.
Later this week, minutes from the latest Federal Reserve meeting will put some flesh on the bones of the central bank’s thinking on interest rate policy which is still just about as easy as it can be. The ability of the Fed to keep supporting the government’s spending plans by buying up the bonds the Treasury issues and keeping the cost of funding the deficit low will be tested as the recovery gets under way this year.
The latest minutes will show just how sensitive the Fed is to the recent rise in bond yields. The central bank has indicated, through the dot plots that show the expectations of individual rate-setters, that it will not raise rates until at least 2024. The timing of tighter policy depends, however, on the path of growth and inflation. The Fed is happy to let inflation rise a bit above its 2% target but there is a question mark over how far and for how long it can indulge that luxury.
One of the reasons why investors fear that inflation will return now is the targeting of fiscal support at the people most likely to spend any rise in their incomes. The most effective way of encouraging aggregate spending in the economy is to hand money to lower-income households, precisely what the latest $1,400 stimulus cheques is designed to do.
Goldman Sachs has drawn a parallel with the 1960s War on Poverty in America which dragged millions of people out of hardship and boosted demand for consumer goods, energy and other commodities. That was one of the reasons why inflation rose sharply in the 1970s in the West, followed by a similar surge in the early 2000s as millions of Chinese workers were brought out of subsistence and into the consuming middle class.
The rise in bond yields is still in the early stages. The 10-year Treasury bond yield has risen from 0.9% at the start of the year to about 1.7%. But after decades of steady decline there is a long way for yields to go if inflation does start to become an issue again.
The scale of the Biden administration’s fiscal response to the pandemic is starting to emerge. We have already seen Congressional approval (just) of the $1.9trn American Recovery Plan. Last week, the President set out his ambitions for the next stage, a 10 year $2trn infrastructure build out that will be part paid for by a rise in corporation tax as a reshaping of the US economy gets under way.
It is the most ambitious, and controversial, spending programme since America built the interstate highway network and led the space race in the 1960s. And it is certainly a gamble that runs counter to the fiscal orthodoxy that has prevailed since the 1980s. It is a bet that an injection of government funds into the economy, paid for by higher taxes, will strengthen the economy over the next 10 years not weaken it as many Republicans believe.
The key elements of the spending plan are: $620bn on transport infrastructure and electric vehicles; $560bn on green housing, schools and water upgrades; $480bn of manufacturing subsidies; $400bn on elderly and disability care; and $200bn on better broadband and other digital infrastructure.
It will be paid for by: nearly $700bn of higher taxes as the corporate tax rate rises from 21% to 28%; $500bn from the implementation of a global minimum tax rate to target tax avoiders like the big multi-national technology companies; and $270bn from ending tax loopholes and fossil fuel tax breaks.
So, it’s an ambitious bid to take the fight back to China, reshoring manufacturing and regaining a technological lead, rebuilding America’s ageing infrastructure and tackling climate change head on.
On this side of the Atlantic, recovery is also in the air, albeit on a smaller scale than in America. The re-opening schedule outlined earlier in the year remains on track, with shops due to lift their shutters next Monday when pubs will also be allowed to start serving food and drinks outside.
There remain question marks over the next phases of the retreat from lockdown, notably about when people will be able to travel overseas again or gather together in mass events such as sports or festivals. There are also fears about the inevitable uptick in infections that an easing of restrictions will bring. But the direction of travel is clear as we start to put the long dark days of winter behind us.
Market optimism is evident here in the UK, even if our domestic market has a lot of catching up to do after labouring under the dark cloud of Brexit for so long. This week’s release of the IHS Markit purchasing managers index data for the important services sector is expected to show a strong uptick in activity even before the April 12 re-opening. In March, visits to retail and recreation venues rose to half the average of February 2020 levels, from 63% below average in January. Credit and debit card spending are rising strongly, according to Office for National Statistics data.
The consumer-driven recovery in the spring and summer is expected to be driven in part by an unprecedented rise in household savings during the pandemic and by the relatively successful roll-out of vaccines here in the UK. The economic forecasting group the EY Item Club is expected to significantly raise its current 5% growth target for the UK economy in 2021.
Across the channel in continental Europe the Covid situation is considerably worse, with rising infection rates and a poor vaccine roll-out. Despite this, however, investors are looking through the gloomy headlines to better times ahead, with the Europe-wide Stoxx 600 index this week moving ahead of its February 2020 high, erasing all the pandemic losses as investors move into economically sensitive cyclical and value stocks.
The weighting of European markets has seen Europe take longer to recover than the more defensive US market but it is now in the sweet spot of recovery, gaining 9% so far this year after crashing almost 40% last spring and ending 2020 4% down on where it began the year. The US market, by contrast, rallied more than 16% last year and has added a similar 9% this year.
Top performing sectors so far in 2021 in Europe are car and auto parts makers, banks, travel and leisure and basic resources, all sectors that reflect a more buoyant economy.
One asset that has notably failed to enjoy the recovery is gold, which like bonds has had its worst quarter in some time. The price of gold fell 10% in the first three months of the year as bond yields rose, making the lack of income from the precious metal more noticeable to investors. At the same time, the roll-out of vaccines and recovery hopes have reduced the need for a safe haven asset. Gold touched a low of $1,678 last week, down from last summer’s high of around $2,070 an ounce.