The drop in infections and the rapid vaccination rollout continued to drive markets higher in February. The UK and US are progressing well with their vaccination programmes and could achieve a large-scale reopening of their economies in the second half of the year. However, virus mutations, such as the Brazilian and South African variants, could still potentially slow down the return to normality. For more detail, see our article: “When Will the Vaccines Allow for a Sustained Economic Recovery?”
On the macroeconomic front, despite the need to maintain some social distancing measures, manufacturing surveys continue to show solid momentum, aided by extended fiscal support, which is boosting demand for goods. The expected approval of President Biden’s fiscal programme should boost the US recovery with positive spillover effects. However, government spending is creating a concern around potential inflation. Core government bond yields are rising as markets price in higher future growth and inflation expectations.
Equity markets closed the month with positive returns, despite a drop towards the end of the month. The rotation in favour of value and small caps continued as a result of the expected post-pandemic normalisation and rising bond yields.
Exhibit 1: Asset class and style returns
Exhibit 2: Fixed income government bond returns
President Biden got off to a quick start by signing a series of executive orders aimed at regaining control of the pandemic and re-entering the Paris agreement, with implications described in our recent article: “What does Biden’s Presidency Mean for the Global Climate Agenda?”
Data on infections continued to trend down and the vaccine rollout accelerated. Vaccine producers are expected to provide 600 million doses, covering the adult US population, by the end of July.
Investors are expecting Congress to approve Biden’s “Rescue Plan” of close to $1.9 trillion. In addition to the Covid relief package approved at the end of December, it could mean overall stimulus for the economy totals around 13% of GDP in 2021. This is on top of the massive stimulus already delivered earlier last year, which helped households to save almost 8% of GDP more than they normally would. The additional stimulus cheques and unemployment benefits could lead to a significant acceleration in consumption, particularly once restrictions are lifted. However, the huge size of the fiscal package—when combined with ample liquidity in the system, possible post-pandemic bottlenecks in supply chains and pent-up demand—could also lift inflation.
Nevertheless, Treasury Secretary, and former Federal Reserve (Fed) Governor, Janet Yellen reiterated her support for the fiscal plan, showing more concern about unemployment than inflation.
January inflation registered a moderate 0.3% month-on-month (m/m) increase, driven by energy, but core inflation remained unchanged (up 1.4% year on year). Inflation is expected to rise in mid-2021 as lockdown-related base effects will drive the annual rate higher. However, the rebound is likely to be short-lived, as highlighted by Fed President Powell, with headline inflation dropping again by early 2022.
With markets already pricing in higher inflation expectations, the US yield curve in steepening. The 10-year Treasury yield ended the month at 1.42% (up from 0.91% at the start of the year). To mitigate concerns over rising yields, the Fed kept its guidance on asset purchases unchanged in its January meeting minutes, and declared that the economy remains “far from the goals” of substantial progress on employment and inflation, stressing that it would be “some time” before it considers tapering asset purchases.
Economic momentum is solid. US retail sales (ex-autos) bounced 5.9% m/m in January, boosted by the $600 stimulus cheques that were approved just before Christmas. Manufacturing and services purchasing managers’ indices (PMIs) jumped to 58.5 and 58.9 respectively, indicating a more favourable outlook, particularly for the services sector, which has been hardest hit by lockdowns. But labour market statistics are still disappointing, with high levels of jobless claims and subdued consumer sentiment.
The S&P 500 index closed the month with a 2.8% return. Value sectors, such as energy and financial services outperformed thanks to expectations of a rapid return to a post-pandemic normality, which lifted oil prices and steepened yield curves. The Russell 1000 value index rose 5.8% compared with -0.1% for the Russell 1000 growth index.
Exhibit 3: Fixed income sector returns
The European Commission (EC) President Ursula von der Leyen admitted delays in the rollout of the vaccines. The goal is now to vaccinate 70% of the adult population by summer. In the meantime, many countries are extending selective lockdowns.
In Italy, the formation of a new government led by Mario Draghi, the former European Central Bank president, was approved by a large majority in parliament, avoiding the undesirable scenario of snap elections during a pandemic. The priorities of the new government are to address critical near-term issues, such as an effective vaccination plan, new support to prevent Covid-19 related layoffs, and an effective plan to use the resources of the European Recovery Fund. The market reaction was favourable, with the spread between 10-year Italian and 10-year German government bond yields falling to 1%. Draghi is still remembered fondly by markets for his role in resolving the eurozone sovereign debt crisis with his "whatever it takes” speech in 2012. He is viewed as a highly competent, pro-euro, “hand at the wheel” who can steer the Italian government through the pandemic.
The European Parliament has given the go ahead for the Recovery and Resiliency Plan. After ratification, individual countries will start to submit projects to the EC for final approval. A rapid implementation could redraw investors’ attention to Europe, after years of net equity outflows.
From a macroeconomic standpoint, the February flash Manufacturing PMI strengthened to 57.7 (+2.9 pts) while the services index remained weak at 44.7. Consumer confidence improved only marginally though, confirming lingering uncertainty about the outlook.
European equities closed up 2.6% with value sectors, such as banks outperforming. The 10-year German Bund yield rose to -0.28% (from -0.52% at the start of the month).
Exhibit 4: World stock market returns
In the UK, the vaccination campaign is progressing remarkably well and has already reached 20 million people. Boris Johnson recently announced a target of achieving full coverage of the adult population by July and announced a gradual reopening, starting with schools, in March.
From a macroeconomic standpoint, retail sales (ex-fuel) fell sharply in January (-8.2% m/m) as a result of the lockdown. But flash PMIs surprised to the upside, indicating improving sentiment, with manufacturing and services moving up to 54.9 and 49.7 respectively.
The FTSE All-Share Index closed up 2% despite a stronger pound, on the back of the strong vaccination progress.
A small rise in new cases in China had led to some mobility restrictions during the New Lunar Year holidays that could moderate but not derail the strong V-shaped recovery. Markets were more concerned about the prospect of a dampening of stimulus measures to curb the risk from rising house prices. The People’s Bank of China confirmed its intention to maintain a prudent but flexible policy stance.
The renminbi continued its appreciation, supported by the increased growth gap between China and the rest of the world, and greater global interest in Chinese assets.
Higher commodity prices have contributed to higher inflation expectations. Oil prices have risen back close to pre Covid-19 levels, boosted by hopes of a return to normal demand and supply constraints, and by the cold temperatures that forced Texas, which is responsible for 40% of total US oil production, to reduce refining capacity. Many industrial metals also rose. Copper registered a bounce that is partly related to rising demand related to its use in various parts of the infrastructure required for the green energy transition.
Expectations for an imminent exit from the pandemic thanks to a rapid vaccination rollout continue to be a positive catalyst for markets. However, new and unpredictable mutations of the virus are a potential risk.
Governments remain focused on a mix of pandemic control and support measures to ensure we get to the end of the “Bridge over Troubled Waters” that we discussed in our 2021 Outlook.
The risk of a return of inflation that could materialise in mid-2021 is fueling a trend of rising yields. Value versus growth rotations could continue as we progress towards the end of the pandemic and are supported by rising commodity prices and rising yields, which particularly benefit financials.
The environment of low but rising bond yields, which emphasises the vulnerability of core fixed income to a potential rise in inflation, is forcing investors to rethink the role of core bonds in portfolios. Our latest article, "Why and How to Rethink the 60:40 Portfolio", analyses how investors can build resilient portfolios that can still deliver decent returns while also providing some diversification, by shifting away from government bonds and towards flexible fixed income strategies, real assets and macro funds.
Exhibit 5: Index returns for February 2021 (%)