As England’s Covid shambles continues – we look to Scotland and find some reasons for optimism. The earnings season is well underway, and companies are again beating analysts’ estimates big time. So why has the market gone down? Do virus variants and rising inflation threaten the bull market?
Inflation – back to the 70’s?
Last week the crucial US CPI numbers were released and they were high – higher than expected. This is the fourth consecutive month that that core CPI has exceeded economists’ estimates. And that core measure now stands at a 30-year high on a year-on-year basis. The Federal Reserve (Fed) say it’s transitory and I reckon they’re probably right. For example, prices of second-hand cars have jumped and car rental prices have doubled because auto producers are faced with a shortage of semiconductors and can’t keep up with demand. Those price pressures will eventually abate. But any honest economist would admit that we just can’t forecast inflation with any confidence. The Fed believes that they caused the great inflation of the 1970’s by mistakenly believing inflation then was temporary when it first began to increase. Car rental prices may have jumped because there is a shortage of cars, but US consumers are able and willing to pay the higher prices because they have lots of money in the bank due to the hugely stimulative monetary and fiscal policies. I’m not saying that we’ll see a repeat of the 1970’s, but the Fed has already met their target on the basis of the new average inflation framework and the case for keeping the foot to the floor on monetary policy has weakened decisively.
Don’t expect to hear anything from the Fed over the next week or so – they’re in blackout ahead of the meeting on 28th July. But if we don’t see price pressures ease significantly over the summer, I think they will announce tapering of bond purchases at their meeting in September, and we’ll be forewarned well in advance. The Fed have learned their lesson from the infamous ‘taper tantrum’ 8 years ago.
Meanwhile, in the UK, we had our own high and higher-than-expected inflation numbers last week. Inflation – actual and prospective – is lower here than in the US, but there is an important reason why the Bank of England (BoE) should be preparing to tighten monetary policy here too.
US and UK labour markets differ, but both central banks may need to act
The UK’s labour market is almost back to pre-Covid levels of employment – in contrast to the US which is still 5% – 7 million jobs – short. Companies in both countries are reporting the difficulties in recruiting workers. There’s lots of jobs mismatch, some workers are reluctant to take jobs perceived to be risky, especially older workers. The UK has the additional problem of EU workers going home and the usual influx of replacement workers simply absent. The US has also seen a reduction in immigration but not on the same scale as the UK. It’s hard to get a clear picture of wage inflation given the distortion from Covid, but it looks set to rise in both the UK and US. If so, both the Fed and the BoE will need to act.
Rising interest rates are bad for equities
So, does this mean that the bull market is set to end? Not at all in my view. First, bringing an end to QE programmes will have only a modest impact, and a rise in official rates is still some way off. Equities normally do well in the run up to Fed rate hikes, it’s a downturn in the economy and the associated inverted yield curve that harbingers a bear market. That is a long way off in my view.
Soccer and schools – key drivers of new cases
Meanwhile, Covid cases are on the rise again, led by the UK. That’s despite the great success of the vaccination program. With the UK’s government abolishing almost all remaining restrictions, no one knows how it will all end. But the evidence from Scotland is encouraging. New cases there have peaked. Schools in Scotland break up for the summer early – they’ve been off since 25 June and Scotland also exited the European football championships earlier than England. Schools in England break up for the summer next week and of course the football is over. So, it’s possible that we see a peak in UK cases next month. The last few days have shown a small dip, but we think that’s due to bottlenecks in the testing process; it’s too early to tell.
Investors should be content with moderate equity returns
There is a chance, then, that Boris’ big gamble does pay off. If so, the rest of the developed world will follow suit. That would be good news for equities. Yet they fell last week despite another set of really strong earnings from US companies. 87% of those that have reported earnings beat estimates and the average was a stunning 23%. The problem is that this is the fifth consecutive such quarter and investors have become habituated.
All in all, I still think the rally in risk assets will continue, and I still think equities will outperform cash and bonds. But don’t expect the stellar performance that we enjoyed in the first half of the year to be repeated in the second. Just be content that returns have survived the biggest challenge the world has seen in peacetime for a many a decade.