“Inflation refers to a rise in the average level of prices sustained over time, which also corresponds to a fall in the internal (domestic) purchasing power of money.

This can be contrasted with deflation which is a fall in the average level of prices, and disinflation, which is a fall in the rate of inflation – say, from 3% to 2%.” – Economics Online

LAST QUARTER REVIEW 

The second quarter saw global equities replicate the steady gains that we saw in the first quarter leaving most indices in the major stock markets up between 9% and 20% so far in 2021. The aptly named post pandemic lockdown reflation trade has continued throughout the first half of this year, and the big question is whether it can continue for the rest of 2021, especially if the views of the majority of market commentators are proved correct, rising inflation is here to stay.

The prevailing trend at the start of the year in stock rotation away from the larger companies and tech giants to the perceived value of medium and smaller domestic focused stocks was largely reversed on Wall Street as the tech heavy Nasdaq 100 index regained its swagger and climbed almost 11% during the last quarter (and 6% in June alone). The broad based large cap American benchmark S&P 500 also did well climbing more than 8% and ending the quarter at another record high 4297.5, while the first quarter’s leading index, the Russell 2000 composed of medium and smaller listed US stocks rose a more modest 4%.

In the UK, investors continued to favour smaller companies as the FSTE Small Cap index climbed another 8.3%; up more than 18% year to date (ytd). Larger companies as measured by the benchmark FTSE 100 did not perform quite as well, but still climbed almost 5% and just over 9% ytd.

Meanwhile government bond markets, despite the seeming consensus from most market commentators that rising inflation is here to stay and that the Federal Reserve (Fed) risks “falling behind the curve”, we saw a reversal of the first quarter action in yields both in US Treasuries and UK gilts. During the quarter, the interest rate on the benchmark 10 year Treasury declined from 1.73 to 1.45, while the yield on the 10 year gilt also fell from 0.86 to 0.72, suggesting that if persistent secular (as opposed to cyclical) inflation is the reality, the bond market is also behind the curve, which historically has rarely been the case, but more of that later.

Markets appeared spooked by a possible change of tack from the Fed at its Federal Open Market Committee meeting on the 16^th June, when its policymakers led by Jerome Powell left the target range for its federal funds rate unchanged at 0.25%, but signalled they expect two interest rate increases by the end of 2023. Officials noted progress on vaccinations and strong policy support had led to stronger than previously anticipated economic activity and employment gains.

The Fed also announced that its bond purchases will remain at a rate of $120 billion a month, while it cited new economic forecasts that showed the GDP is seen growing 7% in 2021, above 6.5% in the March projection. The 2022 GDP growth projection was left at 3.3%, while unemployment is expected to fall to 4.5% this year, unchanged from the March projection, but inflation is anticipated to be much higher at 3.4% in 2021 (2.4% in March), albeit then seen slowing to 2.1% in 2022 (vs 2% in March).

Here, the Bank of England (BOE) voted unanimously to keep its benchmark interest rate on hold at a record low of 0.1 percent during its June 2021 meeting, and by a majority of 8-1 to leave its bond-buying programme unchanged as widely expected. The central bank also reiterated it does not intend to tighten monetary policy at least until there is clear evidence that significant progress is being made in eliminating spare capacity and achieving the 2 percent inflation target sustainably.

BOE policymakers said the economy would experience a temporary period of strong GDP growth following the relaxation of restrictions on economic activity, after which it will fall back. At the same time, CPI inflation is expected to pick up further above the target, owing primarily to developments in energy and other commodity prices, and is likely to exceed 3 percent for a temporary period, before returning to around 2 percent in the medium term.

Across the channel, the European Central Bank (ECB) left monetary policy unchanged during its June meeting, saying it expects net purchases under the PEPP (Pandemic Emergency Purchase Programme) over the coming quarter to continue to be conducted at a significantly higher pace than during the first months of the year. The bank boosted the speed of bond-buying earlier this year, but a recent fall in borrowing costs in the Euro Area raised expectations that policymakers might start considering to slow the pace of purchases.

Meanwhile, the ECB revised up GDP projections for 2021 and 2022 to 4.6% and 4.7%, respectively, supported by stronger global and domestic demand, as well as by continued support from both monetary policy and fiscal policy. The outlook for inflation has also been revised up for this year and the next, largely owing to temporary factors and higher energy price inflation, but the price pressures will likely remain subdued overall.

In the land of the rising sun, The Bank of Japan (BOJ) left its key short-term interest rate unchanged at -0.1% and maintained the target for the 10-year Japanese government bond yield at around 0% during its June meeting by a 7-1 vote. The BOJ mentioned that Japan’s economy has picked up as a trend, although it has remained in a severe situation due to the pandemic, while on the price front, the annual rate of change in the CPI (consumer price index) has been at around 0% recently due to a rise in oil prices, while inflation expectations have been more or less unchanged.

In currency markets, the US dollar fell slightly against a basket of currencies as measured by the popular DXY index, while the more volatile sterling dollar rate was broadly unchanged over the quarter. Over the same period, gold bullion recovered almost half of the heavy losses it sustained in the first quarter, rising 3.6%, while crude oil continued its relentless rise on the back of insufficient supply to meet the increased demand as the price of West Texas Intermediate (WTI) rose 25% during the quarter and is up more than 50% ytd.

GDP Data shown are to the 31^st March 2021; Interest Rate, Equity & Bond Index Data are to the 30th June 2021; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices used: S&P US T-Bond, S&P UK Gilt Index, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond, S&P Germany Sovereign Bond.

CURRENT CONSIDERATIONS

Just as at the end of the first quarter, the key consideration for most market analysts, money managers, and investors at the moment is undoubtedly the likely trend for current and future inflation. This overriding consideration was all too apparent from the price reaction of the key Wall Street stock indices in the last half of June.

Following the comments of the FOMC at the Fed meeting on the 16^th June, that in light of the most recent economic data, they had turned more hawkish and would now begin raising interest rates possibly as early as late 2022 to counter over-heating, Wall Street fell sharply. However during the last full trading week of June, the S&P 500 and the Dow posted their biggest weekly gains since February and March respectively, as the so-called reflation trade gained renewed momentum, and investors appeared to acknowledge that the Fed will not rush to hike interest rates despite mounting inflationary pressures.

The Economist suggested in a recent article titled, “The Fed prompts a change of heart”, that the question investors now face is how much the Fed’s stance has actually shifted? The article goes on to say that it appears the initial market reaction was overdone, and that there are reasons to believe the great reflation trade has further to run, not least because the full opening of the American economy is still in its early stages.

So, potentially good news for equity investors. Also for those wishing to provide portfolio diversification through some exposure to US Treasuries and other investment grade government and corporate bonds, provided, of course, that runaway inflation is not around the corner.

David Rosenberg is a renowned and respected independent economist and market historian of several decades standing, and whose views are sought by major institutional investors and asset management groups, does not believe secular rising inflation is here to stay because the data do not support the inflationary speculation. In a recent interview he asked “how is it that we got to a 3.5% unemployment rate by early 2020, effectively the lowest unemployment in 50 years, coming off a 10 year expansion, with a fivefold increase in the equity market, and a booming residential real estate market, and yet inflation was barely above 2%, whereas the last time we had an unemployment rate that low, the inflation rate was more than double where it was this time around?”

Dr. Lacy Hunt, another highly regarded economist in investment circles, and who has been correctly calling the direction of US long term interest rates since the longest bull market in history, in US Treasuries began in 1981 (when the yield on the US 10 year Treasury exceeded 15%) agrees with David. During April when the inflationary excitement almost got to fever pitch, Dr Hunt was quoted as saying, “contrary to the conventional wisdom, disinflation is more likely than accelerating inflation. Since prices deflated in the second quarter of 2020, the annual inflation rate will move transitorily higher. Once these base effects are exhausted, cyclical, structural, and monetary considerations suggest that the inflation rate will moderate lower by year end and will undershoot the Fed Reserve’s target of 2%. The inflationary psychosis that has gripped the bond market will fade away in the face of such persistent disinflation”

Both emphasise that the unprecedented American debt held by the government, central bank and major corporations is a key consideration as to why interest rates cannot rise much without bankrupting the whole economic system. Debt at all levels of society in the United States stands at an unprecedented 366% of American GDP, and this does not include unfunded liabilities.

The data show that the debt ratio increased by an extraordinary 40% in 2020! As Rosenberg and Dr Hunt contend, aging demographics in the US and disruptive technology, have played a key role since the beginning of the millennium as deflationary factors, and are phenomena that did not exist in the inflationary 1970s, making it futile to use that period as an analogy for what may happen in the current era.

Dr. Hunt made another key observation this time last year when he cited the infamous “deflationary gap” problem that exists after every recession, and which would likely linger for many years once recovery had begun. In effect the deflationary gap is described as the difference between potential and real GDP created by the recession.

Historically, when it comes to forecasting long term interest rates and inflation, there is no better predictor than the bond market. In previous Market Views, we have highlighted the significance of the yield curve, and primarily focused on how reliable an indicator of a forthcoming recession an inverted (when interest rates at the long end of the US Treasury market are lower than the short term ones) yield curve has proved.

However, the yield curve can also provide investors with clues as to the likely direction of inflation / long term interest rates as well by observing the change in the slope’s steepness. On the 1^st January the spread or gap between the interest rates on the benchmark 10 year Treasury and the 2 year bond was 0.82%.

By the end of the first quarter, this spread had widened to 1.58% mainly as result of the yield on the 10 year Treasury rising, and thus the steepening slope of the curve suggested the economy was accelerating and increasing inflation was coming. However, by the end of this last quarter, the spread had narrowed again to just 1.22%, suggesting that rising inflation is likely to be short-lived, and disinflation will follow.

FORWARD OUTLOOK

The data we assess and monitor on inflation currently suggests disinflation is coming. We believe it likely the current short term rising inflation in both the US and UK markets will reverse as a combination of slowing demand and increasing supply results in a resumption of the deflationary trend that has prevailed since the turn of the millennium.

Further signs of the reflation trade slowing can be seen in the commodity markets where many of the frenetic price increases we saw in the first quarter have reversed. Lumber is a classic example of this whereby the price at the start of the year of around $870 per thousand board feet almost doubled to nearly $1700 in early May but has since collapsed to less than the price it started 2021!

The one exception to the reversal we believe is likely to be the energy sector and in particular oil. In contrast to most commodity markets that peaked in May and have since reversed, the oil sector has continued to climb steadily, with for example the price of WTI rising from around $48 a barrel on the 1^st January to around $73.50 currently.

There are a number of special factors of course that inevitably drive the oil market, including the actions of Opec (Organization of the Petroleum Exporting Countries), the profitability margins of US shale producers and the increasing drive to greener cleaner energy. What many investors possibly fail to grasp however is that the drive from a petro-carbon driven world to a green renewable energy world is likely to take many years if not decades and can only be facilitated with continued reliance on fossil fuels in the shorter term.

Depending upon how Opec (who according to various data sources have plenty of spare capacity even at the current global demand levels of around 95 million barrels per day) play their hand, this could facilitate prices of around $100 a barrel and maybe more in coming years. However, as we all know this is an extremely volatile market where almost anything can and sometimes does happen!

Due to our inflation views, we remain comfortable from a portfolio diversification perspective in continuing to recommend some exposure to funds investing in a combination of blue chip government debt (primarily US Treasuries and UK gilts) and investment grade corporate bonds.

On the back of the phenomenal returns seen already in global stocks and especially on Wall Street where valuations are a little richer than most other markets, we remain cautiously positive going forward. We will continue to selectively recommend re-balancing portfolios to include more defensive allocations, whilst increasing exposure to UK stocks which remain relatively cheap especially in the higher yielding value sectors.

The one area where we are seeking to rebalance a little more aggressively is in the commercial property sector where the longer-term impact of the Covid induced lockdown remains uncertain. It does appear unlikely that the occupancy levels that existed pre-pandemic will ever return as the best case scenario suggests a hybrid office / home working pattern will prevail suggesting downward pressure on rental yields going forward.

As always, investment risk is at the forefront of our advice and, whilst it is often necessary to undertake adjustments to individual portfolio allocations in order to maintain individual preferences, we are confident that our advised portfolios remain well placed in meeting our clients’ needs.

Copyright © Ash-Ridge Asset Management 1^st July 2021.

Data Sources: Bloomberg; Brookings Institute; Economic Cycle Research Institute: Financial Sense; Financial Times; German Federal Statistical Office; Hoisington Investment Management; Macro Voices; National Bureau of Statistics China; Office for National Statistics; Real Vision; S&P Indices; The Cabinet Office Japan; The Economist; The Federal Reserve; The National Bureau of Economic Research; Trading Economics; UK Debt Management Office; US Debt Clock.org; Wall Street Journal; Zero Hedge.

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