Market Commentary - May 2021

The pandemic continued to dominate discourse in April as case numbers globally reached record daily levels, but the impact became increasingly differentiated between the developed world, where the vaccine roll-out is bringing herd immunity and the end of lockdowns and movement restrictions into sight, and developing nations, notably India and Brazil, where second waves have spread rapidly with devastating effect and vaccine roll-out is trailing badly. However, the global dominance in both GDP and stock market capitalisation of the developed world together with China, which was the earliest economy to rebound from the pandemic, has underpinned growing confidence in recovery and the prospects for equity markets. The US and global equity market indices reached new all-time highs in April, with the S&P 500 up 5.3% and MSCI World +4.7%. Emerging markets were more constrained by the pandemic news, and by further evidence of China’s widening clampdown on its internet giants as both Tencent and Meituan were hit with anti-trust investigations following a similar move on Alibaba. The MSCI Emerging Markets index returned 2.5% in the month, with China +1.4%.

Bond markets were more settled following the sharp rise in yields in the first quarter. The yield on 10 year US Treasuries fell back to 1.63% by 30 April, down from 1.74% a month earlier, but the undercurrent of rising inflation concerns was not far away, with the 10 year breakeven rate edging up to 2.41%, the highest for 8 years. US Treasury inflation protected bonds were among the best performers in fixed income, returning 1.5% in the month, compared with 0.8% from conventional bonds and 1.1% from investment grade and high yield corporate bonds.

This easing of financial conditions led to a decline of 2.1% in the trade weighted dollar index and a recovery in the gold price of 3.6%. However, the biggest moves in the month came in the broad commodities complex, with oil up 6%, metals 9% and agricultural up 12%, taking year-to-date rises into the 20-30% range.

The evidence of a huge economic recovery ahead continued to mount, with most leading indicators across the developed world pointing to a surge in growth as pandemic restrictions are progressively eased and pent-up demand released. The US is leading the way, with Biden achieving his goal of 200m vaccine doses given within his first 100 days, and adding to the fiscal pump-priming with plans for a $1.8tn American Families Plan – funded by tax rises on corporates and the higher paid, as well as a rise in capital gains tax. For now, markets are embracing the tax- and-spend-big agenda, and the Fed continues to provide support by playing down the inflation risk despite acknowledging an improved economic outlook, reaffirming its expectation that the pick-up in inflation will be transitory rather than persistent, and maintaining its forward guidance.

With the pandemic risks abating, albeit still with serious concerns about new variants and the impact of the virus on the developing world, the biggest risk facing investors in coming months has shifted to inflation. Inflation has already begun to rise as last year’s period of falling prices falls away; headline CPI in the US in March jumped up to 2.6% year-on-year from 1.7% in February, and further rises are inevitable, if for no other reason than base effects. But it is clear that there is more at work than simply base effects. The economic recovery is arriving at a time when there are critical supply shortages in certain sectors and logistical challenges in most, partly due to the impact of the pandemic on production and supply lines, partly due to unexpectedly strong demand in a number of products. The shortage of semiconductors has been widely reported and is having a serious impact on production and revenues in key sectors such as autos, while commodity prices have surged across the board. These are feeding into producer prices and in due course will probably be passed through to consumers. A notable narrative from a wide range of business surveys and companies in recent weeks has been the reference to chip shortages, supply disruptions and general inflation of prices across supply lines, logistical problems and rising freight rates, and in the US in particular, difficulties in attracting and retaining labour, with clear implications for wages. The prices paid component of the latest Producer Prices Index in the US is at its highest in 13 years.

Even if the higher inflation in coming months proves to be transitory, the risks have moved away from disinflation and towards the upside, and could lead to another jump in bond yields, triggering a sell-off in risk assets. The Fed has the tools to deal with a persistent rise in inflation but deploying those tools and bringing an early end to its ultra-loose policy would be damaging for markets in the short term – the ‘taper tantrum’ risk.

Inevitably, then, we expect bumps along the way as we head into and through the economic boom to come. While we are in the early stages of recovery and see a wide range of opportunities ahead, especially in those parts of markets which will benefit most from that recovery, such as value stocks, infrastructure and parts of the property sector, we expect bouts of volatility and are still cautious about bond markets. Portfolio diversification will be more important than ever, blending assets which would protect against rising inflation with those that would perform well should the inflation rise ahead prove to be transitory.