Posted 16 August 2021
Overview: Climbing the wall of worry – again
August continues to be quiet, but pleasing, for investors, with US stock markets hitting new highs again. “Climbing the wall of worry” was a common phrase a few years ago that seems entirely apt now. We have most likely come to the end of a short period of very rapid and exceptionally high rates of corporate earnings growth, as economic activity bounced back following the gradual lifting of pandemic restrictions. Growth is expected to continue, even if the sheer rate of growth will not be sustained at the high levels seen in the first half of the year. This should continue to provide a solid base for risk asset prices, so long as sudden moves in the bond markets do not upset the fine balance between sustained growth and the relative valuation metrics that bond yields so heavily influence. In this regard, capital markets appear to also have been shifting gear, with an acceptance that central banks may be proved right that the current elevated levels of price inflation will prove temporary.
Nevertheless, transition periods when fast economic acceleration gives way to a more moderate pace of growth have also historically been choppy for investors, as sentiment is more likely to gyrate between confidence and fear. This is a particular issue for the richly-priced US equity market and its mega-cap growth stocks – that are vulnerable to a meaningful rise in government bond yields. So, if and when the global growth momentum moderates, there is a risk that investor sentiment sours temporarily – at least until the fragile equilibrium between corporate earnings yields and government bond yield levels reasserts itself.
When we all return from our (non-traditional) summer breaks this September, we will gradually find out where things stand. Perhaps the transition will be towards much slower mid-cycle growth, or even a growth blip, or perhaps collective political will combined with increasing business confidence can open up a much more enticing recovery path for the remainder of the year. Until then, the current calm in markets is both rational and welcome.
The transitory inflation argument
With vaccines rolled out but global supply disruptions still a widespread issue, market attention has once again turned to prices in the post-COVID world. Given the current backdrop, this makes sense even to the lay investor – central banks all over the world are pinning down interest rates and pumping vast amounts of monetary liquidity into their economies. But while demand has certainly been strong during the recovery, the price jumps have much more to do with supply issues than anything else.
Supply problems encompass everything from labour shortages to an undersupply of materials and land. The incredible moves in US lumber prices seen earlier in the year are symbolic of these difficulties. Futures contracts for lumber reached an all-time high of $1,671 in May, as strong housebuilding demand clashed with various bottlenecks in the supply chain, such as wildfires across Canada, difficulty moving inventories, and a general shortage of US sawmill processing capacity. Builders’ wood supplies became severely restricted and prices rocketed.
These are specific issues for the housing and lumber markets, but they echo issues we are seeing everywhere. There is a well-documented shortage of workers in the US, Europe and UK, as restaurants and hospitality businesses report being unable to find enough staff – particularly as many workers must isolate. Equally well-reported has been the global shortage of microchips, having severe knock-on effects for everything from phones to the used car market. In Britain, you can see the severe impacts of these shortages just by going to the supermarket.
Global supply issues are partly down to post-COVID teething problems, along with a host of standalone factors. The pandemic has had a big impact on how global supply chains are organised, and those changes will take time to work out. Ultimately, though, the substantial inflation numbers we have seen recently should prove transitory. Shifts occur in any transition period, and adjusting to the post-pandemic world is certainly that. As we have stated here before, we entered the COVID pandemic period with a latent global oversupply issue, paired with lacklustre demand holding back growth. So, once things settle, supply bottlenecks should ease.
Therefore, for the longer-term, we prefer to focus on the demand side to assess growth potential versus lasting inflationary pressures. On that front, the shortages seen in US markets are a positive sign. Despite US demand causing supply issues in Europe, the fact that US consumers and businesses are purchasing more than they can produce will support the global economy by effectively exporting demand – and thereby growth. The growth emanating from the US can then be used to lead a strong cyclical recovery in other regions.
US politics risk slowing the pace of the recovery
President Biden has plenty on his mind at the moment. Over the weekend, the US began evacuating personnel from its embassy in Kabul, after the Talibantook power. . Biden announced an emergency deployment 5,000 troops to the area, and the situation looks increasingly fraught. Foreign affairs, and the US stuck in the quagmire of war, threaten to overtake the domestic agenda, just when it seemed headway was being made.
At the beginning of last week, a ten-year $1 trillion infrastructure bill, constructed by politicians from both parties, was passed with bipartisan support, in a rare show of agreement between Democrats and Republicans. It contains $550 billion of new spending and no tax increases. The blueprint for a larger $3.5 trillion plan squeaked through along party lines, and therefore much narrower margins. The hope is (and was) that a huge boost of spending would not only propel America’s recovery but also make the economic expansion more sustained, which would ensure a durable positive outlook for businesses.
While the legislation paves the way for a substantial increase in US Treasury spending, this is a long way from final passage, meaning there’s the potential for disappointment and delay ahead. Budget resolutions are not new laws or policy programmes, but they can include ‘reconciliation’ measures which allow policy committees in Washington to affect spending and revenue. Moreover, neither of the deals passed last week include any measures for changing the US national debt ceiling, that well-worn political football that is used to hold the governing party to ransom, by threatening to push the world’s largest economy into (temporary) default.
It’s not difficult to imagine the Republican Party attempting to make hay from the current bind Biden now finds himself in. While it is still almost unthinkable that policymakers – even by Washington’s standards – would allow the government to default on its debt for what is essentially a point-scoring exercise, there remains the possibility of disruption in early October, including a short government shutdown, and that fear is already spreading in bond markets. Even without a genuine shutdown, negative impacts on capital markets could persist.
Any constraint on the US government’s ability to borrow is also a constraint on its ability to support growth. So, hampering fiscal spending will likely also have an impact on economic expectations. This could affect everything, from businesses’ confidence to their ability to raise debt themselves, culminating in a dampening of the US outlook.