Economic data has been very strong over the last month but markets have been more muted after an already strong start to the year. The ongoing vaccine rollout is allowing many economies to gradually reopen, which in combination with sizeable fiscal support – particularly in the UK and US – is supporting a big bounce in economic activity. Nevertheless, markets were constrained in May by concerns that upside data surprises may result in more persistent inflation, which could force central banks to bring about a premature end to the growth rebound. Developed market equities managed to gain 1.5% for the month. Expectations of stronger economic growth and inflation favoured value over growth. MSCI World Value rose 3.0% and MSCI World Growth fell 0.1%. With inflation on the rise, global inflation-protected bonds gained 3.0% on the back of strong demand.
Real world data on vaccine efficacy continues to be largely positive, with hospitalisations low in those countries where the vaccine rollout has progressed far enough to protect the most vulnerable age groups. The tragic health crisis in India has underlined the need for a rapid rollout of vaccines globally. Progress is being made, with over 190 million vaccines so far administered in India – only behind the US and China in the total number of jabs provided so far. This progress, combined with a relatively young population, brings hope that the worst of the Indian health crisis could be over within a few months.
Exhibit 1: Asset class and style returns
The headline acts in May were growth and inflation, and they did not disappoint. The US Purchasing Managers’ Indices (PMIs) for manufacturing and services both beat expectations in May, as they rose to their highest levels on record. The details of the PMIs not only showed that consumer demand remains buoyant but also that businesses are facing rising input costs. Headline inflation rose to 4.2% year on year (y/y) for April. A rise in inflation was expected given the fall in prices this time last year, but even month-on-month inflation rose 0.8%, well above consensus expectations.
The US Federal Reserve (the Fed) acknowledged that it will need to think about tapering its bond purchases at some point. Having said that, the April minutes showed the Fed was broadly unmoved in its view on the economic outlook – calming fears of the punch bowl being taken away suddenly. While the inflation release was a bit of a surprise to the Fed, some of the details suggested there are temporary factors at play – the rise in prices of used car sales, for example, is not expected to last. Whether or not inflation is transitory is one of the biggest questions for investors right now and we look at this in more detail in our recent piece,"Monetary and fiscal coordination and the inflation risks".
There were some signs of upward pressure on wages. The latest National Federation of Independent Business (NFIB) survey highlighted that small businesses in the US are struggling to fill jobs, which has been partly attributed to the boost to unemployment benefits – which are set to expire in early September. The sectors competing most with unemployment benefits recorded strong wage growth. In the April jobs report, 266,000 jobs were regained, but this was well below consensus expectations for 1 million. Such has been the difficultly to re-hire workers that some states have confirmed they will be ending the enhanced unemployment benefits early.
US corporate earnings for the first quarter were much stronger than expected. S&P 500 companies reported earnings growth of 47% (y/y) relative to consensus expectations for 20% growth. Despite the strong earnings performance, the S&P 500 rose 0.7% in May, but the more expensive technology and consumer discretionary sectors – which make up 40% of the index – came under pressure.
Exhibit 2: World stock market returns
After a relatively slow start, vaccination rates in Europe have picked up. Across the major economies, jabs are being provided to around 0.8% of the population per day – in line with the UK. At this pace, the eurozone will soon have provided at least one dose to the over 50s. The prospects for a strong growth rebound this year have therefore risen and this has helped European equities. The MSCI Europe ex-UK Index rose 2.8% in May – the best performing major equity index.
The eurozone PMIs for May were also positive. While manufacturing has been recovering since last year, the rebound in the services sector had been delayed by ongoing restrictions. Vaccinations appear to now be boosting confidence in the services sector, as evidenced by the improvement in the services PMI business survey to a level above 55.
Exhibit 3: Fixed income sector returns
The unlocking of the UK economy continued in May, with indoor hospitality reopening. At the start of May we looked at how a build-up of household savings alongside fiscal stimulus would create a potent cocktail to boost spending (see, “It’s getting hot in here: Growth and inflation are heating up”). That proved to be the case in the UK, as shown by a 9% month-on-month rise in retail sales for April, with clothing sales growing by an astonishing 70% over the prior month.
While demand has clearly been strong, UK businesses have been struggling to meet that demand in a timely manner. The PMI surveys showed that supply bottlenecks in manufacturing became even more acute in May with supplier delivery times growing. Price pressures facing businesses also grew, with the input price component of the manufacturing business surveys hitting record highs. It should be no surprise then that inflation rose by 0.6% month on month. The 1.1% rise in the FTSE All-Share took its year-to-date performance above 10%.
Exhibit 4: Fixed income government bond returns
The MSCI EM index delivered returns of 2.3% over the month, while Asian equities were up 1.2%. After a very strong run between the start of last year and February of this year, Asian equities have given back some of their gains in the last few months before rallying in the latter half of May. Growth stocks have led the decline since February, and the reversal of their fortunes in May helped Asian markets to move higher again. Still, with Chinese growth stocks having corrected by over 20% since February, valuations now look more attractive. We believe that concerns around Chinese policy tightening are overdone and that the long-term outlook for Chinese and Asian equities remains attractive.
The economic outlook for the second half of the year looks bright, particularly for those countries which are far along in their vaccine rollouts. As more countries step-up efforts to vaccinate their populations, the economic recovery should broaden out. The question isn’t whether or not growth will be strong, but more how strong it will be. The concern for markets has been in understanding how central banks will react to potential further upside surprises on economic growth. Investors are particularly worried that if inflation does prove to be persistent rather than temporary, then central banks might have to raise interest rates quickly to slow down an economy that is running too hot. This concern has created some market volatility over the past month.
However, we believe that equities should do well in an environment of modestly rising inflation, as rising sales tend to offset higher input prices, which can be passed onto customers when demand is strong. Looking for areas within equity markets that stand to benefit both from the cyclical rebound but also rising bond yields probably makes sense. Value sectors usually fit the bill in that respect. Overall, equities have had a strong start to the year, and while we wouldn’t be surprised to see a few wobbles along the way, we believe the outlook for the economy and equity markets remains positive. For more details on our outlook, please look out for our upcoming Mid-Year Outlook.
Exhibit 5: Index returns for May 2021