A series of inflationary events
After the surge in U.S. Treasury (UST) yields in 1Q 2021, they have been in consolidation for much of 2Q 2021. Investors and central banks have not forgotten about inflation, but they just have not worked out how this will play out in the months ahead.
For central banks, especially the Federal Reserve (the Fed), inflation is still seen as a temporary phenomenon. The COVID-19 recession suppressed prices, especially commodities, and 2021 is the year of payback. In fact, looking at U.S. consumer prices in 2021 versus 2019, the annualized change has been largely in line with the Fed’s 2% target.
While the base effect is easy to foresee, U.S. headline consumer price inflation and the personal consumption expenditure deflator both came in higher than expected in April. On top of energy prices, used car prices were a surprise factor that added to inflation pressure. It could be argued that this is a one-off event and unlikely to repeat in the future. However, it is worthwhile to consider the underlying factors that could keep inflation elevated in the medium term.
Macroeconomists would argue that aggressive monetary stimulus and three rounds of fiscal support packages from the Trump and Biden administrations are adding fuel to the recovery fire. It is true that money supply in the U.S. has surged, with broad money supply M2 year-over-year (y/y) growth hitting 24% in March 2021. The relationship between money supply growth and consumer prices has not been strong in recent decades.
Fiscal support was critical in maintaining a standard of living for the general public and helping businesses survive through the pandemic. As the U.S. economy gradually recovers, these policies are expected to fade in 2H 2021. The supplementary unemployment benefits were thought to create disincentives for workers to return to work, which explains why businesses are struggling to find workers, but the unemployment rate is still above 6%. The consensus is that such distortion between demand and supply should disappear once this benefit ends in September. However, in some other markets, such as Australia, the end of temporary unemployment support has yet to bring workers back into the market. This implies higher wages could be the only way forward. This would be inflationary in two ways, via stronger purchasing power of workers on the demand side, and high wage costs forcing businesses to raise prices on the supply side.
Beyond macroeconomics, there are other one-off factors and supply-side bottlenecks that could keep inflation high. The surge in used car prices in the U.S. is partly due to the reduced supply of new cars, as production was disrupted by a semiconductor shortage. A prolonged shortage in electronic components could push up household goods prices. Businesses are also facing cost pressures in transportation and logistics. The pandemic has caused severe disruption in global shipping. The Baltic Dry Index, an indicator of the cost of shipping, hit a 10-year high in March.
Back to energy prices, the Organization of the Petroleum Exporting Countries (OPEC) announced in early June that it would only gradually increase output, which led to higher crude oil prices. For other commodities, such as industrial metals, their bull run was capped by the Chinese authorities, warning against excessive speculation.
In sum, inflation could stay higher for longer if we have a series of inflation events. Intuitively, this would require central banks to react and start to remove some policy accommodations. The Bank of Canada already started to reduce its asset purchases in April. The Bank of Korea adopted a more hawkish tone in its May meeting. Even some officials at the Fed are talking about starting the discussion on tapering its bond buying program. However, not all inflation can be cured by tighter monetary policy.
Tilting portfolio toward higher inflation
With the risk of persistent inflation in mind, it still makes sense for investors to tilt their allocations toward hedging against higher prices. UST yields are likely to move higher, either driven by higher inflation or higher growth, hence short duration high yield fixed income, such as high yield corporate debt and emerging market fixed income, is still the way forward.
Since inflation is still at an early stage, businesses should be able to offset higher costs with stronger volume and revenue growth. This implies corporate earnings should continue to expand along with the economic recovery. We note that the global producer price index and earnings per share growth are closely correlated. Moreover, the higher raw material, shipping and wage costs would have varying impacts depending on the sector. Hence, we see cyclical sectors around the world continuing to lead the way.
Europe in a recovery sweet spot; Asia needs better vaccinations, testing and tracking
In terms of geography, we have been advocating a globally diversified portfolio since the start of the year. European equities have been an outperformer partly due to a greater weight in cyclical sectors. In terms of economic fundamentals, its acceleration in vaccinations should be good news for recovery later in 2021 and allow for more sustainable reopening. The European Recovery Fund kicking in should also help to provide additional stimulus to the economy.
For Asia and emerging markets, export performance, especially in technology and commodities, is leading the way in driving economic rebounds. However, COVID-19 outbreaks have been taking place in a number of economies in Asia. Taiwan, Vietnam and Malaysia saw the number of new cases accelerate in May. Their governments had to implement more stringent lockdown measures, and this is likely to impact domestic demand. A more comprehensive and sustained recovery could be delayed until they can deliver greater progress on vaccinations, testing and tracking.
- U.S. inflation data is starting to surge but the magnitude of price acceleration has been faster than expected. Headline inflation in April rose 4.2% y/y. The low base from 12 months ago and rise in energy prices were expected. A sharp rise in used car prices added to the momentum. The Fed’s preferred measure of inflation, the personal consumption expenditure deflator, accelerated to 3.6% y/y in April from 2.4% in March, higher than expectations.
(GTMA P. 28)
- Despite the higher inflation, the Fed still views inflationary pressure as transitory. That said, given the robust rebound in economic activities, along with sizeable fiscal stimulus, it could start to discuss the process of reducing asset purchases later in the year.
(GTMA P. 21, 29)
- China’s monetary policy normalization continues with moderation in April credit growth. New bank loans and total social financing (TSF) both exhibited slower expansion. Specifically, new bank loans came in at RMB 1.47trillion (trn) (down 13.5% y/y, versus market consensus at RMB 1.6trn) while the aggregate credit measure of TSF flow came in at RMB 1.85trn (down 40.4% y/y, versus market consensus at RMB 2.3trn).
(GTMA P. 10)
- Global equities returned to a more positive tone in May, but some divergence is still visible. The S&P 500 was up 0.6%, while NASDAQ was down 1.5% as technology continues to remain under pressure. The Euro Stoxx50 was up 1.6% as the pandemic in the euro area starts to ease and vaccination progress is accelerating.
(GTMA P. 31)
- In Asia, outbreaks in some economies have pressured individual markets, notably Malaysia and Taiwan. After a few months of consolidation, China outperformed the region with the CSI 300 up 4%. Despite a sizeable outbreak in India in the past 2 months, the peaking of new cases has provided some new momentum to the market, with the Sensex up 6.5%.
(GTMA P. 31)
- Despite the sharp rise in inflation, UST yields have been largely range-bound. The 10-year UST yield was stuck between 1.58% and 1.7%. Investors are still waiting for signals on whether the current bout of inflation spikes will ease later in the year.
(GTMA P. 54)
- Greater stability in UST yields helped fixed income generate returns in May. U.S. investment grade delivered 0.6% in the month with 4bps credit spread tightening, while high yield lagged (+0.29%). A softer U.S. dollar and spread tightening also helped emerging market fixed income deliver returns in the month, with high yield outperforming. Asian U.S. dollar credit returned 0.6% in May, with high yield outperforming with 0.9% in returns.
(GTMA P. 50, 60, 61)
- Oil prices have been moving in a range (West Texas Intermediate ranged between USD62-67 per barrel), while the market is waiting for OPEC’s next move in deciding production in early June. Industrial metals, such as copper and aluminum, hit their 2021 highs in early May. However, warnings from the Chinese government on commodity speculation and monetary policy normalization have prompted a correction. A weaker U.S. dollar and lower real yield continue to fuel the rally in gold, breaching above USD 1,900 / oz for the first time this year.
(GTMA P. 72-74)
- Strong risk appetite and higher inflation are still pressuring the U.S. dollar with the U.S. Dollar Index down 1.6% in May. The Chinese yuan has already gained 3% against the U.S. dollar since the end of 1Q 2021 on the back of a strong trade surplus and the resumption of capital inflows. However, the People’s Bank of China could step in to curb one-way appreciation expectations.
(GTMA P. 11, 69, 70)