X

Inflation will be crucial in determining the market outlook

By Rupert Thompson, Chief Investment Officer at Kingswood

In contrast to the weather, some of the heat came off equity markets as they edged down last week and have also opened some 2% lower today. This weakness is most likely to be down to worries that the rapid spread of the Delta variant may slow the economic rebound. Just like the UK Government, the markets are now taking a rather more cautious view than only a few weeks ago. It should also be said that a pause for breath is well overdue given the strong performance seen so far this year.

Beyond the spread of new more infectious or deadly variants of Covid, a major resurgence in inflation probably posts the biggest threat to the global recovery, and last week’s numbers only added to the uncertainties on this front. US inflation surprised significantly on the upside for the third month running, with the headline rate hitting 5.4%.

Once again, a few categories, such as used car prices and airfares, were big contributors to the rise. However, they were not behind all of it, and there are signs that the upward pressure is now broadening out. That said, it is really still far too early to know whether this will turn into a longer lasting rise in inflation.

A key factor will be whether the pick-up in inflation and the shortages now being seen in the labour market feed through to a sustained rise in wage growth. The latter would prompt businesses to try and pass on the increased costs to consumers, thus providing the mechanism for the upturn in inflation to become more entrenched.

Fed Chair Powell still appears relaxed on this front. In his testimony to Congress last week, he continued to express confidence that the bulk of the rise will prove temporary, even if it has been considerably larger than the Fed was expecting. The bond market also seems strangely confident that inflation will remain under control. 10-year US Treasury yields have edged down a further 0.06% to 1.30% and are now as much as 0.45% below their high in March.

We are a bit less sanguine. Inflation looks set to remain elevated over the rest of this year and, while it should retreat next year, we don’t expect it to fall back all the way to 2% as the Fed does. Instead, inflation looks more likely to remain above the Fed’s 2% target, requiring the need for a sustained tightening of policy starting in 2023.

The US is not alone in seeing inflation pick up faster than expected. It has also surprised on the upside in the UK, with the headline and core measures rising to 2.5% and 2.3% respectively. Inflation remains considerably lower than in the US but is looking increasingly likely to rise to 4% later this year, before falling back again next year.

Such worries are now being vocalised at the Bank of England. Two additional members of the MPC have now echoed the warning by its recently departed Chief Economist that the Bank was underestimating the inflation risk. A rate rise should still be some way off but the QE programme could be brought to a close sooner than year-end, which is the current plan.

All this leaves us believing inflation risks are tilted to the upside and our client portfolios are positioned accordingly. Most importantly, only a relatively small proportion is invested in conventional government bonds, which are in the long term particularly exposed to a rise in inflation. We also hold inflation-linked bonds and our fixed income holdings are generally of relatively low maturity, reducing their vulnerability to any rise in yields.

Equities should also provide protection against a rise in inflation, as long as it remains below 3% or so, and we have recently increased the equity exposure in our lower risk portfolios. Finally, we have an allocation to infrastructure where contracts are generally tied to inflation.

Inflation will be crucial in determining the market outlook over the next year or two. Near term, however, the US earnings season that kicked off last week is more important. The big banks generally beat expectations, leading to forecasts for S&P 500 earnings growth rising to 70% from 65%. Earnings should remain an important support for markets going forward, even if the best is now behind us with growth rates set to slow sharply later this year.

Featured News

This Week’s Most Read

Wealth DFM