Written by George Lin/Senior Investment Manager CFS
Over the month, a run of disappointing US economic data raised some doubts about the strength of the US economic recovery, while at the same time, concerns about inflation remained a dominant theme in financial markets. Still, share markets rose modestly, bond markets proved resilient, and iron ore prices surged and corrected. By month’s end, the Australian share market rose about 2.3% while the Australian Dollar (AUD) remained stable – last trading at 77.4 US cents.
KEY ECONOMIC DEVELOPMENTS
A Developed Versus Developing Divide
The developed world is rapidly moving towards a post-pandemic environment which presents a number of opportunities for investors, while rising case numbers and a lack of vaccine supply remain constraints to growth in much of the developing world. This division is expected to persist in 2021. For example, with about 40% of the population fully vaccinated by the end of May, it appears the US is now on the verge of achieving early herd immunity. The situation is drastically different in developing nations – particularly across several Asian countries like Singapore, whose previous efforts managing the initial spread of coronavirus were considered exemplary. Meanwhile, a two-week lockdown in Victoria was a timely reminder that with only 14.9% of the population having received at least one vaccine dose, Australia remains vulnerable to outbreaks of coronavirus.
Support For The Australian Economy
The Australian Federal Budget for 2021-22 is a continuation of fiscal policy to support the economy for longer. A better-than-expected economic recovery and higher commodity prices resulted in a $37 billion lower fiscal deficit for 2020-21 compared to previous estimates. This improvement allowed the government to announce a number of measures – ranging from a continuation of the low and middle income tax offset, to additional infrastructure spending which totals $96 billion over the next five years. The extra fiscal stimulus is “front-loaded”, with $18 billion (or around 0.9% of Gross Domestic Product) to be spent in 2021-22. Importantly, the government plans for fiscal consolidation were delayed until unemployment falls below the pre-coronavirus level of 5%.
Us Economic Data Disappointed…
Macroeconomic news in April was dominated by disappointing US economic data and higher-than-expected US inflation. The Citi Economic Surprise Index for the US, which measures actual economic data relative to the expectations of professional forecasters, fell sharply in April and briefly fell into negative territory – meaning, US data has been underperforming relative to market expectations.
April labour force data, in particular, received media attention as perceived evidence of a faltering US economy. US non-farm employment increased by 266,000 in April, which was significantly below market expectations of around 900,000. Further, the non-farm payroll estimate for March was also revised down to 770,000. While disappointing, it seems the poor April data has overstated weakness in the US job market. Firstly, the trend in job creation is still strong. On a three-month basis, non-farm payroll increased at a rate above 500,000 per month – a very strong pace. Secondly, the poor data was driven mainly by losses in couriers and messengers (which reflects a shift from takeaway delivery to in-person consumption) and construction (which probably reflects supply-side constraints). Both are likely temporary. Thirdly, other data points paint a more positive picture for the US labour market – for instance, the number of job openings has been steadily increasing since November, while surveys have indicated employers are actually finding it difficult to hire employees. Finally, the US market is experiencing some temporary dislocations – namely, the generosity of unemployment benefits relative to the minimum wage in some states.
…But Inflation Surprised Markets
The other data which generated discussion among investors was the significantly higher-than-expected US CPI inflation in May at 4.2% year-on-year. Core CPI also rose 0.9% on a monthly basis to push annual underlying inflation to 3%. While financial markets expected an acceleration in CPI inflation due to a combination of the base effect and ongoing economic recovery, the magnitude of the increase surprised markets. The increase in the annual headline CPI rate was the fastest since September 2008, while the monthly gain in core inflation was the largest since 1981.
The big question now is whether this increase is transitory and if year-on-year inflation will actually return to around 2.5% by year’s end as markets and as the US Federal Reserve (the Fed) expect. The evidence from April CPI data is mixed. There are certainly some “one-off” price rises that are unlikely to persist. For example, the 10% rise in used car prices in April (which alone accounted for almost a third of the increase in core CPI in April) was probably caused by the disruption in new car production due to shortage of computer chips and is unlikely to persist. At the same time, the rise in prices is sufficiently broad-based across different categories to dismiss the April result as totally driven by the base effect and entirely transitory in nature. In summary, while the April CPI data most likely exaggerated the extent of US inflation, underlying inflationary pressures are indeed building.
KEY MARKET DEVELOPMENTS
Given the focus on the poor US inflation data, the resilience of bond markets (particularly US bonds) surprised some investors. The 10-year US bond yield finished the month at 1.62%, down slightly compared to its end-April level of 1.63%. Since the sharp rise in bond yields in February, US (and Australian) bonds have traded range bounded. A key support for US bonds is continuing low bond yields in Europe and Japan, which make relatively high-yielding developed market sovereign bonds attractive. In addition, the below-consensus run of US economic data was also supportive of bonds.
Share markets also traded somewhat range bounded, but recorded small gains. The Euro STOXX rose 1.87%, the Hang Seng rose 1.49%, and the S&P 500 rose 0.55%. Concerns about interest rates hurt growth stocks in May. In the US, growth stocks fell 1.56% while value stocks rose 2.19%. In particular, a number of mega-cap tech stocks performed poorly; Apple fell 5.2%, Amazon fell 7%, and Netflix corrected by 2.1% – pushing the NASDAQ down by 1.53%. In Australia, the ASX 300 rose 2.3%. Resource companies continued their strong run, with the ASX 300 Resource Index rising 1.4%. However, the ASX 300 Industrial Index performed better and returned 2.5% over the month.
May saw a dramatic rise (followed by a minor crash) in the price of iron ore, one of the most important commodity exports for Australia. Surging demand from China – driven by the global economic recovery and continuing supply difficulties from Brazil (the other important iron ore exporter) – pushed the spot price to a high of USD$214 per metric tonne in mid-May. The surge provoked Chinese authorities to issue a number of warnings against speculation in the commodities market. And by month’s end, the spot price ended at around $205 per tonne.
Developments in May left investors no better informed than a month ago, with many struggling to reconcile the economic recovery with the extent of the inflationary pulse, as well as the implications on monetary policies and financial markets. Despite the disappointing economic data in the US, the underlying upward trend in US economic growth remains intact – even if somewhat weaker. And for now, investors seem to have already priced in positive economic news, which suggests that unless there is a marked acceleration in the pace of economic recovery, share markets returns should be more subdued. However, there may be opportunities for other developed nations (for instance, Europe) to play catch-up with the US as their economies continue to reopen.
The big question for investors remains how the Fed will react to higher inflation in the US. It has been vocal so far in communicating its commitment to targeting average inflation of 2% – meaning that it will tolerate modestly higher inflation in the short term. However, the sentiment seems to have shifted recently, with the comments of some senior officials suggesting it may soon be time for the central bank to begin discussing a plan for adjusting its current monetary policy settings. So it seems the Fed is in the early stage of communicating to markets that a tapering of asset purchases will come. The timing will be data-dependent, but the market consensus is that the taper will happen in early 2022. If past history is a guide, the Fed may communicate its plan after the FOMC meeting it has scheduled in September.
It will be exceedingly difficult to differentiate the base effect from the longer-term inflation drivers in US CPI data over the coming months. However, a number of leading indicators of US inflation are currently “flashing red” – weighing the risk of US inflation to the upside. Looking ahead, there is a reasonably high possibility that US inflation will overshoot market expectations over the next 12 months, but the magnitude is highly uncertain and a spike is unlikely to be persistent – particularly if the Fed reacts by adjusting monetary policy.