Weekly review: inflation and variants rattle markets – how worried should we be?

The news on US inflation last week was bad, very bad. At a more parochial level, the UK is seeing a new variant of the virus, first detected in India. Both are worrying developments.
May 2021

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Past performance is not a guide to future performance. The value of investments and any income derived from them can go down as well as up and investors may not get back the original amount invested.

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

Key takeaways

Inflation and variants rattle markets: how worried should we be?

An investor survey which has just been published shows a marked shift in investor concerns over the last month. It suggests that worries over the virus have eased but have been superseded by sharply increased worries over inflation. We examine what this means for market prospects.

Let’s begin with US inflation. We highlighted this risk in last week’s video but never for a moment thought it would appear on this scale. Economic forecasters are normally quite good at predicting US consumer price inflation, especially the core index, which excludes volatile food and energy. An error of 0.2% for the month-on-month change would be a big error in normal times. Markets were expecting a 0.3% increase month-on-month, but it came in at a whopping 0.9%. That error is the biggest I can recall in decades of following the numbers. And that was followed by a big rise in US producer prices, a measure of pipeline inflation.

A sharp rise in inflation expectations – but the Fed still sees this as temporary

US breakeven inflation expectations have been on a rising trend for almost a year, but last week’s data form the University of Michigan also showed a sharp rise in inflation expectations among the general public. It seems clear that US inflation is set to rise further in the coming months – and not just from base effects as last year’s price falls drop out of the numbers. This week sees the release of the UK’s inflation numbers, which are also likely to show an increase.

All this is worrying. But there is one major source of comfort: the US Federal Reserve believes that the surge in inflation is temporary, reflecting the extraordinary recovery in the US economy. Speaker after speaker has repeated the message. I wouldn’t be surprised if one or two Fed members break ranks and voice concerns.

Choppy waters for financial markets

All this will make for choppy waters in the markets. But as soon as we see some of these price pressures ease – even if other prices are still rising – the confidence in the ‘it’s all temporary’ view will increase. The VIX index of volatility reached 28% after last week’s figures, up from just 17% a week ago, though it has now settled down again.

As for the virus, we have seen more of the countries that did well last year suffering of late. Extra restrictions have been imposed in Taiwan, Singapore and Japan. In the UK, the almost continuous flow of good news on the virus since the turn of the year has been interrupted by fears that the Indian variant could undo much of the good work. Boris Johnson has said that the wider easing of restrictions due on 21 June is in doubt, but it is early days. There is a race going on to contain the virus. The PM’s decision to delay putting India onto the red list may come back to haunt him. Especially if it is linked to the desire to get a trade deal.

The UK is ahead in vaccination take-up

Nonetheless, it does seem that the UK has vaccinated a sufficient proportion of the vulnerable groups: 95% of the over 65s – an astonishing success. This should go some way to limit the extent to which the inevitable rise in new cases associated with the new variant and the easing of lockdown feeds through into hospitalisation. In addition, the UK seems well placed relative to other countries. No other major country has achieved the same rates of penetration as the UK. In the US, 85% of the over 65s have received at least one dose, a high figure but it still means that the unvaccinated percentage is three times as large as in the UK. Indeed, the US vaccine programme is now limited by take up – demand. In every other country in the world, the limit is the availability of the vaccine – supply.

Inflation worries a headwind for equities; bond yields to go higher

So, what do we make of all this? Inflation worries are set to increase. They represent a headwind to equities. But I agree with the Fed that these pressures will ease. Meanwhile, the recovery in developed markets should continue. All this means that equities could see significant setbacks but still outperform. Bond yields are headed higher. As for the UK, we look better placed than most countries and have a decent chance of containing the Indian variant. I’m still bullish on sterling and negative on gilts.

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