Mark Harries, Chief Investment Officer at Square Mile Investment Consulting and Research provides a review of bond, equity and currency markets as at the end of the second quarter of 2021.
Global economic backdrop
Expectations of global economic growth in 2021 continue to be revised higher and even now may prove to be conservative. The release of pent-up demand as vaccines are rolled out and economies re-open, whilst the monetary and fiscal taps still remain in full flow, is a heady mix.
Since winning the election last November, President Biden has announced the pandemic-relief American Rescue Plan, the infrastructure-related American Jobs Plan and the welfare-focused American Families Plan, totalling US$6trn in additional spending.
At the same time, the US Federal Reserve continues to pump US$120bn into the economy each month through quantitative easing.
The widely respected US Conference Board is forecasting that the US economy will have grown by 9% on an annualised basis in the second quarter of 2021. Similarly, in May the Bank of England raised its forecast of economic growth in the UK in 2021 to 7.25% (from 5% just three months earlier).
In the eurozone, where vaccination rates have lagged significantly behind those in the UK and US causing restrictions to remain in place for longer, growth of 4.3% is now expected in 2021.
Despite this and as in the US, neither the Bank of England nor the European Central Bank seem keen to begin the pullback from quantitative easing.
The main focus of attention over the last few months, however, has not been excitement about the rebound in economic growth but worries about the threat of inflation.
In the US, the annual inflation rate (CPI) has soared from 1.7% in February to 5.0% in May, its highest level since August 2008.
In the UK, the inflation rate has tripled from just 0.7% in March to 2.1% in May and the Bank of England expects it to rise above 3% in the months ahead.
In China, for long a byword for the cheap manufacturing that has helped keep global inflation at bay, factory gate prices rose by 9% in the year to May. Interestingly, China is now seeing the same demographic trends as much of the developed world with an ageing population, declining birth rate (despite the abolition of first its one child policy and then its two child limit) and a shrinking workforce.
Commodity prices are soaring with the price of oil up by 45% in the first half of 2021. The prices of iron ore and copper are up by 39% and 20% respectively. Supply bottlenecks, which exert upward pressure on prices, are commonplace, spanning semiconductors for use in computer chips to lumber to labour. The trillions of dollars and pounds being earmarked for infrastructure and environmental projects as well as to address social inequality may also be inflationary in nature.
Central bankers, however, remain steadfast in their assertion that the inflationary spike we are seeing is transitory and not the beginning of something more structural.
Bond markets in Q2 2021
Inflation is bad news for bond investors because it erodes the real value of interest payments and capital return, both of which are fixed. We might therefore have expected that that the sharp increases in inflation in Q2 would have caused bond prices to fall (and yields therefore to rise).
However, 10-year gilt yields fell from 0.85% to 0.72% in the period, so gilts provided a positive return. Despite a much bigger jump in inflation it was the same in the US where 10-year US Treasury bond yields declined from 1.75% to 1.47%.
Of course, yields soared in the first three months of the year, from 0.20% to 0.85% and from 0.91% to 1.75% for gilts and US Treasury bonds respectively, so government bonds have still been a very poor investment year-to-date. Indices representing the return of the broad gilt market are down by about 6% in the first half of 2021.
The slight recovery in the second quarter of the year therefore suggests that the earlier sell-off earlier was overdone or that, for now at least, investors believe that the current bout of inflation will indeed be transitory.