Last week was broadly positive for markets, as the MSCI All Country World Index (ACWI) of global stocks rallied +1.8% in GBP terms. It was a mixed bag beneath the surface, with European Equities and US tech stocks driving the rally while UK and Emerging Markets were more muted and Chinese markets were down. Both the riskiest and least risky forms of debt posted positive returns as high yield bonds and treasuries were up roughly +0.5%.
These patterns of returns are not typical for markets and may reflect the principal ongoing debate taking place among market participants, that being the topic of inflation. Last week saw another release of Consumer Price Index (CPI) data in the US which showed inflation was running ahead of expectations, albeit by a modest amount. Headline inflation came out at +5% on an annualised basis, while “core” inflation (which excludes volatile food and energy) printed at +3.8%.
The relevant markets were decidedly unperturbed by this news. The yield on the 10 year US Treasury Bond fell (not what we would traditionally expect when inflation is rising), while the 5 Year Breakeven inflation rate also continued on its downward path. We follow inflation “breakeven” rates as they imply what the market thinks inflation will average out at over the next five years. Right now the markets share the Federal Reserve’s view that the current inflationary spell will be temporary.
We think there are very good arguments on both sides for whether inflation will prove as “transitory” as the Fed expects it to be. On the one hand, while the data shows an inflationary trend that is faster than many expected, it has been spurred by increases in prices that are likely to be temporary such as used cars and flights. There are also major deflationary global forces arising from technology and an aging population.
On the other hand, the bond markets (and indeed many multi-asset managers) may well have been conditioned by decades of low/falling inflation to believe it never poses a threat again. Vast amounts of money have been injected into the system to keep economies alive during the pandemic, and the velocity of this money is expected to increase as economies reopen. In addition, we have seen commodity prices rise rapidly and employers struggle to fill jobs which could lead to non-transitory wage inflation.
We have been moderately adding inflation-sensitive assets to the portfolio but appreciate that, unlike the current weather, the picture remains quite unclear.