Stuck in transit

5 min read 14 Oct 21

Summary: Growing fears of more persistent inflation led to correlated declines in both equity and fixed income markets in September. What’s driving the inflationary pressures and what can we expect as we head into year end? Investment Specialist, Kirsty Clark reviews recent market performance and the current economic backdrop.

After a strong month for risk assets in August, signs of more persistent inflation and increasingly-hawkish tones from central bankers prompted concerns that monetary policy tightening and interest rate hikes would come sooner than anticipated. Growing fears led to correlated declines in both equity and fixed income markets in September

The MSCI AC World Index finished the month down 4.1% in US dollar terms. Global value outperformed growth, with more rate-sensitive areas of the market outperforming growth stocks and the US tech giants in particular. Energy and financials led the returns at a sector level.

Source: Refinitiv DataStream, 30 September 2021. Total Returns in USD.
 

Most major regional markets ended the month in negative territory. In the UK, energy names propped up the large-cap FTSE 100 index in relative terms, but the mid-cap FTSE 250 index was among the weakest performers. The tech-heavy NASDAQ indices also lagged the wider market, along with Germany’s DAX 30 – as the country went to the polls after long-serving Chancellor, Angela Merkel, stepped down.

Japanese equities bucked the trend with investors optimistic about economic recovery following a change in political leadership – the TOPIX and Nikkei 225 posted some of the strongest relative gains in the month. Chinese onshore equities (Shanghai A shares) also outperformed in the month.

In fixed income markets, fears of monetary policy tightening and rate hikes curbed investors’ appetite for both government bonds and corporate debt. As yields rose, UK gilts sold off, along with US, Italian and German 10-year government bonds; while global high-yield bonds remained comparatively resilient.

In commodities, the energy supply squeeze sent Brent crude up 7.6% in September to over $80/barrel, as OPEC+ maintained previous output levels. Gold finished down while the US dollar strengthened against a basket of currencies.

As swiftly as investors shrugged off inflation concerns in August, the worries resurfaced in September – with inflationary pressures proving more persistent than initially anticipated.

Headline Consumer Price Inflation (CPI) figures have shot up recently, exacerbated by lingering supply-chain bottlenecks and rising goods and commodity prices. Annual CPI inflation in the US stands at 5.4%[1] (with Personal Consumption Expenditure at 4.3%[2]), while euro area annual CPI inflation is expected to be 3.4% in September[3]. In the UK, although annual CPI inflation is currently running at a relatively modest 3.0%[4], the Bank of England expects this to rise to 4.0% by the end of the year.

Supply-chain disruptions, and the resultant shortages, are continuing to create costs and backlogs for producers while lengthening delivery times for consumers. If we consider the well-flagged supply shortages in semi-conductors (used in everything from cars to home technologies to personal gadgets), a host of factors are disrupting production as demand accelerates, and companies are warning of enduring supply issues.

Given that it can take up to 26 weeks to make a ‘chip’ and (at least for one US chipmaker) 90% of this year’s output has already been accounted for[5], the ‘chips may be down’ for some time to come. With the production of new cars in Europe and the US in particular being impacted, the purchase and rising cost of used cars has also been feeding into recent inflation numbers.

Rising energy prices have compounded the woes, with increased demand being met with limited supply. Demand destruction through lockdowns has reduced investment and run down inventories, while policies designed to limit carbon emissions and increase renewable energy production have left some countries with thin supply buffers. Weather-related issues have also played a role. For example, droughts in China and Latin America have reduced the contribution of hydro-power generation while the conditions in Europe have led to a reduction in wind-power generation. The demand-supply squeeze has prompted calls for the OPEC+ alliance to increase output, but the group have so far resisted calls to ramp up production.

Meanwhile, the recent uptick in inflation prints combined with softer economic data, has been driving the ‘stagflation’ narrative over the past month. Looking at Bloomberg trend data, stories from across sources revealed over 4,000 mentions of stagflation in September  – more than at any point in the last decade.

Source: Bloomberg, News trend charts: monthly stagflation story counts. All sources on Bloomberg. 11 October 2021.
 

Depending on how ‘stagflation’ is characterised, it is a challenge to square a slowdown in growth with the notion of stagnating growth. The IMF recognises slowing momentum in global growth but has only revised forecasted global growth for 2021 down from 6.0% to 5.9% in its October quarterly update, and forecasted global growth for next year remains at 4.9%[1]. However, it does acknowledge growing regional divergences due to ‘supply disruptions’ and ‘worsening pandemic dynamics’.

At a corporate level, (while many companies are yet to report on third-quarter earnings) the emerging trend amongst S&P500 companies, according to Factset[2], is one of companies warning that supply-chain disruptions, labour costs and shortages, and rising transport, freight and raw material prices, have negatively impacted earnings (or are expected to impact future results). A broadening of this theme could provoke more widespread concerns about the second-round effects of supply-chain blockages and more persistent inflationary pressures – looking at what this means for the sustainability of corporate margins or, indeed, consumer spending habits if companies maintain pricing power and push through price hikes.

For now, the upside risks to inflation are causing wider concerns than the potential for a return to stagflation. With inflationary pressures seemingly remaining ‘in transit’ for longer than initially anticipated, the balance of opinion is still leaning towards the current pressures stabilising over the medium term before easing back to pre-COVID levels, as supply-chain bottlenecks are ironed out and unusual demand trends normalise. However, a degree of uncertainty remains, prompting the International Monetary Fund’s (IMF) recent call for central banks to be “very, very vigilant” and to take early action to tighten monetary policy if price pressures prove persistent.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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