5 min read 8 Jun 21
Summary: Cyclical sectors led the equity market gains in May, mirroring the year-to-date leaders, supported by positive data revisions, ongoing stimulus and vaccine success. However, inflation concerns rumbled on. Will central banks be forced to contend with a rapid and sustained pick-up in inflation? Investment Specialist, Kirsty Clark reviews recent market performance and explores the factors feeding into fears of ‘runaway’ inflation.
Despite a mid-month sell-off, global equities delivered positive returns in May as upward revisions to macro and earnings data, along with falling COVID-19 cases globally, buoyed investor sentiment. The MSCI AC World Index finished the month up 1.6% in US dollar terms.
The cyclical reflation trade continued apace and value stocks reasserted themselves – mirroring the year-to-date trend – while global large caps outperformed their small cap counterparts.
Emerging markets pulled ahead of developed markets in May, with Chinese A shares among the strongest performers. Eurozone and UK equities also outperformed, and small caps led UK markets higher. Despite the S&P 500 hitting a new high in the first week of May, US equities were the laggards over the month, with the tech-heavy NASDAQ finishing in negative territory.
Source: Refinitiv DataStream, 31 May 2021. Total Returns in USD.
In fixed income, despite an uptick in inflation indicators, bond markets remained relatively sanguine during the month. US, UK, German and Italian 10-year government bonds gained ground in US dollar terms (although German 10-year bunds were marginally down in local currency terms). Global high yield bonds also secured positive gains. In currency markets, sterling and the euro strengthened against the US dollar, which continued to weaken against a basket of currencies in May.
In commodities, the reopening trade continued to boost demand for Brent crude – which topped $70/barrel in intraday trading during the month and is up more than 30% year to date. Inventory build-ups have begun to unwind and oil stocks are almost back to pre-pandemic levels, prompting the OPEC+ alliance to forecast a tighter market in the second half of 2021. Oil prices continued to rise into June after the group agreed to only ‘gradually’ increase supply in July, given ongoing uncertainties. Gold also performed well in May, helped by a weaker dollar, as did the broader CRB Commodities Index.
Strengthening macro and earnings data coupled with ongoing fiscal stimulus and dovish central banks, continued to drive sector rotation in equity markets. Cyclical sectors most exposed to the re-opening trade outperformed in May. Energy, financials and materials led the gains, and the same sectors are the strongest performers year to date. Laggards in the month included consumer discretionary, information technology and utilities.
Recent inflation indicators have been surprising to the upside, prompting fears that the global economy is at risk of overheating. Most focus has been on the US Consumer Price Inflation (CPI) figures. In May, we saw headline US CPI rise to 4.2% year-on-year in April - the highest rise since 2008. To some extent, this can be attributed to rising commodity prices, which have the potential to push up food and energy prices – as shown in the chart below. However, core CPI (which strips out more volatile food and energy prices) rose to 3.0%, well ahead of consensus expectations of 2.3%, fuelling the debate about more widespread inflationary pressures.
Source: US Bureau of Labour Statistics, May 2021 – Year-on-Year percentage change in CPI for All Urban Consumers (CPI-U): US city average
Euro area headline CPI in April was subdued in comparison, coming in at 1.6% year-on-year – in line with expectations. However, it did amount to the highest reading since April 2019, mainly driven by the higher cost of energy and industrial goods. Notably, diverging from the US, core Euro area CPI in April weakened from a month earlier, while UK headline CPI more than doubled to 1.5% in April from 0.7% in March, driven by rising energy and clothing prices.
Despite the higher-than-expected inflation indicators, and lingering concerns of rapidly-rising inflation, the consensus view on the nature of these inflationary forces is that they are largely ‘transitory’ and down to a combination of temporary factors such as the release of pent-up demand as we emerge from lockdowns, supply-chain bottlenecks (creating supply-demand imbalances as economies begin to reopen) and favourable base effects – meaning year-on-year comparisons with low-activity lockdown periods in 2020 are distorting relative figures in 2021.
This view aligns with that of central banks in the US, Europe and the UK, which remain dovish while being alert to signs of prolonged inflation. Officials have reiterated their expectations of a ‘transitory’ spike in headline inflation on the back of base effects and temporary factors, anticipating that inflation will overshoot targets in the second half of this year before retreating as conditions normalise. European Central Bank president, Christine Lagarde, has said policymakers should “see through a higher period of inflation”, with the underlying factors and fundamentals still not there to forecast prolonged inflation.
However, recent language also suggests central banks are preparing the ground for some policy tightening if we start to see evidence of broader and more persistent inflation. US Federal Reserve officials have been “talking about talking about tapering” while the Bank of England governor, Andrew Bailey, suggested the bank would not tolerate a persistent overshoot in inflation from its 2% target — signalling that it could raise interest rates to combat this.
With economies gradually opening up, rising prices had been expected due to these demand-supply imbalances, but the magnitude of the rises have taken markets by surprise. Some argue the inflation spikes were well flagged and that the magnitude is of less concern, given the balancing act facing central banks, who are equally concerned about avoiding a deflationary environment. While we have seen evidence of a range of price rises from the latest inflation indicators, it’s difficult to argue that these early price hikes alone amount to a more permanent shift in the rate of inflation – especially as the global economy is recovering from an unusual recession, in an uneven fashion. What we can observe are pockets of price rises that may persist in the near-term in line with reopening activity and, potentially, changing consumer preferences.
If we take the price hikes seen in some consumer goods and services – such as vehicles, flights and travel accommodation – we can see the dual impact of an expected surge in demand and existing supply-side hurdles. Auto production has fallen victim to the global semiconductor shortage, having a knock-on impact on used car prices (as seen in recent US sales data), while demand for cars may also be rising due to consumers requiring or preferring private rather than public transport until we see further penetration of vaccine rollouts. Meanwhile, the potential for holiday travel over the summer months (in the northern hemisphere) is providing an outlet for excess savings after extended lockdowns. In turn, as the OPEC+ alliance plans to only ‘gradually’ bring reduced oil production back online, this will likely feed into the cost of flights until we approach supply-demand equilibrium. The widely-held expectation is that these disruptions to global supply and demand relationships will moderate near the end of 2021, as supply normalises and post-COVID demand wanes.
There are some observations to support investors’ concerns about runaway inflation, not least the combined scale of fiscal and monetary stimulus, globally, along with the rising structural demand for raw materials driven by infrastructure spending and the ‘green’ recovery. In addition, while the most recent US jobs figures continue to show some slack in the economy, a labour crunch in the US has led to wage hikes from large corporations seeking to attract workers (stoking debate about the role of the federal government’s direct stimulus cheques). Meanwhile, consumer confidence data has pulled back from recent highs, with those polled citing inflation concerns. If expectations of inflation change to meet price rises, this could potentially drive prices higher over the medium term and fuel more persistent inflation. With consensus expectations firmly behind a ‘transitory’ inflation scenario, currently, an abrupt pivot from central banks could catch markets off-guard. However, it’s likely that any tapering of quantitative easing will be communicated well in advance, especially if the Fed’s recent rhetoric is a barometer, and will rely on consistently robust economic data.
As we head into the second half of 2021, central banks, investors and consumers alike will be keeping a close eye on indicators of rising and persistent inflation. For now, we believe the reflation trade has further to run, with more cyclical areas of the market well-positioned to benefit. However, investors should be mindful of the potential near-term threats to a continued recovery and orderly reopening, not least pockets of vaccine hesitancy in developed markets, low levels of vaccination penetration in some emerging markets and the ongoing prospect of more infectious or resilient COVID-19 variants.
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.