Monday Digest

Posted 10 May 2021

Overview: Sell in May and go away?
The traditional stock market adage of ‘sell in May and go away’ is back in vogue again this year, after the first four months of 2021 brought healthy returns to investors with equity exposure. Of course, historic return observations have rarely been good predictors of future returns, and this year has hardly followed the traditional pattern. May has made an encouraging start, with stock markets only briefly spooked by former US Fed Chair Janet Yellen’s prediction that yields would likely have to rise to prevent economic overheating. However, overheating fears might have cooled slightly after the announcement that the US labour market added just 266,000 jobs last month, compared to the 770,000 new jobs added in March. Some analysts were expecting the new jobs number to reach one million.

The somewhat downbeat announcement caused long bond yields to fall initially (which increases bond value), and that caused equities to rise sharply. However, the concern that employment in the US is still shy of pre-pandemic levels could spark fresh worries that labour shortages are holding back the recovery. Nevertheless, the prospect of the inevitable price-push from the reopening morphing into outright inflation – spoiling  the party through rapidly rising bond yields – remains the predominant investor scare story.

Overall, there seems little motivation for investors to heed the traditional wisdom and sell now and then stay on the side-lines. Central bank support looks set to continue, fiscal support from governments is increasing. No more so than the new US administration determined to recapture its world leader status and reputation as the engine of global growth – a position which it effectively forfeited to China after the global financial crisis. Company earnings and profit margins are expanding, and the economic data suggests a decisive post-pandemic rebound is firmly on the cards. As always, there are various serious risks and ‘unknown unknowns’ capable of spoiling the party, but at this point the biggest question for investors is whether the economic recovery will simply return us to the status quo before the pandemic, or if the opportunity for governments to build society back better, stronger and greener, will be seized, putting us in a fundamentally better place than we were before the pandemic.

Good election results for Boris, but the UK’s fractures only widen
Politics across the world has grown increasingly rancorous and viscerally divided in recent years and nowhere is this more readily apparent than here in the UK. While the government assures us that Brexit is now a settled affair (Jersey fishing rows, Northern Ireland’s trade position and ongoing negotiations about the services sector notwithstanding), attention has now turned inward again. With pro-independence parties securing a majority in the Scottish Parliament, the future of the 314-year-old union is once again in question. The added spice is that the stage is now set for several independence pushes, from Scotland to Northern Ireland, and even Wales.

We will resist musing whether the regional outcomes indicate that referenda are more or less likely, let alone whether any referendum might see a vote for independence. We would note, though, that the regional responses to coronavirus through 2020 meant the Scots accorded their regional government a much higher approval rating, which fed into support for independence. However, poor performance on health and education have begun to reverse the position. While Brexit may be a source of rancour in Scotland and Northern Ireland, it also highlighted the enormous costs which come from separation. The argument that Brexit has changed the nature of the Union – and that the central government should revisit the independence question – is not likely to carry weight.

The MPC could become more dovish after Haldane exits
Last week, the Monetary Policy Committee (MPC) of the Bank of England (BoE) voted in favour of maintaining interest rates at the current 0.1% level, as well as continuing its £875 billion target for bond purchases. The biggest surprise was dissent from the MPC’s outgoing chief economist Andy Haldane, who voted to reduce the asset purchase target by £50 billion, arguing that growth objectives had been reached and the current policy response needed to be trimmed. Haldane’s dissent will be his last before leaving the BoE, having made a name for himself as a contrarian. Haldane’s departure should mean less drama and more consistent messaging at the BoE, but we also suspect it sets up the MPC for a more dovish stance of lower rates. Despite holding policy steady, it delivered a substantial upgrade to growth forecasts for this year – up to 7.3% from 5.1%. According to its own forecasts, this means interest rates will follow the path currently discounted by the market, and likely stay on hold until at least 2023. But according to the BoE’s outlook from 2023 and beyond, the UK’s output gap will drop to 0%, meaning a permanent drop in activity compared to expectations at the beginning of 2020. Our calculations put that at around 2.5% of lost GDP.

Reading between the lines of its forecasts, the MPC clearly believes that greater investment – both public and private – is needed to make up for what has been lost because of Brexit. This is likely to become even more of an issue once COVID effects fade and the recovery gets underway. But the BoE can only do so much to stimulate business investment. At a certain point, fiscal policy as well as trade policy progress will need to take some of the pressure off.

Food inflation because the new concern
Inflation is the watchword in capital markets these days. While the Fed is showing no sign of backing down from its substantial stimulus programme, investors are concerned that rapidly rising prices will force the Fed’s hand – tapering asset purchases or even raising interest rates too soon. Fears were compounded following US Treasury Secretary (and former Fed Chair) Janet Yellen’s that rates may have to rise “to make sure our economy doesn’t overheat”. Yellen’s comments were hardly revelatory, but the reaction was telling. Investors were spooked by her ‘intervention’, and those markets particularly sensitive to interest rates – such as the tech-heavy Nasdaq Index – sold off.

More to the point, inflation is now mainstream, evidenced by the already substantial pick-up in food prices. According to the United Nations, global food prices have been climbing for 11 months straight, and prices in aggregate are now at the most expensive level since 2014. Soft commodities of all types, from grains to sugar, have rallied in recent weeks, which have increased costs for producers. In Africa, various geopolitical issues have disrupted supply chains, while in South America and parts of Asia, weather-related difficulties have affected harvests and the pandemic continues to create problems for producers. Brazil, the world’s second-largest producer of corn and soybeans, is currently experiencing a drought just as virus numbers are spiking again. When we combine these various difficulties with China’s recent crop-buying spree, global food supply looks incredibly tight.

For emerging markets and those in the developed world on the lowest incomes, food prices are hugely significant, as they make up a bigger proportion of overall non-discretionary expenditure. This makes rapid food inflation a real social and political problem – particularly as low-income consumers have been the worst hit, and the least able to save, during the pandemic. But for most in the developed world, food price inflation tends to be ‘transitory’, causing only a short-lived spike in costs.

We are not yet in a position to tell whether higher prices will affect demand in the short-term, but consumers in the developed world have, in aggregate, increased their savings during the pandemic, are in a good position financially, and likely have an increased propensity to spend and make up for life missed out on over the last year. At the same time, employment measures continue to improve – particularly in the US – leading to a sustained pick-up in consumer confidence. Central banks will therefore remain mindful that should higher prices meet healthy demand – initially funded by surplus savings and later by rising wages – this could translate into a more sustained rise in inflation which, eventually, will have to be met by a policy tightening. That presents a problem for central banks. If the demand is not there to meet higher prices, it could lead to a short-term downturn which, if central banks do respond to by tightening, could choke off the recovery before it has begun. No wonder then, that even the most anodyne quote from policymakers ends up being deconstructed for meaning.

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