Market Insights, June 14, 2021

There were no real surprises at the European Central Bank’s latest meeting. Christine Lagarde revised up the region’s growth and inflation forecasts for 2021 and 2022. And more importantly, the markets were reassured by the lack of any mention of a potential tapering of the ECB’s asset purchase programme, suggesting that monetary policy will remain accommodative for some time to come. 

Industrial metals have come down from their May highs. This was a much-needed consolidation, given the sharp rise in prices recorded since the start of the year. Investor sentiment has also calmed down. We think that the risk of further downside is now limited. 

China’s producer price index jumped 9.0% year on year in May, reaching its highest level since end-2008. This rise reflects the sharp increase in commodity prices and the economic recovery and could have knock-on effects on the cost of goods imported from China.

A bond market unfazed by inflation’s jump

In the industrialised world, the last major spike in inflation dates back to the second oil crisis, in the early 1980s. Back then, the rise in consumer prices reached an annualised rate of more than 14% in the States. To prevent hyperinflation from undermining confidence in the dollar, the then-chair of the US Federal Reserve, Paul Volcker, didn’t hesitate to take drastic action. By raising rates sharply and shrinking the money supply, he managed to rein in the spiralling inflation but unfortunately triggered a major economic contraction as well. In 1983, annual inflation began declining sharply and the Volker doctrine went on to inspire generations of central bankers in the US and elsewhere.

Since then, the developed world has experienced an exceptionally long period of relative price stability. Investors now seem to have complete confidence in our central bankers’ ability to keep inflation bottled up. Otherwise, how can we explain the bond market’s reaction to the US’s May consumer price figures? A sharp rise was expected, given the unfavourable basis for comparison after commodity prices plunged a year ago due to the public health crisis. Inflation rose by 5% year on year, with retail price inflation now at the level it was at in the summer of 2008 and during the early 1990s. 

Yet 10-year US dollar yields fell sharply on the news, to 1.45%, well below their recent end-March high of 1.75%. Officially, US central bankers keep driving home the message that inflation’s surge is likely to prove temporary before gradually returning to the 2% target over the coming months. This scenario means that they can still plan to very gradually bring monetary policy back to normal, which explains why the financial markets have been so serene recently. The strategy for how to end the Fed’s emergency monetary policy will be discussed at its meeting this week and will probably be refined over the summer. 

For the time being, the Fed’s not likely to raise interest rates, because it will first want to gradually wind down its asset purchases and stop printing money. But if inflation doesn’t drop off as much and as quickly as the Fed hopes, bond investors could be served a brutal blow in a few months’ time.

USA – what will happen after growth peaks?

Q1 2021 was filled with good news in the States. The vaccine rollout was in full swing, economic indicators were pointing upwards, and the generous financial aid distributed to many households helped companies to return to growth. And what growth it has been! In Q1, S&P 500 earnings rebounded by 50% year on year – something we haven’t seen in recent history.

And  it looks like there will be a similar trend in Q2, although investors and markets that pay close attention to economic developments over several months are right to wonder whether stock markets can continue to gain ground once earnings growth and GDP head downwards. Because starting in Q3 2021, the comparison basis will be less favourable and economic growth will gradually begin to return to normal. 

We don’t think this environment will hold back the stock markets. If you look at companies’ Q1 financial results, it’s not the sectors that recorded the strongest earnings growth that actually performed the best – it was those that surprised analysts and investors the most. Financials, oil companies and commodity groups delivered the biggest surprises and thus recorded the strongest stock market gains.

Rather than worrying about the natural slowdown in growth, it would be better to identify the sectors that can continue beating expectations as the economic environment normalises. They will almost certainly be different from the ones that did well in the first six months of the year, and we’ll probably see another round of abrupt sector rotations this year.