The Big Squeeze

In fixed income, UK, US, German and Italian 10-year government bonds lost ground in February as a combination of stronger-than-expected economic data, technical factors, and rising inflation fears pushed up yields and triggered a widespread sell-off in government bond markets.

In commodities, Gold was another casualty of the market volatility in February, dropping to levels not seen since June last year. More broadly, commodity prices continued to rise and the CRB Commodities Index finished the month up around 9% in US dollar terms. Copper prices soared to their highest levels in a decade. Brent crude performed particularly well on the back of accelerated growth expectations – extending its year-to-date gains by more than 18% in February, and finishing the month above US$61 per barrel.

Energy stocks tracked the oil price higher, logging the strongest global sector gains in February. Cyclical sectors and areas of the market more sensitive to rising interest rates were the strongest relative performers. Financials, industrials and materials outperformed the wider market while utilities, healthcare and consumer staples were the relative laggards.

Macro news:

In the US, the House of Representatives approved President Joe Biden’s US$1.9 trillion stimulus package, paving the way for a Senate vote. US weekly jobless claims hit their lowest level in three months and a rise in personal incomes was recorded; largely due to direct coronavirus relief payments. In response to rising inflation concerns, Fed Chair Jay Powell stressed that inflation remains ‘soft’ for the most part, and that it may take more than three years for average inflation to reach the central bank's target, and rate rises to kick in.

In the UK, Prime Minister Boris Johnson unveiled plans for a gradual lifting of lockdown restrictions from March, while UK Chancellor Rishi Sunak prepared to announce details of the latest budget; with expectations of extended pandemic support schemes, more targeted industry relief packages and a potential corporate tax hike.

In Europe, Mario Draghi was sworn in as the new Prime Minister of Italy, Germany’s fourth-quarter 2020 GDP growth came in stronger than expected, and economic sentiment and consumer confidence showed signs of improving. However, delays in vaccine rollouts and concerns of vaccine hesitancy threaten to derail the pace of the region’s recovery.

In Latin America, Brazilian President Jair Bolsonaro ousted the CEO of stated-owned oil company Petrobras over fears of strikes on the back of rising oil prices, after the company raised fuel prices in line with crude oil.

Elsewhere, manufacturing in China continued to expand in February, albeit at a slower pace, with a the latest Caixin manufacturing PMI score coming in at 50.9, down from 51.5 in January. Japanese manufacturing also climbed into expansion territory with the manufacturing PMI hitting a 22-month high. Meanwhile, falling coronavirus infection rates prompted Japanese authorities to remove the state of emergency in six prefectures a week earlier than the scheduled.

Chart(s) of the month:

COVID-induced demand growth combined with supply-chain disruption is putting upward pressure on input prices for companies in the manufacturing sector. In the UK, this has been exacerbated by Brexit-related ‘red tape’ as companies try to adjust to the new post-Brexit trading conditions.

Depleted inventories, following COVID-related stock piling, has fuelled demand growth in some areas. While supply-chain pressures – due to lockdown restrictions, shipping container shortages, congestion at ports, limited production capacity, mining closures and weather shocks – have led to delayed delivery times and factory closures, along with rising freight costs and raw material/ commodity price spikes.

As developed countries look to reignite growth through increased infrastructure spending and the build-out of technologies to support ‘green economies’, the rising demand for basic materials and component parts will likely put further upward pressure on input prices, and on already strained supply chains.

To date, the most affected sectors have included autos, consumer electronics, chemicals, and metals and mining. While many businesses have absorbed the rising costs, others have passed them onto consumers either to combat the ‘margin squeeze’ or to, opportunistically, expand margins.  

Should we be worried about an inflation surge in the near term? With many businesses still absorbing higher input costs, the squeeze on company margins combined with a lack of wage growth (due to reduced labour demand, and as stimulus measures roll over) should act as a deflationary force in the short term.

In addition, higher input prices in the manufacturing sector are being offset, in part, by more sluggish demand for many services hit by the pandemic, particularly in hospitality, travel and tourism – limiting the overall impact on inflation. Until economies can fully reopen, unemployment comes down, and deferred demand for services can be realised, output gaps will likely remain negative.

However, the prospect of a steady return to higher inflation should be positive for the economy and equity markets – signalling a stronger growth environment and supporting company earnings – while potentially leading to rising employment and wage growth over the medium term.

If inflation does start to pick up but earnings remain sluggish or take longer than expected to materialise, companies with strong pricing power, and those planning ahead to mitigate the impact of supply-chain ‘bottlenecks’, will be best placed to weather the storm and defend company margins.