It has been a mixed week for markets as US inflation data has once again exceeded expectations, coming in at 6.2% for the year ending in October, higher than forecasts of 5.9%. Whilst on the positive side, company earnings results have continued to exceed expectations, with the majority of companies having been able to pass on rising costs to customers.
Congress also passed an additional $500bn of spending on US infrastructure last Friday, with the ‘Build back better’ plan covering education, social and environmental issues still to come. And if that was not enough positive news, Pfizer’s late-stage trials for its antiviral Covid 19 pill produced positive results as to its effectiveness.
Short-dated US Treasuries sold off on expectations of nearing US interest rate rises, despite the US Federal Reserve (Fed) re-confirming that it expected inflation to be transitory and so would remain patient. More expensive growth stocks sold off versus more economically sensitive companies trading on cheaper valuations. Against this backdrop, as of 12 pm on Friday, London time, US equities were down 1.0%, having completed their longest all time streak of closing highs since 1997 on Monday. The US technology sector fell 1.7%.
European and UK stocks, which have greater cyclical exposure, both rose 0.5%. Japanese stocks were flat, whilst the Australian market fell 0.2%. Emerging markets rose 1.4% with positive returns being experienced across broad swathes of the index.
The 10-year US Treasury yield, which moves inversely to price, rose to 1.56% following the release of the latest US inflation data. UK gilts and German bunds rose in concert, now trading at 0.91% and -0.24% respectively.
Gold rose by over 2%, benefitting from higher inflation and now trading at $1,855 an ounce, whilst there is no immediate prospect of rates rising until the Fed drops its line of remaining patient in the face of what it sees as transitory inflation.
The UK economy’s growth in the third quarter came in beneath expectations, with GDP growing by 1.3%, lower than forecast by the Bank of England and sharply down from the proceeding quarter when GDP grew by 5.5%, benefitting from the end of lockdown. Output in the third quarter was negatively impacted by rising cases of Covid 19 and a shortage of goods and workers hitting growth. However, September’s output was encouraging, coming in higher than expected as the economy expanded by 0.6%, a significant uplift from 0.2% in August. The UK economy remains around 2.1% below its pre-pandemic size, a much larger gap than any other country in the G7, whilst the US and China have both exceeded the size of their pre-pandemic economies.
The start of this year, value (more economically sensitive) stocks outperformed the market materially as growth and inflation expectations rose, whilst growth stocks (companies less affected by the economic cycle) have outperformed from the summer onwards as the emergence of the Delta variant of Covid and supply chain bottlenecks have impacted the growth rate from reopening.
The US Federal Reserve continues to tell investors that it expects inflation to be transitory, despite it having exceeded its 2% target every month since April. What is interesting is what the bond market is telling us. Short-dated treasuries are selling off, which suggests investors are increasingly expecting interest rates to rise sooner rather than later, with futures markets pricing in a 75% chance of two 0.25% rate rises in the second half of next year. Whilst longer dated Treasuries have rallied. This tells us that the bond market accepts that inflation is here today, but once interest rates start to go up, growth is likely to come down relatively quickly and inflation with it.
Since the financial crisis of 2008, the US’s public debt to GDP ratio has risen from 68% to 128% today. A very similar picture can be seen in many other countries across the globe, including China where it has risen from 27.2% to 67%. Indebted countries are much more sensitive to rate increases with, as an example, a 1% increase in rates for the UK adding about £18 billion to the UK Treasury’s financing bill, which ultimately has to be paid for by taxpayers. Therefore, although rates are more than likely to increase in the short term, the level that they peak at may be much lower than historically we would associate with current rates of inflation.
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