Inflation Scare & Tapering Fear: Will History Repeat Itself?

Key arguments for no structural inflation problem

• US fiscal policy will moderate in 2H this year and become a drag on economic growth next year. US growth momentum will likely peak in 2Q21. We have already seen softer-than-expected consumer confidence and housing data lately. Our forecasts for US GDP growth is 6.9% for 2021 and 4.7% for 2022.
• Labour will re-enter job market after the pandemic unemployment benefits expire in September (we have already seen early ends to unemployment benefit program in some states). This will slow wage growth.  
• Surge in technology capex is increasing productivity which tends to be deflationary.

If history is any guide

What is happening now is similar to the inflation scare in 2010-11, when the US economy recovered from the Global Financial Crisis, and  inflation then subsided after several quarters. The chart below indicates that topping out of short-term inflation expectations could be a sign of peaking in US yields. 

Value/cyclicals tend to outperform when inflation expectation is rising

If you are worried about inflation, our analysis below suggests that materials, financials, industrials and energy show higher positive correlation with rising US inflation expectation. Also, Eurozone (with more cyclical exposure) shows relative outperformance when inflation expectation is in an uptrend. 

Furthermore, the underperformance of the tech sector in recent months may imply that once inflation expectations and bond yields peaked, growth stocks may regain their leadership. 

When will the Fed taper?

Inflation expectations stand at 2% (according to the Fed’s own gauge) - a perfect number, not too high, not too low. Thus, unemployment is more of a concern than rising inflation as the latter is seen as transitory.

In our view, the Fed will start discussing tapering at the June meeting and will announce its decision in September. The tapering is likely to be a slow process and to be implemented in early 2022. The tapering could start from the mortgage backed securities (MBS) as the Fed currently holds 32% of the MBS market while the housing market is in good shape.

Potential impacts of tapering

The chart on the right shows the performance of US 10-year treasury yield, US and emerging markets (EM) equities during 2013, when the Fed announced tapering in May and started implementing it in December. It seems that tapering was less an issue for US equities with S&P 500 having a benign 4% correction after the tapering announcement and rallied into the actual tapering. The US yields also peaked when the implementation started.  Nevertheless, EM equities were more vulnerable to both tapering announcement and actual implementation during 2013.

The impact of tapering could be less pronounced this time compared to the 2013 taper tantrum as the Fed seems to communicate more clearly and hints at a slow move in an attempt to minimise the negative impacts. 

CONCLUSION / STRATEGY

• The abundant liquidity has created a mini bubble in bitcoin, SPACs and non-profit techs etc. We see the big corrections in those areas in recent months as a healthy removal of excesses rather than the equity market is peaking soon.
• We remain positive on equities overall. We expect value/cyclicals to outperform in line with higher inflation expectations in the medium term, while defensives could lead in the more volatile summer months. We are positive on the financial, real estate and healthcare sectors.  

Overview of our CIO Asset Allocation for June 2021

GDP & CPI Forecasts

Growth

• The US economy is recovering fast, thanks to the fast pace of vaccination and exceptional fiscal stimulus package.
• The positive effects of the EU fiscal stimulus programs combined with the boost in demand linked to vaccination and reopening will lead to a major acceleration in Eurozone growth in 2H21.

Inflation

• In the US, a surge in inflation in Q2/Q3 is likely to fade before reheating in H2 2022.
• There is still a lot of excess capacity and the potential for people to return to the job market. This limits the inflation risk especially in Europe.

Equity

• Positive on equities overall: with a preference for Eurozone and UK stocks. We continue to recommend a more defensive sector stance for the summer months, biased towards quality dividend/dividend growth strategies. We also like the financial, real estate and healthcare sectors.
• Downgrade Asia materials to neutral: long-term structural trend remains unchanged, but the attention from Chinese officials on commodity prices could impact market sentiment in the near term.
• Upgrade Asia healthcare to positive: the normalization trend of hospital activities will provide emerging opportunities on biologics, chronic disease drug manufacturers, and medical equipment players. 

Fixed Income

• The latest US economic data has been uneven. The Fed is likely to wait for more clarity. We expect the Fed to start discussing tapering at the June meeting and will announce its decision in September. The tapering is likely to be a slow process and to be implemented in early 2022.
• Higher realised inflation, higher wage growth and the announcement of the tapering are potential reasons for US bond yields to take another leg higher. We keep our 10-year UST yield targets at 2%. 
• Turn neutral from positive on Eurozone IG corporate bonds: Valuations are stretched, and low yields provide very little buffer against higher interest rate. We maintain our positive stance on US IG corporates. 

Forex & Commodities

There are talks of vaccination passports to allow cross border travel within Eurozone, which should narrow the region’s GDP growth gap with the US in Q2 and perhaps outgrow the US in Q3. Additional stimulus from the Recovery Fund and the ECB’s potential tapering announcement in June should support the euro. Therefore, we adjust our EURUSD target to 1.25 (from 1.20) for the next 3 months. We keep our 1.25 target in one year.

We also adjust our targets on the CNY to see a rather lateral move over the coming months (6.40 for the 3 and 12-month targets).

GOLD: Negative real yields, inflation fears, perceived excessive money creation and expected USD weakness should push gold back to $2000/oz.

OIL: The prospect of a comeback of Iranian exports if sanctions are lifted and the slowly increasing US shale oil production should see Brent trading around $60-70 in the coming months and higher after.

BASE METALS: Our positive stance on base metals has been well rewarded with new all-time highs in copper and tin. But with China’s economy cooling short-term, we take tactical profits and downgrade base metals to neutral.

Click on the link below to download the full report in PDF