Peak Macro - A market wrap of May
Inflation remained top of mind in May, in particular the continued focus on whether or not the spike being witnessed is of a transitory nature. In the run up to the April CPI data release on May 12th, the S&P 500 began what became a c. 4% peak to trough fall, with both the headline and core inflation readings exceeding expectations (4.2% and 3.0% year on year, respectively). The theme of the month though seems to have been that these concerns have now peaked and moderated somewhat. By month end when the PCE inflation readings were released (the Fed’s preferred measure), the similarly strong readings (3.6% headline and 3.1% core, year on year) caused barely any reaction.
The month of May seemed to mark peak everything, for the US at least. Peak economic momentum with Q2 witnessing what will be the strongest GDP growth of the recovery; sky high PMIs moderating; peak earnings growth with Q2 expected to be the strongest quarter of the year; and therefore peak momentum for markets generally as the strong tailwind fades to a more modest one. Overall still a constructive backdrop backed up by good fundamentals, but inevitably harder work now as the rate of change slows and the gains for equities will come less easily. To that point, May saw a modest gain of 0.5% for the S&P 500.
The below chart, courtesy of The Carlyle Group, considers the cumulative change in US GDP since the onset of the pandemic and the same for US employment. Significantly, for GDP the US has now surpassed the former high-water mark, much quicker than had been forecast a few months ago. The picture on employment is more nuanced. Whilst there are pockets of the economy with shortages, overall at aggregate level, there is still a long way back with some 8m fewer on US payrolls than pre pandemic. This is the main other reason that the Fed is hesitant to act with employment being the second pillar of their (official) dual mandate, alongside inflation.
In Europe by contrast, there is still a lot of ground for the economy to make up, compared to pre-pandemic levels. Even if Europe continued growing at its current 6% rate for the rest of the year, Carlyle's analysis suggests it would still end around 2% below its pre-pandemic peak. For this reason greater returns can be expected from Europe for the remainder of the year compared to the US with the higher momentum retained, as was seen in May with the Euro stoxx 50 adding 1.6% and outperforming the S&P 500. Whilst the same could be said for other non-US markets, Europe seems less at risk of COVID interruptions. Although the European vaccination rollout had a poor start, the vaccination rates now seem on a smoother path than many other parts of the world. Europe has also had a structural headwind often commented on in recent years with its lack of fast growing tech companies. With the current ongoing rotation, the reversal of this dynamic can provide a further tailwind.
Back to the main current preoccupation with inflation, a read of the April report from the US Bureau of Labour Statistics does seem to back up the hypothesis of a temporary spike, given that the major contributors of the recent increase detailed within are primarily pandemic related. The below analysis from Goldman Sachs brings this to life more clearly, with the dark blue negative contributions representing the drag on prices from virus sensitive services and apparel, offset by inflationary boosts from stimulus sensitive or bottlenecked core goods. After peak in April and May, the net impact is expected to subside.
The risk to equities as an asset class doesn’t really come from inflation per se, as all historical studies show that inflation itself doesn’t have a strong relationship with returns, until inflation is very high and north of at least 5%. No one is really predicting these kind of levels at present. Rather the risk comes from the reasons why price pressures are building and the context in terms of whether there is sharp interest rate tightening or a worsening growth picture. By these measures, the risk is fairly limited right now.
What is more likely to materialise before too long and cause a wobble is the telegraphing of a timetable for tapering. For all the Fed’s protestations that tapering won’t happen any time soon, dissent across the FOMC is evident and early 2022 wouldn’t be an unreasonable expectation for when tapering may commence. When you add in the fact that the Fed has made it abundantly clear that they will pre-announce the action well ahead of the fact, solving for the missing variable takes you to some kind of tentative announcement in the next 3 months or so, perhaps at Jackson Hole in late August.
A tapering announcement is one of those market events a little like Schrodinger’s cat, in that it can both be concerning and not concerning and we won’t really know until we open the box. Superficially it shouldn’t be a surprise and so should be of little concern. Equally it’s something that could happily be pointed to as a catalyst after the event, if it precipitates a greater reaction. Trying to guess when the next correction will happen is a pointless exercise though as the equation that unites fundamentals, technicals, momentum, flows and sentiment is a grand unified theory that hasn’t yet been worked out will elude both Fermilab and CERN.
More useful is to think about how to position whilst remaining invested for the longer term. Geographically Europe has already been highlighted as benefitting from better momentum. In terms of the ongoing rotations, for all the progress made so far, there are many parts of the economy with significant room to recover; and whether fast or slow, rates will rise eventually. Therefore both cyclical and value stocks should still be favoured and whilst leadership may occasionally revert for short periods, they will outperform overall for the remainder of the year. Two legs are required though in any portfolio and as well as these medium term preferences, its important not to neglect structural growth stories regardless of what label they come with, as companies that can fundamentally change our lives can do well regardless of the backdrop.
In fixed income markets, there was little change to longer term yields – the 10 year Treasury yield inched down 2 basis points to 1.60% whilst he Bund yield moved up the same amount to end at -0.18%. US inflation expectations as measured by 10 year breakeven rates peaked mid month and then ended at 2.45%, 4 basis points higher on the month. Real rates fell back by more though, falling to -0.86%, hence the net overall fall in the Treasury yield.
The fall in real rates above helped gold to gain almost 8% to $1,906. WTI oil added 4.3% to close at $66.32 as OPEC+ stuck to its existing plan for raising production quotas whilst the pandemic glut has almost gone and stockpiles are expected to fall with increased demand. In currencies the 1.6% fall in the DXY dollar index has erased its gains for the year and taken it back to flat.
Steady progress and more modest returns will now be the norm based on known knowns. Pent up demand from consumers and improving labour markets should support the ongoing improved macro picture and corporate fundamentals. From the perspective of technicals, having now loitered at these levels for some time, technical measures are normalising and what once looked stretched no longer does. As the uncertainty of COVID variants becomes increasingly apparent, those countries with good vaccination programs will offer a much more stable investing environment compared to those that may have used effective containment measures but still house vulnerable populations.
All data above from Bloomberg, other than where separately attributed above in charts.