Recent disappointing economic data in the US has taken some of the wind out of the sails of the reflation trade. First, there was the big miss for US non-farm payrolls, when only 266 000 jobs were created, far below the nearly one million expected. Then, retail sales growth disappointed and consumer sentiment declined.
Hard economic data has in fact been coming in below expectations both in the US and in the eurozone for a while now, although survey-based data such as the purchasing manager indices has continued to surpass forecasts (see Exhibit 1).
Despite the weaker data, US consumers are facing sharply higher prices: the CPI index rose by 4.2% YoY in April. This reflects a more stagflationary environment – rising inflation, but slowing economic growth – in contrast to the acceleration in both growth and inflation that had been expected after the passage in the US Congress of the last trillion dollar stimulus package in March.
Near-term inflation expectations are in fact close to all-time highs. However, importantly, medium-term expectations are no higher than they were in 2018. This backs up the US Federal Reserve’s assertion that the current inflationary pressures are merely temporary as the economy comes out of lockdown and the government’s massive fiscal stimulus packages boost demand.
If anything, the Fed might now arguably worry that medium-term inflation expectations are not higher. The central bank has failed to meet its stated object of 2% annual inflation (as measured by the core Personal Consumption Expenditures index) for years. Market expectations suggest that inflation will continue to undershoot the target, even once the disruptions from the coronavirus pandemic have passed (see Exhibit 2).
The other key part of the Fed’s message has been that it will not tighten monetary policy any time soon, again because the current rise in inflation is temporary. The market, so far, believes this.
Forecasts for the level of the benchmark fed funds in two years’ time have been steady at 50bp even as inflation expectations jumped. Nominal 10-year Treasury yields have been stable as a result, ranging from 1.55% to 1.70% since the beginning of April.
The reaction of equity markets to the changing inflation and policy rate dynamics has been to tread water; most major indices are at roughly the same level as they were a month ago. Value stocks have lagged recently given steadier bond yields and oil prices, while tech shares have rebounded. The weaker economic growth data has also led to a stall in the outperformance of cyclicals (see Exhibit 3).
We nonetheless hold to our preference for value, cyclical and (European) small-cap stocks. We believe the growth and inflationary impulse still has room to run. Retail investors appear to share this view as recent fund flows have seen redemptions from large-cap and growth funds.
While the reflation momentum remains, our geographic focus may change. The US market may by now reflect most of the good stimulus and reopening news, whereas Europe stands to see a bigger improvement in the months ahead.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
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