Written by Andrew Cassar Overend
8 min read
Last Updated on June 19, 2021
Welcome to the Financial Fortify Week 24: 2021 round-up!
The highlight of this week was the meeting of the Federal Open Market Committee last Wednesday. After months of shrugging off inflation, the Committee members started "talking about talking about raising rates" and they surprised the market with their proposal of two interest rate hikes in 2023. This means that the FED projects higher inflation ahead, but it still expects the price increases to be transitory.
Those who have read our interest rates master class should know that 1) bond yields of short duration move closely to FED interest rate announcements and 2) bond prices are inversely related to yields, so an increase in yields implies a fall in bond prices. This resulted in selling pressure in bonds of shorter duration like the 2-year and 5-year bond, causing upward pressure on yields.
At the same time, the FED seemed to do a decent job in convincing the market that inflation will be transitory. In fact, inflation expectations as shown by the 5-year, 5-year forward inflation expectations rate and the 5-year breakeven inflation rate, reversed course.
These movements challenged the consensus view which projected inflation to be persistent. The narrative that inflation will be transitory does not play out well for companies of cyclical nature
The text-book reaction to an announcement to increase interest rates should be negative for growth stocks, because their future cash flows will be discounted at a higher rate. However, the tech-heavy NASDAQ nonetheless registered a marginal gain of 0.14% this week. This is because the narrative that fears that inflation may indeed be transitory and hence medium economic growth may slow dominated the higher interest rate narrative.
However, towards the end of the week, longer term bond yields dropped significantly as bond prices shot upwards. The flattening of the yield curve
The anticipation of higher interest rates also gave life to the dollar, which many investors downplayed as of late. This is because higher future interest rates make US bonds more attractive for foreigners, so the demand for dollars increases. But it may also be that the surge in the dollar is a result of investors anticipating slower growth over the medium to long term, so a capital flight to safety ensued. The rapid move upwards was also a result of the reversal of a record amount of short positions on the dollar. That's what happens when everyone is all on the same side of the boat.
As a result of the stronger dollar, assets denominated in dollars suffered. Commodities like lumbar, which benefited from inflation fears over the first half of the year, encountered intense selling pressure, while zero-yielding assets
Finally, in the crypto markets, Bitcoin's price action has been increasingly news driven lately. Towards the end of last week, the announcement that Bitcoin would be adopted as legal tender by El Salvador and a change of heart by Elon Musk helped Bitcoin test the $40K levels early this week. However it found resistance at that price and reverted following the FED's interest rate decision last Wednesday.
Later throughout this week, El Salvador was denied support regarding its decision to make BTC legal tender by the Bank of International Settlements and the World Bank, which further weighed on its price.
If you read our inflation article, you should know that although inflation is indeed happening in the US, the extent to which it can be sustained is questionable. In fact, I suspect that the economy will not even let the FED raise interest rates. And here is why:
As I tweeted this week, without further fiscal stimulus, next year the US economy is prone to a deceleration due to base effects following this year's record stimulus.
Secondly, the pace of price growth is already slowing in the economic giant China, which has resumed its state of pre-virus normality earlier than western economies. The following chart shows a deceleration for a second consecutive month in China's PMIs
Also, loans and leases in the US, which is the key metric for creation of money and inflation is still relatively subdued for consumers and declining in the case of commercial and industrial loans. Money velocity
Last and not least, the bond market is giving us a signal. While yields at the short end of the curve did increase in line with the FED's announcement, longer term bond yields dropped significantly as bond prices shot upwards. This narrowing yield curve spread suggest that the bond market is pricing in less rosy prospects.
So over the latter half of 2021, we may start to see some initial signs of an economic slowdown emerge. But what happens then? Here is a possible chain of events:
So although there may be some short term pain in the markets, my base case is that the FED will come to the rescue again. You can read my full hypothesis in this article.
In the meantime, your portfolio allocation should be a function of what the dollar does. In this article, we mentioned why the dollar is one of the most fundamental things to watch when adjusting any portfolio. If the dollar finds support at the 200-day moving average and increases from that point onward due to concerns about the prospects for economic recovery, then the inflation thesis needs rethinking.
This does not mean that you should sell all your assets which do well under inflation like commodities, especially because long term demand coupled with supply constraints should remain strong. However, you should bulletproof your investment portfolio in case economic growth turns out subdued through the end of 2021, by investing in growth stocks with strong balance sheets which do well when there is more monetary stimulus flushed into the economy, as well as Bitcoin and gold, which are hedges against currency devaluation.
On the contrary, if the dollar retraces back under the 200-day moving average and resumes its downward trajectory, then the reflation story may still play out, and economic growth and inflation narratives are likely to continue.
May the FED have signaled tightening too soon? Possibly, especially since US initial jobless claims turned out to be higher than expected and the Philadelphia FED Manufacturing Index witnessed a deceleration.
US retail sales continued to recede from the prior month, but this is probably due to base effects following the stimulus cheques sent out last April.
However the FED Chair himself reiterated that the latest interest rate projections should be interpreted with a "grain of salt" if the economic recovery slows.
Meanwhile, US core producer price growth surprised on the upside, growing 6.6% from a year prior and 0.8% from the previous month. Compared to the latest 5% consumer price inflation print, it seems that not all of these costs are being passed on to consumers. Similar upward price pressures were faced by factories in the UK which recorded a surge in input costs of 2.1% from the prior year and 0.6% from the previous month.
European consumer price inflation data was published last Tuesday. Germany, and France recorded higher rates than the prior month, but Italy recorded lower than expected inflation. This led to European overall CPI exactly in line with expectations of 2.0% year-on-year and 0.3% month-on-month. These are higher rates than the prior published growth rates, suggesting that the reopening is still underway and growth in Europe over the 2nd-3rd quarter 2021 may outperform that of the US and emerging markets, especially if the dollar continues to strengthen which benefits European exports. However, on the political front, the leading candidate likely to replace Angela Merkel next September announced his intention to push for more fiscal discipline now that the reopening is underway. If pushed too hard, Europe can fall into the austerity trap it already succumbed to following the financial crisis, which led to a decade of slow growth.
Speaking of emerging markets, following last week's disappointing PMI readings, China's performance disappointed once again, as May's industrial production decelerated from the prior year for a third straight month, while year-on-year retail sales also receded to 12.4% from 17.7% the month prior.
While the above charts suggest that the recent growth rates recorded by the Chinese economy are still above the pre-pandemic average, keep in mind that it is coming off low base effects from the prior year. When taking that into consideration, growth may not be as strong as it looks.
Financial Times: https://www.ft.com/content/46450be2-99dd-43ec-a9f3-9cf3c60d72e1
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