Market Update from our partners at LGT Vestra

At the start of the year, investors were encouraged by the pace of vaccination rollouts, which had the propensity to speed up the recovery from the pandemic. To a large degree, this has occurred across the developed world, but the spread of the Delta variant, combined with softening economic data, has given investors some pause for thought. In broad terms, the data continues to show strong growth, supported by consumers spending some of their lockdown savings. The economic backdrop paired with powerful policy support stoked inflation fears, driving a reassessment of equity exposure from technology stocks towards more cyclical stocks until late May.

The most recent Consumer Price Index (CPI) report continued to show second-hand vehicle prices, oil base effects and re-opening supply-demand imbalances remain the key drivers for large price increases. This in turn supported the Federal Reserve’s (Fed) view that inflation is predominantly a result of ‘transitory’ effects. As inflation fears have abated somewhat, this has supported Treasuries with bond yields declining considerably over the past few weeks. Thus, flows have started to move back into high-growth technology stocks and enthusiasm for value sectors has waned. Given these gyrations in markets, investors were eagerly awaiting the latest Fed meeting, to get a sense of how they are poised to respond to a US economy that is recovering quickly from the pandemic, albeit with pricing pressures concentrated in a few sectors.

Investors sought clarity on when the Fed might contemplate tapering asset purchases, as well as its outlook for interest rates. The Fed’s “dot plot” showed that the majority of their members now expect to raise interest rates in 2023, with median projections showing two 25 basis points rate hikes that year. Relative to no increases anticipated in March, this change in position was somewhat of a surprise. Jerome Powell, Chair of the Federal Reserve, indicated that the Fed would provide advance notice before tapering asset purchases, and that these would occur at least several months before raising interest rates. This implies that tapering could occur during 2022 and that we could see the Fed announcing their intention to taper later this year. Chair Powell continued to highlight that tightening is highly dependent on economic progress from here, particularly within the labour market. Hence, future job reports may have an outsized impact on rate expectations over the coming quarters. The Fed has made it clear that they will only look to withdraw the pandemic stimulus so long as it does not upset the path to recovery. We expect the Fed will continue to err on the side of caution and only gradually shift their wording to prepare markets for a slow, gradual withdrawal of the support put in place during the pandemic.

On our side of the Atlantic, the European Central Bank (ECB) has been conducting a comprehensive strategy review over the last eighteen months, paying close regard to the way it targets inflation. Like many central banks, the ECB sets a target for stable prices, which was previously defined as “below, but close to, 2% over the medium term”. The ECB has stated that it would now be prepared to tolerate short periods of inflation above 2%. They have not gone as far as the Fed, which also recently redefined its inflation target, as an “average” of 2%. Whilst the change indicates that the ECB may be more tolerant of inflation, in practice, it makes little difference. Core inflation, for the last ten years, has been well below 2%.

Pent-up demand, combined with supply-side constrains have lifted short-term inflation, as highlighted through sales of second-hand cars and domestic lodging costs. This broadly confirms the view that inflationary pressures will be transitory over the medium-term, albeit with inflation running above target in the near term. In the near term, we may continue to see some inflation due to bottlenecks in supply and a pick-up in demand as we recover from the pandemic. However, the downward pressures on prices due to ageing populations, automation and other technological shifts are not going away, and the recent changes made by central banks simply enable them to keep interest rates lower for longer, which should continue to support both bond and equity markets.

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