As economies recover from last year’s collapse in demand, partly on the back of large-scale government budget spending and amid ultra-low interest rates, investors can expect inflation to bounce higher as well, especially in sectors that were hit hard in the COVID-induced slump.
How confident can we be that, as maintained by leading central banks, this is only a temporary, recovery-related bump? And to what extent will even a relatively short-lived spike in inflation trigger the kind of ‘normalisation’ of equity valuations that looks like it is overdue?
Should recent inflation data set off any alarm bells?
With the US in the lead when it comes to major western economies bouncing back from the lockdown recessions, markets are keeping a close eye on inflation developments there and in particular on how the Federal Reserve (Fed) will react, or perhaps rather, when it can be expected to take action.
The rise in core US consumer prices in April exceeded market expectations, jumping to the highest rate since the mid-1990s. As the economy reopened, sectors badly hit last year posted large price increases: hotel prices, admissions to sports events, airfares, used car prices and vehicle rental rates.
Various supply chain issues were also visible: TV, electronics and toy prices all rose notably.
There is likely more near-term upward pressure in the transportation, entertainment and hotel categories as a part of a surge in inflation into the summer. Overall, however, as the economy continues to normalise, the price pressures should level off in line with the Fed’s view that this development is transitory. Hence the US central bank’s relaxed stance on the need for corrective monetary policy this year and into 2022.
Further out, though, a concoction of de-globalisation (which reduces competitive trading), government stimulus on a massive scale and demographic trends (such as population ageing) might produce a more lasting increase in inflation and ultimately spark central bank action.
What’s next for equities?
Will that mark the end of the tailwind for equity markets from lower interest rates or can earnings growth take over as the main driver of equity valuations?
We believe a more rapid increase in earnings than in equity prices is likely and that investors should look for normal market volatility to provide an entry point. Our market temperature indicators indicate that such a time may not be far off.
Indeed, one potential catalyst could be the US economy overheating as a flood of stimulus coincides with a smaller output gap and inflation expectations become unanchored. This could force the Fed to raise policy rates, perhaps sooner than the market currently expects.
Another possibility is that large tax increases to help finance the US government’s multi-trillion dollar stimulus damp investor sentiment and corporate profit growth.
Recent US earnings reports, though, have surpassed analyst estimates handily. This bodes well for the equity market as vaccination rates rise, more and more countries come out of lockdowns, and pent-up demand is fulfilled.
Looking beyond US equities
The strong performance and high valuations of US equities have prompted some investors to consider European equities. We believe the prospect of higher interest rates and taxes in the US, at a time when relative valuations in Europe are more attractive, could indeed make such a move worthwhile.
Emerging market (EM) equities outperformed on last November’s upbeat vaccine news, but have since lagged. We expect EM ex-China to outperform developed markets given EM’s cyclical nature, the benefit from reduced trade tensions between the US and China and a weakening US dollar.
The risks are that rising US interest rates make EM investments relatively less attractive, but foreign portfolio inflows have been strong. In addition, Chinese GDP growth, which is a key driver of emerging market growth, could disappoint as the government seeks to reduce debt in the economy.
In summary, recent market activity has reflected a heightened risk of a pullback in equities. Against this backdrop, we expect markets to remain nervous in the short term, but given the breadth of supportive medium-term fundamentals, we see corrections as opportunities for investors to add to their equity exposure.
Also listen to the podcast with Christophe Moulin, Head of Multi Asset, in which he discusses the prospects for a synchronised global upturn in the course of the second half of this year, favouring risky assets including commodities, equities generally and notably emerging market equities.