Should we be worried about inflation? Senior Investment Manager George Lin takes a look at the latest market developments in the February Monthly Wrap.
|Written by George Lin
Senior Investment Manager | Colonial First State
Ongoing vaccination rollouts, company reporting season results and a social media frenzy were some of the key drivers behind a busy month for financial markets. However, perhaps the biggest driver behind markets can be linked to rising bond yields. Improving Coronavirus developments, better-than-expected economic data and vaccination programs in several countries have improved the overall sentiment on the return to economic normalcy. But this positivity has also had a drawback – that is, a continued rise in bond yields which has renewed the debate surrounding higher inflation, the potential for a pull-back in monetary policy support and possible flow-on effects for markets. Though this uncertainty erased some earlier gains, the Australian share market still rose 1.4% for the month, while the Australian Dollar fell from a three-year high to trade at about 78.3 US cents.
Coronavirus developments were largely positive in February, with the number of new cases falling dramatically in both the US and Europe. The dramatic fall in new case numbers came after an acceleration in the speed of vaccination program rollouts in many countries. In particular, the UK has administered at least one dose to 27% of its population, while the US has administered one dose to 19.2% of its population. At the end of the month, the Australian government kicked off its own vaccination program. While there are lingering concerns about new variants of Coronavirus and supply chain issues for vaccines, markets are increasingly confident that herd immunity can be achieved, at least in more developed economies, towards the end of 2021.
Vaccination by country as at 22 February 2021 (Source: Worldometre)
|Country||Doses (per 100 of population)|
The global economy continued its uneven recovery in February. The global manufacturing sector continued to expand, with the Purchasing Manager’s Index (PMI) in China, the US and Europe all firmly anchored above 50 – the level which suggests an expansion in activity. However, the services sector was mixed. The European Services PMI has started to bottom out over recent months. The weakness is due largely to the region’s various economic shutdowns, starting around Christmas. As those restrictions are gradually lifted, we expect the services sector in Europe to improve. One good piece of news for Europe is that December quarter Gross Domestic Product was higher than markets’ pessimistic expectations of a contraction. While Germany and Spain recorded weak but positive economic growth, France and Italy GDP fell, though to a lesser extent than expected.
December quarter 2020 economic growth
US economic data generally pointed towards a strengthening economic recovery. After recording two consecutive monthly falls as the country struggled with the third wave, retail sales rebounded strongly in January with a 5.1% rise. The US labour market also continued to improve, with the unemployment rate falling to 6.3% – the lowest level since the pandemic started in 2020. However, the pace of improvement in the labour market has slowed recently.
Inflation in a post-pandemic world
A fierce debate is currently raging among policymakers and investors alike on the timing, magnitude and potential impact of President Biden’s proposed US$1.9 billion fiscal stimulus package. The debate started when a former Secretary of Treasury and a prominent economist, argued that the package would be too late and too large given the ongoing economic recovery and the shrinking output gap. He also said it would likely lead to higher inflation in the future.
For the first time since the pandemic, markets began assigning a stronger possibility to higher inflation in the US, as well as questioning the commitment of the US Federal Reserve (the Fed) to its ultra-accommodative monetary policy stance. While higher inflation is not guaranteed, it is possible. One of the biggest reasons for this is that there will be a high level of public sector debt in the post-Coronavirus world following the extensive monetary policy and financial stimulus deployed by central banks and governments in response to the pandemic. This suggests central banks (like the Fed) may have an incentive to generate higher inflation in order to manage their debt-to-GDP ratio.
While no one expects the Fed to increase policy rates in the near future, there are concerns that the central bank may start to reduce or ‘taper’ its asset purchase programs earlier than expected. The breakeven inflation rate, which is a measure of market expectations of future inflation, has surged in the US to 2.2%. In turn, this led to a sharp rise in nominal US 10-year bond yields from 0.98% at the end of 2020 to 1.39% during February. The rise in US bond yields has pulled up bond yields globally – including Australian bonds, which experienced volatility. The Australian 10-year bond yield recorded some of the strongest rises, ending February at 1.88% – up 79 basis points since the end of January.
The flow-on effects of rising bond yields
Share markets rose strongly in early February before being negatively impacted by rising yields in the last week. The All Ordinaries rose 1.4% in February, while the S&P 500 rose 2.6% and the NASDAQ rose 0.9%. Despite this volatility, investors remained encouraged by the prospect of higher company earnings as economies normalise. This optimism is reinforced by the company reporting seasons in both the US and Australia – with 87% of Australian companies that reported announcing statutory profits for the year to December 2020, as well as just under 85% issuing dividends. Optimism on the economic recovery, it seems, trumps the fear of higher bond yields – at least for the time being.
A significant shift in sentiment took place over the past fortnight, with investors shifting their focus from the deflationary impact of the pandemic (which has dominated markets since 2020) to the potential risks posed by higher inflation. Within this context, shares and other reflationary assets may be preferred in the short term, though it is important to acknowledge the considerable risks that higher inflation and bond yields pose to those assets. There are two reasons for favouring shares at this point in the cycle:\
- Firstly, the driver for higher bond yields is the expectation of higher inflation, which is the result of stronger economic growth as the negative impacts of the pandemic continue to fade. Although US real bond yields have risen, levels remain low by historical standards and financial conditions remain accommodative. In this regard, it is especially encouraging to note that the spread on corporate bonds has so far remained steady.
- Secondly, stronger economic growth is leading to earnings growth for companies, which should accelerate as economic conditions continue to normalise. In turn, higher earnings should be able to offset some of the negatives of higher bond yields. This has so far been validated by the relatively optimistic US reporting season – with the US share market leading its global peers. Australia is also seeing a sharp improvement in earnings expectations.
A preference for shares does not mean equity prices will stay immune to higher bond yields. As we’ve discussed earlier, share markets are expensive by historical metrics and have so far been supported by extremely low bond yields. As yields rise, some of this support is removed, but this may represent more of a technical correction than the start of a bear market. But on a longer-term basis, rising bond yields do pose a significant threat to share prices. That’s because higher yields can eventually have a negative impact on economic growth. The question now is, how far away is this tipping point? Inflation is the key here. As long as the rise in inflation is modest and largely reflects stronger economic growth that results from the economic normalisation, central banks will retain their accommodative monetary policies.
The main central bank to watch is the Fed. Given the Fed is targeting average inflation and is deliberately allowing inflation to overshoot its target, it is unlikely to raise the cash rate in the next 24 months. The risk, however, is that significantly higher inflation will cause the Fed to reduce its purchase of bonds much faster and earlier than markets anticipate. While this is a very real risk, such tapering is some way off for two reasons:
- While US inflation is expected to increase in the next two quarters due to the base effect, inflation is likely to remain well contained due to the large output gap in the US economy.
- The Fed will be extremely careful in the unwinding of quantitative easing. Post-GFC history suggests that this will be a long and gradual process, starting with a suspension of the re-investment of coupons from its holding of bonds. The Fed will try not to spook investors.
In summary, it may be premature to call the end of the reflation trade, but risky assets – especially long duration assets – are vulnerable to a further rise in bond yields.
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