Weekly Market Update: Raising Inflation Expectations Impacts Markets
Mon 22 Feb 2021
Global equities suffered as steepening yield curves impacted valuations and helped drag most major equity markets negative for the week. The steepest rise in yield curves was found in the UK, where the valuation effect was offset by growing optimism about the outlook due to the vaccination programme. UK equities rose +0.7%, the best performing developed market equity index in Sterling terms. The next best performing region was Emerging Markets, which rose in local currency terms but fell -1.1% in Sterling terms. US equities fell -1.8% in Sterling terms despite better than anticipated earnings data. Inflation expectations picked up during the week and as a result sectors better suited to an inflationary environment outperformed, with Energy and Financials the two best performing sectors. The US 10Y yield rose 12.8bps to 1.3% and the UK 10Y rose 18.1bps to 0.7% as investors grow bullish on economic recovery and inflation. Gold fell -3.3% on the week, while Oil fell -1.6%.
The race for gradual reopening of the global economy is about to begin as the UK and the US are close to reaching significant milestones in Covid-19 vaccination rates. From that perspective, markets have every reason to feel positive, with stocks near all-time highs and equities experiencing record inflows. The US earnings season further boosted equity returns, with US large caps increasing their earnings by 3.4% in Q4 2020, against a 9% drop expected by markets, as companies managed to weather Congress’ tardiness in handing out stimulus cheques. A further reason – or perhaps sign – of buoyancy is the capitulation in bond markets. The recent rise in yields and steepening of the yield curve are a confluence of economic optimism and rising inflation expectations.
Despite all the usual flags, however, we can’t treat this as a run-of-the-mill bull market. For one, we are already in the bubble-building stage. We see circumstantial evidence of bubbles building, whether it is in the US automotive industry, US microcaps, cryptocurrencies or other company-specific evidence, with US equities trading significantly above historical levels. Additionally, we believe that exceptional fiscal stimulus will be withdrawn as soon as it is practicable, lest countries see their public finances derailed after a year of nearly-unprecedented borrowing. This could have a significant impact on the corporate bottom line going forward.
The most important factor that keeps us on our toes, however, is that we know that market performance is still driven by exceptional monetary stimulus. Accommodation will most probably remain elevated for the year, but 2021 will challenge the iron resolve of central bankers, as inflation figures are expected to materially climb. While we believe that this inflation will probably be transitory, a result of supply chain pressures, stimulus and mere year-on-year consumer price comparison (against the horrid Q2 2020), we need to remain vigilant in case it overshoots or overextends its welcome, causing central bankers to question a 12-year market-friendly policy which has often been dubbed as “the only game in town” for portfolio managers.
David Baker, CIO