Turning a corner

One of the perennial dilemmas of strategists is figuring out when good news becomes bad news in the eyes of the market, and vice versa. Say the jobs report comes in stronger than expected. This would be good news and the market would go up. More people working means more tax revenues, less spending on unemployment benefits and an increase in demand. But, instead, the market could be thinking that, with more people working, the Fed would be more likely to raise rates sooner rather than later. Business costs could rise and less money be available to shareholders as dividends. So that may mean that, as and when the Fed does raise rates, stock prices would come down. Of course, this is an oversimplification. For now, as economies reopen, activity is picking up and, with the inflation spike in the US likely to be temporary, policy will probably remain supportive for quite a while. But what’s going to happen when we’re past the peak in both growth and stimulus?

Reopening consequence #1 | Activity snapback: The US economy, over the next couple of months, should grow at the fastest rate of the year and, in fact, throughout our forecast horizon – and, quite likely, it’s going to be a really fast rate. Of course, this isn’t new news and global equities have already responded to these dynamics, reaching record highs. However, while the gap has obviously narrowed, our economic forecast is still higher than consensus and so, possibly, we think the full strength of the bounceback in economic activity that we forecast may not be fully reflected in asset prices just yet. To us, the dominant macro narrative remains one of economic recovery, asset-price reflation and rotation into cyclical markets – with equities, commodities and government bond yields alternating in pushing higher. In more than a way, though, this back-and-forth may perhaps make things somewhat more volatile going forward.

Reopening consequence #2 | Inflation spike: In the US (and, so far, in the US only), inflation is rising too. Part of the acceleration in the pace of increase in consumer prices is due to an easy comparison with falling prices during the first lockdown last year. But not all of it is a statistical quirk. As oil prices have trended higher, energy inflation has picked up quite a bit. And another contributing factor is supply bottlenecks in the context of pent-up demand finally being unleashed. With significant spare capacity still out there, and moderate wage growth at best, our medium-term inflation path remains benign: we expect inflation to get back to the Fed target early next year. But, even if this forecast was to ultimately prove right, it may be hard for the market to relax about the risk of a more persistent inflation spiral during a period of accelerating growth and consumer prices.

Here’s why this matters:

Moving through ‘peak growth’: The shift in growth momentum from acceleration to deceleration is likely to be important for markets. That point is still ahead of us (probably the middle of this year). But, when it does come, what’s likely to happen is that upward pressure on the most cyclical assets, and also on global yields, may ease – even if the actual pace of growth is likely to stay strong. Timing these shifts is very hard. Pockets of investors seem to wonder whether these dynamics are already playing out. After all, the US bond market has seen quite a relief rally lately and US cyclical stocks have underperformed somewhat. While we see moderate short-term risks to the recent enthusiasm for rate-sensitive assets if longer-dated yields move gradually higher again as we forecast, a further rise in yields form here – if the Fed continues to remain dovish – shouldn’t be that disruptive.

Moving through ‘peak stimulus’: The shift in the policy impulse from very expansionary to less so is likely to be key too. The overall stance will probably stay supportive. But, as economies emerge from the pandemic, central banks will likely scale back the degree of monetary easing. Although actual execution will probably wait, we expect the Fed to start talking about tapering (slowing the pace of) its bond purchases over the next few months. The Bank of England should follow and, at some point in 2022, the European Central Bank too will likely discontinue its emergency asset purchases. China is already withdrawing liquidity. Government budget plans are shifting from temporary support to public investment on physical and digital infrastructure, as well as on climate change. The net fiscal thrust will probably remain quite stimulative, but taxes on high incomes, corporations and capital gains look set to increase – in the US and/or the UK for now – hitting earnings and profits.

Meanwhile, Fed watchers stay tuned…

US in focus: After the central bank of Russia delivered a bigger-than-expected rate hike last week, this week markets will watch for any sign that the Fed may be moving to a decision to taper its bond purchases later this year. The US GDP report for the first quarter is likely to reveal strong growth especially in consumer spending, given reopening and stimulus. Consumer confidence should confirm that households are feeling more optimistic. Personal income and spending, more recently, are likely to have risen further. Core PCE inflation – the Fed’s key gauge – is expected to rise. Durable goods orders should have bounced back strongly. In Europe, the German Ifo business climate is likely to be the highlight, as it will probably incorporate the impact of the recent tightening in restrictions. The latest round of purchasing managers’ indices has surprised to the upside, though activity in services remains weak. Euro area inflation should accelerate, but there really is no spike.

Daniele Antonucci | Chief Economist & Macro Strategist