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Inflation risk on the horizon as markets adjust to the new nominal theme

 

June 1, 2021

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Global markets have responded to the re-opening of the more developed economies with double digit stock market year-to-date returns. The S&P 500 index closed May 2021 with a positive return for the year at 11.93 per cent while the Nasdaq and the Dow Jones both produced returns of 6.68 per cent and 12.82 per cent respectively.

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London’s FTSE index recorded a year-to-date gain of 8.70 per cent, Paris CAC closed at 16.80 per cent and the Frankfurt’s DAX index produced a gain for 2021 of 13.13 per cent. Asia also recorded more modest performances with Shanghai’s stock market benchmark increasing by 3.68 per cent and Hong Kong’s Hang Seng appreciated 6.99 per cent for 2021.

 

U.S. Markets

 

A powerful economic restart ignited the new nominal theme, that is a robust jump in global inflation expectations and a more subdued rise in nominal bond yields. Investors are grappling with how to interpret unusual growth dynamics and new central bank frameworks. U.S. activity looks set to restart strongly mid-year, powered by contained demand driven by income and excess savings. Growth forecasts have been catching up, but the magnitude of the restart may still be underestimated according to economist.

 

Financial markets have underestimated the potential for the Federal Reserve to achieve above-target inflation in the medium term. Bond yield have trended higher, an indication of economic growth and corporate balance sheet expansion. But the overall adjustment will be much more muted than one would have expected in the past based on growth dynamics and given that much adjustment has already taken place.

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Inflation is expected to build steadily over the medium-term as easy monetary policy allows the U.S. economy to recover. Nominal long-term bond yields have risen but less than inflation expectations as reflected in ‘breakeven’ inflation rates. That has kept real yields negative, positive for risk assets such as high yield corporate and emerging market debt.

 

One of the biggest factors driving the year-on-year increase in the reported inflation in April by the US Federal Reserve Board was the ‘base effects’, the comparison with 2020 performances that were exceedingly low during the first coronavirus lockdowns.

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Europe

 

Academics based at the Resolution Foundation and Centre for Economic Performance at the London School of Economics and Political Science have launched an inquiry into the U.K.’s decisive decade. The U.K. must grapple with recovery from Covid-19, the aftermath of Brexit, an ongoing technological revolution and the transition to net-zero emissions of greenhouse gases. Moreover, it does so from a base of stagnant productivity, high inequality and high debt.

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The Resolution Foundation report spells out in detail the challenges and the legacy. Firstly, following the aftermath from Covid-19, there has been a permanent shock to high-street retail, a particularly important source of jobs for women. Secondly, Brexit impact on trade with European Union countries is already visible, with little chance that trade with the rest of the world will offset these losses. Thirdly, technology is anticipated to create large and continuing shifts in the structure of employment and competitive pressures, with many firms disappearing. Fourthly, to transition to net zero, the country must make huge investments before any gains from lower operating costs can be recorded.

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The policy response to Covid-19 took resource mobilization, competent political and administrative personnel, a supportive relationship and dynamic private sector. The U.S. and U.K. responses via lock downs and vaccinations led most of the developed world. Mass testing was followed by nationwide vaccination programs that were supported by pharmaceutical companies that delivered at an unprecedent pace.

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European stocks are set to record their fourth consecutive month of gains, as confidence in the region’s economic recovery grows and its vaccination program accelerates. MSCI’s broad measure of equities across Europe has risen almost 4 per cent since the end of April, bringing its year-to-date gains to 12 per cent in US dollar terms, that is taking into consideration the dollar appreciation versus its European Union counterparts.

 

Exchanges in Frankfurt, Paris, Madrid, Milan and London have all climbed in May. While the vaccination program in the European Union states lagged significantly behind other regions, efforts by major countries to accelerate the rollout has bolstered individual investors’ and fund managers’ confidence. Albeit economists maintain their forecast of a strong economic recovery in 2021. Evident of this improving outlook, the latest Economic Sentiment Indicator (ESI) survey released by the European Commission last week showed confidence across the eurozone in May was running “markedly above its long-term average and pre-pandemic level”.

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Asia

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Soaring commodity prices are putting pressure on businesses in China, even as the country’s wider industrial sector rebounds from the early effects of the coronavirus pandemic. The National Bureau of Statistics (NBS) released figures on Thursday that showed a 57 per cent rise in profits at large industrial companies in April compared with a year earlier, with the sector benefiting from the comparison with a low base in 2020 owing to the pandemic. Profits grew 92 per cent in March.

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The data highlighted an unbalanced improvement in corporate performance in China, the NBS said, “despite the economy’s broad recovery over the past year, higher prices for raw materials have boosted the profits of miners and other producers but they also stand to increase costs for downstream businesses further along the supply chain”. In addition, to the high prices of commodities, this has increased the pressure on the production and operation of midstream and downstream industries.

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The Chinese government has expressed mounting concerns over a rally in commodity prices that has been driven by the country’s rapid industrial recovery as well as hopes of stronger global growth. Factory gate prices in China, which are derived from commodity prices, leapt by 6.8 per cent last month, their fastest pace in three years. But consumer price inflation remained below 1 per cent. The country’s economic planning agency issued a warning on last Monday over “excessive speculation” and said it would crack down on hoarding and monopolies in commodities, this resulted in the price of iron ore declining by 7 per cent after it hit a record high in May.

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A quota system means outflows from China are tightly controlled, but firms hope for greater flexibility to take the country’s savings to global markets. Goldman Sachs, which expects there to be $70 trillion of investable assets across the country’s households by 2030, plans to offer “cross border” products to its customers, while JPMorgan also points to its “global capability”. In a clear departure from Washington DC stance on international and political relations with China, major U.S. investment banks are positioning themselves to benefit from increased savings from Asia’s ageing population by expanding their Wealth Management products in the world’s second largest economy.

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Emerging Markets

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India’s economy expanded 1.6 per cent for the first quarter of 2021, a signal economic activity was recovering steadily prior to the country suffering a second wave of coronavirus infections in April and May. The new wave was a surprise to Prime Minister Narendra Modi's administration after last December declaring a premature victory against the virus.

 

The expansion in the first quarter of 2021 followed year-on-year growth of 0.5 per cent in the last quarter of 2020, when Indians began to cautiously venture out for the traditional festive season after a lockdown during the spring and summer last year. “The overall numbers do signify a steady revival of demand,” KV Subramanian, the government’s chief economic adviser, said after the data were released last Monday. But Subramanian conceded that “some of the momentum that was gathered was affected by the second wave of the pandemic”. At least 170,000 have died in the past two months as cases have surged again.

 

Over the full financial year from April 2020 to March 2021, India’s gross domestic product contracted by 7.3 per cent, its worst performance in four decades. Still, the decline was less severe than some had anticipated after highly restrictive lockdown measures last year led to a 24 per cent contraction in economic output between April and June 2020.

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Chinese tech giants, have thrived as covid-19 forced consumers to get their necessities and leisure online. In May Tencent, China’s most valuable tech firm, reported operating profit grew by 20 per cent year on year in the first quarter, to $6.5bn. China’s ‘big tech’ are spending more on research and development. Even after these expenses and administrative costs, they is significant re-investable cashflow.

 

Myanmar’s minister of investment, Thaung Tun in January promised local and foreign investors a swift recovery from damage resulting from covid-19 pandemic. Two weeks later the army launched a coup, placing Thaung Tun and other members of Aung San Suu Kyi’s cabinet into detention. Since these unfortunate developments, analysts estimate that the economy could contract by as much as 20 per cent in 2021.

 

The army in Myanmar has closed companies it believes are sheltering opponents, including many media firms, while also trying to force businesses it deems essential to stay open. The army is concerned by continuous strikes that have been organized in protest against the coup and the hundreds of killings its soldiers have carried out during demonstrations. The instability in Myanmar continues to negatively affect economic growth forecast in the trading bloc of the Asia Pacific region.

 

Regional Markets – Pan Caribbean

 

The Trinidad and Tobago Stock Exchange - All T&T stock index recorded a year-to-date growth of 5.78 per cent, a significant portion of the returns were generated from cross listed stocks such as NCB Financial Group, JMMB and Guardian Holdings Limited. In May, Sagicor Financial Company issued US$ 400 million 7-year bond at an interest rate of 5.30 per cent, the bond has appreciated by 3.25 per cent and trades with a market yield of 4.74 per cent.

 

The Government of Trinidad and Tobago also closed TT$ 725 million fixed rate bonds at a coupon of 6.12 per cent on May 26th, 2021, the debt has a maturity of 17 years. The funds were used for general budgetary purposes, that is financing the Government's fiscal plan for 2021.

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In Jamaica, the Jamaica Stock Market index appreciated by 4.81 per cent for 2021 and provided a quarterly return of 4.97 per cent in the last quarter. While the economy has been gradually re-opening, businesses have seen a moderate return to growth. The local currency to the US dollar has temporarily stabilized around JA$151.50 to US$1.00.

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