We have previously highlighted the different inflationary pressures building in the global economy, especially in the US and to some extent in the UK (where the Bank of England delivered a surprise rate hike in December, lifting the base rate to 0.25% from 0.1%)
Part of these pressures are due to the rapid restarting of activity after COVID lock downs and resulting imbalances in supply and demand, and thus transitory in nature. But there has been increasing evidence of more durable inflation emerging in the US economy, led by wage pressures and cost of shelter.
Before the new, virulent “Omicron” variant of the COVID virus spread, some of the worst supply/demand imbalances in the global economy had started to ease and growth momentum was again picking up; current estimates for real GDP growth in 2021 are 7% for the UK, 5.5% for the US, 5% for the Eurozone. But high infection rates are once again starting to wreak havoc with labour supply, even though the US and UK are unlikely to resort to the tough containment measures many European countries are adopting. Until the Omicron wave crests it will have the effect of temporarily dampening growth and further increasing inflation.
Chart 1) Estimates of the Path of Headline CPI Inflation, by Capital Economics
Sources: Capital Economics, Refinitiv
It is notable that inflation in the eurozone is expected to fall back below the ECB’s 2% target level by the end of this year, while inflation in the US is expected to settle at 3%: not too high for comfort but above the Fed’s recent 2% target, and above the recent (post Great Financial Crisis) levels.
What is also notable is that, despite its newly found hawkish tone, the Federal Reserve’s own “dot plot” indicates they see the longer-term peak in the Federal Funds rate at 2.5%; considerably below previous peaks and below current estimates of where CPI inflation will settle. Meaning that “real” (after inflation) interest rates, though increasing, are expected to remain negative. As stock market valuations are influenced by the level of real interest rates, this bodes well for the continued attractiveness of stocks as an asset class. Though the trajectory of the market is likely to become more volatile in a rising rate environment, the positive risk premium offered by stocks remains well supported.
Chart 2) FOMC “Dot Plot” 15 December, compared to market estimates
Source: Bloomberg Finance LLP
Market estimates of the Fed’s coming rate hike path (as expressed by the Overnight Indexed Swap (OIS) rate and Fed Funds Futures), have adjusted to the Fed’s median estimates up until the end of 2022, but remain below the projected trajectory for 2023 and 2024, perhaps fearing that renewed waves of COVID will depress economic activity and cause the Fed to backtrack on its path to normalization.
Chart 3) Level of Real US Interest Rates – using 5 year and 10-year inflation estimates
Source: Bloomberg Finance LLP
The chart above shows the nominal 10-year US Treasury yield (orange line) compared to the market-derived real (after inflation) yields on the 5-year (blue line) and 10-year (black line) Treasury bonds – these remain deeply negative, hence our negative view of Developed Market government bonds as an asset class.
Meanwhile, corporate earnings estimates have increased in line with stock prices. Also, despite paying higher wages and input cost inflation, most companies have been able to pass increased costs on to their clients and profit margins remain at an all-time high. When it comes to stock selection though, identifying companies with pricing power is imperative.
By Marianne Rameau, ASIP, Portfolio Management Team, ISGAM AG
Manager’s Report published on 31 December 2021
Featured Image Source: Bloomberg Finance LLP, Capital Economics, Refinitiv
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