In the face of the delayed lifting of Covid restrictions, our thoughts are with those involved in hospitality, as well-addressed in this issue. I’ve relished glimpses of great service in the odd restaurant or pub or café in recent weeks, and here’s to much more ‘normality’ soon, writes Jeremy Hill from Kleinwort Hambros’ Newbury Office.
In global markets, there is from time to time a single data point that garners intense, widespread scrutiny and reflects the zeitgeist of the moment. In the immediate aftermath of the Great Financial Crisis, it was US house prices. During the Eurozone crisis, it was credit default swaps – a tool to hedge default risk – on periphery borrowers and banks. A year ago, it was the daily number of new confirmed Covid-19 cases. Today, it is inflation, in particular in the US.
Why? Money supply growth has reached historical highs at over 20% year-on-year (YoY) ever since May 2020; growth in hourly earnings has averaged 4.6% YoY since January 2020; commodity prices have surged 62% over the past 12 months; supply bottlenecks (for example, in semi-conductors) have fuelled fears of overheating; and fiscal spending plans announced since last December amount to over 30% of US GDP.
Rapid progress in vaccinations has fuelled hopes that the pandemic will soon be over and mobility measures show that traffic related to retail and recreation are almost back to normal. This has bolstered business confidence. The IHS Markit US Composite Purchasing Managers Index (PMI) hit an all-time high of 68.7 in May 2021 as it registered the steepest upturn in business activity since data collection began in October 2009. Rates of new business growth were the fastest on record in both the manufacturing and service sectors. Therefore, unsurprisingly, some market participants have begun to fret about rising prices, as witnessed by market expectations for US inflation.
This matters because inflation expectations have enormous influence over monetary policy, bond yields and equity market valuations. Bond prices have tumbled as 10-year Treasury yields rose from 0.51% last August to 1.64% and the iShares 20+ ETF of long-duration bonds has fallen 20.5% over the period. For equity investors, short-dated Treasury yields are often used as the risk-free rate when discounting the net present value of future cashflows – this means that Growth stocks (where high valuations rely on earnings growth many years into the future) are particularly vulnerable to rising rates.
However, we should note that these inflationary worries are largely a US phenomenon. Market expectations for inflation have risen in the Eurozone, but not to the same extent – The Bloomberg consensus of private forecasts sees Eurozone headline inflation peaking at 1.7% in 2021 before easing back to 1.3% next year. In China, both headline and core inflation are below 1% – and the country is much further ahead in its recovery from the pandemic than its Western counterparts.
As we noted last month, this year should see higher prices as economies reopen and pent-up consumer demand is unleashed, but this should prove transitory. Gaps between actual and potential output still gape wide and there is enormous slack in the labour market, as well as huge underutilised capacity in commercial real estate. In addition, ageing populations, supply-chain efficiency and technology-driven productivity gains will exert lasting disinflationary pressures. We believe that these factors will push inflation lower again in 2022.
We remain sanguine and believe it unlikely that base interest rates will rise for many months to come, if not years. Moreover, we remain risk-on. As always, we are guided by the four pillars of our investment process:
We believe the case for risk-taking is well supported given a strengthening economic backdrop and strong momentum. Nonetheless, we are wary of expensive valuations. On balance, we are moderately risk-on with a continued preference for equities but have been tilting more towards less expensive, value-oriented regions. We also continue to hold a stable of safe-haven assets, including gold, low-volatility, defensive alternatives (eg hedge funds) and government bonds.
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