Inflation: The greatest enigma going forward
The biggest enigma over the next several quarters and, and perhaps years, will be inflation. In fact, weather we are talking about short term or long-term inflation, it’s the issue market participants will be required to wrestle with most.
Listening to analysts and pundits there is no agreement as to the inflation endgame. The debate on both sides is fierce, and both parties have convincing arguments. Central Bankers insist it is transitory, and so far, the bond market seems to agree (mostly).
However please note that dealing with inflation is something new to most market participants, especially fund managers. It has been several decades since fund managers had to deal with inflation, and very few of those that did, still manage money.
Central Bank policy still in focus
Monetary tightening sems to be on everyone’s mind. And while this tightening is still very vague, everyone agrees it will happen in some form. Initially at least, some form of tapering will happen (or so they say) and further on, we will get rate hikes.
Even assuming all the above happen, what is very different this time around is that negative real rates will still be with us (nominal rates adjusted for inflation). As such, this is not a typical economic rebound that we are used to. As such, investors need to adjust to a new reality, and that is one where yields will not rise by much in the face of an economic snapback.
Irrespective of what inflation does, there isn’t much Central Banks can do about it
If you recall, several years ago the Fed tried to raise rates in the name of inflation expectations. It did so to the tune of 2.5% and the U.S. economy and markets collapsed. So, if the economy was not able to withstand interest rates of 2.5% back then, how are today’s economies going to withstand the increase in interest rates needed to combat today’s inflation? The answer is they will not be able to. The US, Europe, and Japan cannot operate in a high interest rate environment. The main reason is that a significant rise will cause havoc for government budgets, debt to GDP metrics, and in most cases higher rates will trigger a recession.
In other words, even if we assume raising interest rates is the solution to fight inflation (a view that I do not subscribe to), it is impossible to raise interest rates to levels needed to fight today’s inflation headline numbers.
So, while Central Banks talk about tapering and higher rates (AKA normalization of policy), I am personally talking the rate hike talk with a huge amount of salt. This because economies will crash and burn with much higher rates, and that is not a Central Bank mandate in any country.
A long list of things to worry about
1. Economies are more leveraged today than they were just several years ago.
2. Individuals, companies, and governments have much more debt that needs to be serviced.
3. Markets have a much higher multiple than almost any time in the past.
4. Real estate prices are elevated all over the world.
5. Economies are snaping back, but there has been a lot of pull forward demand
6. Concerns about growth in China
7. A higher Dollar is bad for global growth
The big risk to economies and markets are higher rates. If we do see much higher rates, all my above worries will be triggered, and the outcome will be brutal. Central Bankers know this, which is why they are being vague about normalizing monetary policy, and refrain from saying when rates will “takeoff”.
Please note that while inflation is a concern, a collapsing economy and a bear market in equities is the lesser of two evils. As such, Central Banks will probably do more talking than acting when it comes to rates. Central Banks know all too well higher rates will do a lot of harm to economies and markets. And personally, I just don’t think this is what they have in mind.
So Central Banks will continue to assure markets they are committed to fighting inflation, but it will not act upon these commitments. But even if we assume Central Banks raise interest rates substantially to alleviate inflation concerns, they will probably lose.
So, what should investors do?
Overall, economies are still growing fast with fiscal and monetary policies still supportive for risk assets. However, investors must not be complacent. There are far too many things that could derail the current global economic recovery. There are still many potholes on the equity yellow-brick road.
My two biggest concerns are elevated equity valuations (especially the US), and the strengthening dollar. Especially insofar as the later, a stronger dollar means that there is either a dollar deficit in the world, or investors are buying dollars as a safe-haven trade. In both cases this is not good for equities.
However, to the extent that Central Banks don’t make a major policy mistake – like tightening too fast, or more than needed – equity markets should continue to offer better returns than bonds. It’s also important to remember that diversification is very important in this environment. Investors need to diversify across asset classes, geography, and sectors.
Global financial markets slightly fall in Tuesday trade, retreating from their record highs over persistent anxieties about possible barriers to Joe Biden’s $1.9T fiscal pandemic-relief stimulus and the rising Covid-19 cases around the world.
Uncertainty over the time and size of the US stimulus package:
US futures moved slightly lower on Tuesday amid softer risk appetite among investors over disagreements on President Joe Biden’s $1.9T stimulus package. The market worries about the timing of the package to be agreed as the Congress members debate about the size of the relief bill needed to stimulate the US economy. Even the Democratic Majority Leader Chuck Schumer notified yesterday that a complete bill could be four to six weeks away.
Covid worries and fresh lockdowns:
The market participants concern about the growing number of Covid cases around the world, especially in China. Many governments in Europe and Asia including China and Hong Kong have set additional strict lockdown measures to limit the spread of the new fast-spreading variant virus, increasing the economic damage in the local markets.
The tech-heavy Nasdaq Composite rose 0.7% on Monday, hitting an intraday fresh all-time high of 13.700 before closed at 13.635, lifted by robust gains in some tech giants such as Apple, Microsoft, and Facebook.
The S&P 500 index also closed at record highs of 3.855, up 0.4% ahead of corporate earnings, while the industrial Dow Jones index slightly dropped 0.1% to 30.960 amid losses in Boeing and cyclical sectors over stimulus worries.
Stocks in Asia retreated nearly 2% from their record highs in Tuesday trade following the overnight losses on Wall Street amid a general risk aversion sentiment and the geopolitical tension in the region.
The Hang Seng index in Hong Kong led to losses in Asia by 2.4%, following by 2% losses in China’s mainland indices after the boiling tensions in the Taiwan Strait and the South China Sea. Hence, South Korea’s Kospi followed with 2.2% losses, Japan’s Nikkei 225 slid 1%, while markets in Australia and India are closed for public holidays.
Commodities-Forex and Fed’s 2-day policy meeting:
WTI and Brent crude oil prices fell 1% on Tuesday morning to $52 and $55.50 per barrel respectively after China (the world’s largest fuel consumer) reported rising new virus cases and fresh restrictions, causing doubts over petroleum demand recovery in the country.
Gold and Silver prices rise above $1.850/oz and $25.50/oz respectively, gaining support from the falling 10-year US Treasury yields near 1.03%, despite the US dollar strengthen.
The DXY-US dollar index against major currencies rises to 90.50 while the EUR/USD retreated from the resistance level of 1.22, finding support near 1.21.
The recent strength in the safe-haven greenback came after the risk aversion mood over the speed and size of Biden’s stimulus bill, and ahead of the Federal Reserve’s two-day policy meeting, which is scheduled to begin later in the day.
Investors expect FED to maintain its dovish monetary policy and keep the zero interest rates for a longer time to help the US economy mitigate the pandemic-led damages.
The dovish Fed is a bearish signal for the US Treasury yields and US dollar while it is a bullish catalyst for the non-yielding gold and silver precious metals and other dollar-denominated commodities.
Global equities hit fresh record highs on improved risk sentiment, gaining support from Netflix’s robust corporate earnings, Biden’s inauguration, and the falling US dollar-Yields.
Biden’s inauguration-A new American chapter:
The 78-year-old Democrat Joseph Robinette Biden Jr. became the 46th president of the United States on Wednesday, while Kamala Harris became the first Black American woman to become vice president.
The “Biden-Harris” inauguration has completed the most violent power transfer in recent American history, exactly two weeks after a group of ex-president Trump’s supporters stormed into the Capitol Hill building and leaving five people dead.
On top of that, Trump became the first president since Andrew Johnson in 1869 not to attend his successor’s inauguration, ahead of his second impeachment trial in the coming weeks.
All US stock indices extended the recent rally by ending Wednesday’s trading session at fresh record highs. The Dow Jones rose 0.83% to 31.188, almost 100 points above its previous all-time high. The S&P 500 was up 1.4% to 3.851, the Nasdaq Composite gained 2% to 13.457, while the small-cap benchmark Russell 2000 popped 0.4% to 2.158.
The share of the streaming giant Netflix hit a record high of $586, up 17% yesterday, after it reported strong subscriber growth and share buybacks. Also, the shares gained an additional boost after the company announced that they would no longer need to borrow billions of dollars to finance its TV shows and movies.
Asian-Pacific equities advanced on Thursday morning, following the overnight gains in Wall Street. Shares in Australia edged higher by 0.7% as the local unemployment rate came in at 6.6% in December, below expectations for 6.7%. China’s Shanghai Composite rose 1.3%, Japan’s Nikkei 225 ended up 0.80%, while Hong Kong’s Hang Seng index settled 0.20% higher.
Falling Treasury Yields weigh on the US dollar
The 10-year US Treasury yields edged lower to 1.08% as investors expect Federal Reserve to continue with its dovish monetary policy and not taper until the end of the year.
The recent back foot in yields, together with the market risk appetite, and dovish Fed monetary policies have weighed on the greenback. The DXY-US dollar index, which tracks the greenback against a basket of major currencies, dropped below 90.20, only a few days after it reached 91 levels.
The optimism around the massive $1.9T US fiscal package has sent investors away from the safe-haven currencies such as the US dollar, Japanese Yen and Swiss Franc and into more growth-led currencies such as Euro, Sterling, and the commodities-led currencies of Canadian, Australia, and New Zealand dollars.
The EUR/USD pair advances back above 1.2140, the USDJPY slips near 103.400, the USD/CAD falls to a 3-year low of 1.2630. Meanwhile, the NZD and AUD extend gains against the greenback to 0.722 and 0.777 respectively on improved Aussie unemployment rates and higher commodities prices.
WTI and Brent crude prices advance near $53 and $56 per barrel respectively, over a growing optimism that the massive fiscal and monetary pandemic-relief packages will improve the global economic growth and hence the demand for petroleum products.
Furthermore, crude prices took an extra boost after China, the world’s larger crude consumer, shown an increase in fuel demand by 3%, a record high in the pandemic-shaken 2020.
Gold and Silver have gained traction recently, climbing to weekly highs of $1.870/oz and $26/oz, as they considered the ideal hedge against inflation and US dollar devaluation amid the $1.9T US stimulus.
Hence, the precious metals gain support from the dovish Fed, while the lower Treasury yields reduce the opportunity cost of holding non-yielding gold and silver metals.
Global equities hit another fresh record high on Friday over a growing optimism for a stronger economic recovery around the world despite the political unrest in the United States.
All major US stock indices such as Dow Jones, S&P 500, Nasdaq 100, and Russel 2000 rose to all-time highs on Thursday, while European and Asian equities hit fresh multi-year highs on Friday morning, after the US Congress confirmed the election of Joe Biden as president, removing some political risk from the financial markets.
The inauguration of Joe Biden as the 46th president of the United States will mark the beginning of the four-year term of Joe Biden as president and Kamala Harris as vice president. A public ceremony is scheduled for Wednesday, January 20, 2021, at Capitol Building in Washington, D.C.
Investors are optimistic about the so-called “blue wave”, expecting that the new political landscape under Joe Biden’s administration together with the Democratic-controlled Congress would pass larger fiscal stimulus to support the pandemic-damaged US economy.
Equities got an extra boost after the Institute for Supply Management said its index for nonmanufacturing activity in the U.S. rose to 57.2 in December from 55.9 in November.
Capitol Hill chaos:
Investors were shocked on Wednesday after a group of President Trump’s supporters stormed into the Capitol building, causing Congress to suspend proceedings to confirm the election of Democratic Joe Biden as the next president of the United States.
Protesters invaded the halls of Congress and Senate Chamber, shouting “Trump won that election!”, while the members of Congress and Senate staffers were ordered to take shelter in the building. Unfortunately, 5 people died during the riot, including a policeman, a woman who was shot by police inside the Capitol building, and 3 other people who died from medical emergencies.
The Dow Jones Industrial Average added 211 points, or 0.7%, to 31,041.13, surpassing the 31.000 level for the first time, while the S&P 500 climbed 1.5% to 3,803.79. However, it was Nasdaq Composite that outperformed the market, advancing 2.6% to 13.067, and posting its first-ever close above the 13.000 level.
Asian stock markets hit fresh multi-year highs following the overnight rally in Wall Street. Japan’s Nikkei 225 index ended Friday morning at 28.138 points, up 1.75%, posting its higher closing since 1990.
Meanwhile, South Korea’s Kospi index jumped 4%, boosted after a local media reported on a possible deal between tech giant Apple and South Korean automaker Hyundai Motor on developing electric vehicles and batteries. Hyundai Motor reported that it has early talks with Apple but without any decision yet, while its share price skyrocketed by 23%, pushing S. Korea’s auto sector to finish the day with more than 10% gains.
Global equities rallied strongly at the start of the final trading week of 2020, as investors celebrate the Brexit trade agreement, the start of vaccinations in Europe, the positive news over AstraZeneca’s vaccine and the signing of the well-expected US Covid-19 relief package by President Trump.
US stimulus relief package:
Appetite for riskier assets increased this week after US. President Donald Trump signed a $900 billion coronavirus relief package into law on Sunday. Trump prevented a government shutdown late Sunday, extending the unemployment benefits into March for an estimated 14 million people in the USA. The new package includes a $600 direct payment to most individuals and adds $600 for every child.
President Trump suggested last week to veto the legislation demanding $2,000 direct payments instead of $600. The House voted Monday to increase the second round of federal direct payments to $2,000, leaving it up to the GOP-controlled Senate.
The stimulus-led market euphoria sent the industrial Dow Jones to close at fresh record highs of 30.400, up 0.7%, while S&P 500 and Nasdaq finished on Monday higher by 0.9% to 3.735 points and 0.7% to 12.900 points respectively, reaching new all-time highs as well.
Dow Jones and S&P 500 gained 6% and 15% respectively in 2020 recovering all Covid-led losses. However, it was the technology-focus Nasdaq Composite that outperformed the whole market, adding more than 45% in the same period as investors felt safe to position their funds into pandemic-winner tech names such as Netflix, Amazon, Zoom, and Apple.
Brexit trade deal and AstraZeneca’s vaccine:
Germany’s DAX index finished up 1.5% on Monday, erasing almost all pandemic-led losses, while France’s CAC rose 1.3%, on Brexit deal optimism, AstraZeneca vaccine news, and the start of mass vaccinations in Europe.
Britain’s FTSE 100 hit 8-month highs at 6.660 points on Tuesday after the drug maker AstraZeneca announced that its COVID-19 vaccine candidate is set to be granted emergency use approval from UK regulators this week. Hence, the company believes that its vaccine would be effective against a new variant of the virus that has helped drive a spike in cases in Britain.
European investors also cheered the long-awaited Brexit trade deal between the European Union and Britain last week. Euro and Pound Sterling currencies rose to 2 ½ year highs against the US dollar.
Equities in Asia were higher this morning, following the overnight gains on Wall Street. The Japanese index Nikkei 225 finished Tuesday’s session with 2% gains at 27.560 points, trading at levels not seen since 1990. South Korea’s Kospi finished the day at 2.820 points, up 0.50%, hitting fresh all-time highs, the Hang Seng gained 1% near yearly highs, while Australia’s ASX 200 rose 0.50%.
Crude oil gains:
Crude oil rose on Tuesday along with gains in global equities, over the growing optimism that the fresh US stimulus bill combined with the expectation for a global economic recovery in 2021 would increase the demand for petroleum products.
WTI and Brent crude prices added 1% yesterday, to $48 and $51 per barrel respectively erasing most of last week’s losses propelled from concerns over the new fast-spreading Covid variant in the UK.
Market outlook for 2021:
The market outlook for 2021 will remain bullish if the pandemic-damaged global economies will be supported by the ongoing massive monetary and fiscal stimulus, the low-interest rates, the weaker US dollar, and the successful mass vaccination of the global population which will allow economies to reopen after the devastating COVID