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May Market Update: what’ll last longer – inflation or the conversation about it?

Financial professionals only

In a nutshell:

  • US inflation hits 4.2%, UK inflation doubles to 1.5%
  • UK growth projections upgraded, Sterling strengthens
  • Biden proposes $6trn spending plan for 2022, as current infrastructure package continues to be debated

What’s moving markets…

Last month, we saw the jump in inflation that we’ve been reading about since last years’ lockdown. The ‘base effect’ (the distortion that a change in base month can have on year-on-year numbers) seems to have attracted more airtime than ever, as the US saw a Consumer Price Index (CPI) read of 4.2% in April.

The reaction of the market is arguably more interesting than the number. The US yield curve, which essentially sets global market prices, rose marginally with the 10 year hitting 1.7% before retreating. So, what does this mean?

Well, yes, it was a big jump up – but not unexpectedly big. The harder call is how long it now lasts. That’s what equity markets seem to be struggling with. There were some fairly sharp daily moves throughout May (the FTSE 100 fell 2.7% in a day), though the net result was a set of monthly market returns not particularly out of the ordinary.

We saw a similar inflation story in the UK, with CPI coming in at 1.5%, double the previous month. We’ve had tighter lockdowns and a slower recovery, so perhaps it’s not surprising to see US prices rising more. Or maybe everything really is bigger in America.

The Bank of England’s (BoE) growth and inflation upgrades for the year ahead may actually present a risk of undershooting projections. So much depends on a smooth transition to normality and the impact of any virus variants. With ‘everything going as planned’ as the base case scenario that markets are pricing towards, there is cause to expect some volatility – though not enough to take risk off the table.

The BoE also confirmed rates were to remain at their current level, as were asset purchases. This is the tailwind markets have become accustomed to, but how long can Central Banks keep supporting asset prices? Inflation affects the cost of living and the real return investors receive, but its secondary impact on the pace of monetary policy is what keeps investors, economists and strategists up at night. After all, the primary aim of monetary policy is maintaining manageable and stable levels of inflation, not long term support of markets.

The Bank of Japan delivered a similarly supportive message, confirming their ETF purchasing programme would continue in “bold” fashion, but at their discretion, rather than on a schedule. Japan continues to struggle at the other end of the inflation see-saw, which is stubbornly planted in the ground.

In the US, Joe Biden is still trying to get his infrastructure spending in motion. The predictable back and forth continues, with Republicans offering a $1trn alternative to the $1.7trn plan proposed. Looking further ahead, Biden also announced a $6trn fiscal package for 2022. This would ramp up spending across education, infrastructure and climate change, and involve a circa $2trn deficit. “Borrow while it’s cheap” is the justification for the spending, but one that Republicans are unlikely to get on board with.

Asset class implications…

All this talk of spending wasn’t enough to boost equity returns, with the US lagging all other major markets. The impact of Sterling on returns can be ignored in May. While the FTSE USA is still bottom of the pile, run the data in local currency and all markets are in positive territory.

Put simply, a stronger pound means overseas investments are worth less when translated back. It’s a negative aspect of what is generally a good sign for the UK economy, and ultimately part of the comeback from the Sterling fall that followed the Brexit vote in 2016.

The value of Sterling will always play a big role for UK investors, but the direction of the Dollar is arguably most important for global markets. Continued falls in May have brought the currency close to 5-month lows, as it lost out to commodity led currencies. This is typical through a recovery – and often what drives strong relative performance from Emerging Markets. At the same time, the yields on offer in the US (and the prospect of raising rates ahead of others) should also attract capital. There can be various factors at play with currency and knowing which will win out is a tough ask.

As economies reopen and we start to get a real sense of consumer and business sentiment, we’ll be in a better position to judge the longevity of both inflation and this phase of the business cycle. For now, we view a pro-cyclical position, via a higher allocation to equities and credit, as adding value (and offering an inflation hedge), alongside lower exposure to changes in interest rates (duration).

Asset classes in numbers

Name 1m 3m YTD 1yr 3yr
FTSE Actuaries UK Conventional Gilts All Stocks TR in GB 0.43 0.99 -6.34 -7.43 7.96
ICE BofA Global Broad Market Hedge GBP TR in GB -1.86 -1.55 -6.62 -10.33 5.72
IA UK Direct Property TR in GB 0.60 1.17 1.29 0.27 -0.55
FTSE All Share TR in GB 1.11 9.64 10.92 23.13 5.92
FTSE World Europe ex UK GTR in GB -2.15 8.13 7.39 22.46 53.13
FTSE USA TR in GB 1.78 11.07 8.95 26.62 31.33
FTSE Japan TR in GB -1.10 -0.26 -2.04 8.69 11.79
FTSE Asia Pacific ex Japan TR in GB -1.10 0.91 3.57 32.54 27.53
FTSE Emerging TR in GB -0.09 1.85 3.97 29.52 25.18

Source: FE Analytics, GBP total return (%) to last month end