A Summer Lull
Summary: US equities were mixed overnight whilst the dollar fell, and treasuries held steady. Markets continue to range trade with low energy, and low volumes. Its a waiting game ahead of China PPI data, US inflation data on Thursday and beyond that a lasting test on whether the market can continue to buy the transitory narrative.
The Fed continue to spruik in a coordinated fashion the transitory nature of current price pressures, however the evidence is stacking up that transitory may be an extended period and may not be so transitory after all. It is difficult to believe the market will be so patient if inflation continues to print to the upside. We remain sceptical not only of the assertion that price pressures are transitory but also of the Fed’s commitment to stay the course. A Fed pivot looms and the probability the Fed may signal a shift toward tapering of its asset purchases is rising. For now, our money is still coalescing around Jackson Hole as a potential signalling forum for the impending policy pivot surrounding the pace of liquidity provision. Yellen’s commentary earlier this week clearly an attempt to prepare the ground for this shift.
Last weeks miss on the US jobs data has been viewed as a “goldilocks” print, allowing markets to run high on the cool aid that the labour market is recovering, but not to a degree that the punchbowl of liquidity will soon removed. Large caps loved the softer data, but we sense complacency as the balance of probabilities continue to point to further price pressures, a recovery in the labour market that is gathering pace (additional UI rolling off from June in 24 States) and a Fed who will find their position increasingly difficult to justify. And not inconsequentially, the irony is the longer the punchbowl remains in play, the further inflation expectations can climb.
In the US renormalisation continues and the path to more persistent inflation remains open as supply remains constrained with demand rebounding, pandemic fatigued consumers flush with “stimmy” cheques and savings are ready to spend (in the US the poorest quintile of households - the cohort most likely to spend - have seen ~20% boost to annual incomes). The combination of the two a melting pot for price pressures and visible across the goods and services economies as reopening’s continue. Wage and price expectations could well shift higher during this upcoming period of price pressures. Even if the initial kicker is transitory – the lasting impact may be less so. And in terms of read throughs for asset pricing the definition of transitory comes into question.
The latest readings on inflation expectations are sitting in the upper spectrum of the range seen in recent decades, and with pent up demand in play price hikes could be relatively sticky, embedding inflationary psychology. The University of Michigan's survey of inflation expectations surged in May. The measure that gauges near-term inflation expectations pushed to 4.6% from 3.4%. Expectations in many ways are a self-reinforcing feedback loop for future inflation - if business and consumers expect price increases in the future, they will be more willing to pay up today. Both market and consumer expectations of inflation have picked up and soon the Fed will have to take note, monetary policy remains in crisis mode – a stance that will be increasingly hard to justify. Particularly if the labour market continues to recover through the summer as some 24 States end the additional $300/week enhanced unemployment benefits and school reopening’s continue, promoting increased return to work. In short with further price pressures filtering through as the macro recovery continues, the reflation trade should have room to run, supporting positioning for higher inflation, commodities and value/cyclicality/economic sensitivity/reflation orientated sub sectors of risk assets. With US yields eventually pushing higher in tandem with the aforementioned dynamic, post this period of consolidation.
That said, there remains a lot of noise and unknowns when it comes the interactions of the COVID-19 crisis and stimulus response with the global economy and mass human behaviour. Although we think it is probable to see higher and more persistent inflation, we do not have all the answers and it is perhaps still too soon to draw decisive conclusions. However, from a portfolio standpoint the risk of higher inflation must be accounted for – its no longer a one-way bet. Longer term structural shifts toward fiscal dominance and climate change mitigation could well counter the disinflationary spiral of debt, demographics and disruption that has shaped the last decade.