While there was some increased volatility in May, the overall market move was small. Some nervousness crept in, as investors are becoming increasingly aware that the apparent strength of the economic recovery may mean that central banks will act sooner than previously expected. Central banks for their part have been keen to talk down the prospect of any tapering of quantitative easing or interest rate rises, although there is growing pressure for them to address the issue. Fundamental to this is inflation, which is now seeing higher headline figures. This was highlighted in the month on the release of April’s year on year CPI inflation data in the US, posting a 4.2% rise, significantly overshooting the 3.6% expected for the month and the 2.6% recoded in March. While there are some large uplifts from transitionary effects, such as the increase in the oil price from the lows last year, there is growing evidence that inflation is more widespread, and potentially flowing through to wage pressures. This is the area that the Federal Reserve will be most keen to monitor.
For equities as a whole, moderately higher inflation should not be a challenge, particularly if price pressure is primarily being driven by strong demand. However, the impact of inflation and the resultingly probable higher interest rates and yields in the medium term will not impact individual companies and sectors equally. This has already been seen to an extent in the market rotation.
At this stage, overinterpreting economic data may be treacherous, and those wanting to extrapolate the current boom need to be cautious. There is no precedent to an enforced shut down of economic activity which limited consumers’ and companies’ ability to spend, invest and produce as normal. Furthermore, the breadth and magnitude of government support also has no comparison. The response to these restrictions being unwound is therefore highly uncertain. Impacts being seen in commodities and labour markets illustrates the difficulty that the global economy is facing when trying to meet pent up demand that is now being released. For example, iron ore prices have risen over 125% in 12 months, breaching $200, significantly higher than the average of $80 over the last 5 years. Indeed, concern is now growing that the hot commodities market may itself cause weakening economic activity and price pressures as these costs are passed through to the end consumer.
Nevertheless, the prospects for earnings growth for companies remains strong as the economic rebound provides a tailwind. This rising tide will lift all boats and given this; it is no surprise that those companies that were closest to insolvency are those that have seen their share prices rebound hardest. Conversely, fixed income markets continue to appear unattractive with the backdrop of higher inflation and the risk that central banks may remove support in the medium term.