Price inflation, stock deflation?
Paul Williams, Director of Research at Blankstone Sington, gives his assessment of Quarter 2, 2021.
One topic that came to the fore in April, May and June of 2021 was inflation.
It’s back in town and no-one knows whether it’s a short visit, or it’s back to stay!
U.K. inflation jumped to 2.1% in May, then rose again to 2.5% in June – above the Bank of England’s 2% target. For now the bank is essentially choosing to ignore it, suggesting it will be transitory.
Nevertheless, futures markets started to price in an earlier increase in interest rates, bringing forward the expected timing of the first rise in U.K. rates to next year from 2023. The same scenario is being played out in the U.S. where CPI growth has hit 5%, the highest since 2008. The U.S.Federal Reserve has shrugged it off for now, maintaining its huge monetary stimulus and suggesting that it needs to see more comprehensive evidence that the economic recovery from the pandemic has durability, before changing policy.
Equities have remained buoyant in the U.S. and Europe, although the U.K. market continues to lag. There is a nervousness because valuations are high on a historical basis, and due to the fear that central banks may suddenly panic about inflation and start to tighten monetary policy. Cyclicalstocks – those whose returns follow the cycle of the economy – are outperforming. The spread of covid variants means the improvement in cyclical sectors such as travel, clothing retail, and hotels is stuttering. In others such as housebuilding and construction, it is healthy.
Government bond prices were quick to price-in the changing inflationary outlook and are now, if anything, ahead of the game. The U.K. economic recovery is proving stronger than expected and the deficit in public finances (although still huge) is coming in lower than forecast. Ten-year U.K. gilts now yield 0.84% which on the face of it is not enticing but taken in context of a base rate (0.1%) which may not rise before the end of next year, suggests there may be some upside.
We recognise the risk of an equity market correction but believe it is higher in other developed markets than it is in the U.K. because of the lower valuations here. Value stocks, dividend stocks, and cyclicals should outperform going forward as we continue the move into an inflationary environment. The recovery in Travel & Leisure stocks should gather momentum as we get on top of the virus, and shareholder returns from financials could quicken as they accelerate the return of surplus capital.
And finally – an eye on Japan…
Data coming out of Japan suggests that economic growth and corporate profitability may surprise on the upside. Japan’s core machinery orders reported to have risen 7.8% in May from April, while Japan’s business optimism reached a 12-year record high in June, according to IHS Markit.
Corporate earnings year-on-year growth was expected to have peaked in the April-June period but as we move into a new season of reporting, early results show no let up in the improvement, outpacing conservative forecasts.
This article does not constitute personal advice. If you are in doubt as to the suitability of an investment, please contact one of our advisors. Past performance is not a reliable indicator of the future. The value of your investment can go down as well as up, and you can get back less than you originally invested.