The biggest question for markets remains is inflation returning? As the global economy recovers, after tremendous levels of Central Bank stimulus during the Covid inspired economic crisis of the last 18 months, which has pumped extreme amounts of money into the economy is, is inflation returning?
This post Covid economic recovery, with a significant rebound in demand, is compounded with major global supply issues highlighted recently by headline news around surging wholesale global gas prices and a crisis level lack of petrol in the UK, the later partly due to post Brexit labour supply issues. But it is a global supply issue with commodity prices, everything from oil to zinc to nickel to timber to aluminium at multi-year highs as the global economy recovers.
Let’s be clear, inflation is bad news for financial markets – it erodes the real value of assets and it normally leads to higher interest rates. Higher interest rates are bad for both bond and stock markets:
Bonds – if interest rates shift from 1% to 2% then current bond prices fall to accommodate that interest rate rise so that a bond yielding 1% now yields 2% (remember bond prices and yields have an inverse relationship – as yields/interest rates rise, bond prices fall).
Higher interest rates are also bad for stocks since
-higher interest rates make investing in bonds relatively more attractive versus stocks
-higher interest rates/bond yields raise the cost of corporate borrowing e.g. If Coca Cola has to issue a 10-year bond at 3% not 2% that directly increases their borrowing costs.
-higher interest rates result in lower present day stock valuations as analysts discount future earnings using higher interest rates
Where is inflation now?
Central Banks normally target 2% annual inflation (not zero as the risk of missing the target and having a deflationary environment where consumer debt increases in real terms is too dangerous a target).
In the US, inflation has jumped over the last few months to an annual rate of over 5%.
In Europe, inflation is also above target at 3% and at a 29-year high in Germany at 4.1%.
So, the markets are asking?
- Will the US Federal Reserve become less accommodative and taper (reduce) its $120 Billion monthly bond purchase programme (Note: When a Central Bank buys a bond from a bank, it gives the bank money for the security, so increasing the money supply)
- Will the ECB (European Central Bank) slowdown its EUR 1.85 trillion pandemic emergency bond purchase programme)?
- Will both Central Banks also raise interest rates to combat the inflationary threat?
But it is not as simple as this? Both Central Banks have made noises over the last few months that they think the current uptick in inflation is temporary as the data is comparing prices today with pretty much the economic lows of the Coronavirus crisis 12 months ago. But no doubt, inflation is rising in many countries as the world economy rebounds from the impact of the pandemic, increasing pressure on central banks to start winding down back the monetary stimulus they launched last year. Indeed, Jay Powell, Chairman of the US Federal Reserve said last month that it would start scaling back its asset purchases this year but also spoke of the dangers of reducing the Fed’s $120 BN of monthly purchases of debt too rapidly – the markets liked the September ‘dovish’ comments.
Last month I said “everything is reflected in current bond yields and equity prices. Financial markets are relaxed about the inflationary threat at the moment”. Well, financial markets have become less relaxed. The S&P ended September with a five-day slide of 2.2% – its worst weekly performance since end February – and both the NASDAQ and S&P were down about 5% last month in total. Surging global gas prices has been one of the key focusses in early October. It is not just about gas, however, looking at increases in the prices of commodities from cotton to coffee alongside pandemic-related worker shortages in the US, Europe and the UK. But equity markets have rebounded to just be in positive territory in October.
Bonds – the US 10-year Government Bond is the key security to follow. It is currently trading at 1.55% 30 yield-to-maturity (annual rate of return) sharply higher than the 1.30% reported last month and the market considers higher inflation and therefore interest rates. The yield would be higher if it wasn’t suppressed by the Federal Reserve bond-buying programme that has kept borrowing costs lower during the pandemic.
Commodities: GOLD is trading just below $1,750 per ounce, well below its peak of $2,050 reached in the summer of 2020. Gold performs best in an inflationary environment since it holds its real value i.e., a bar of gold is worth a bar of gold whatever inflation does. In some ways it surprising gold prices aren’t higher given the inflationary news.
OIL: Brent oil is trading $80 per barrel which is $10 higher than this time last month reflecting a mini-global energy crisis with OPEC resisting calls to increase output. Compare this price to the Covid stricken lows of last year of $20 pb.
Keep following the US 10-year bond yield – it tells you everything you need to know about financial market sentiment and the current market thinking on “Is inflation returning?”