Weekly Update 5th April 2021 – By Andrew Milligan

MUNIX COMMENTARY – WEEK OF 5 April

On some occasions, financial markets move in a close relationship – usually driven by an identical story, such as the appearance of a global pandemic or a war in the Middle East affecting the price of oil. On other occasions, the divergences between how different financial markets assess the current situation and the likely outlook, well they leave investors scratching their heads!

The past month has been just such an example. If we start with bond markets, they are drifting sideways. UK 10-year gilt yields have range traded about 0.75%. Its US counterpart has eased a whole 10 basis points over the month to approach 1.65%.There is a startling contrast with the euphoric performance of most global stock markets. Both the S&P500 index and the Eurostoxx 600 have just reached record highs, followed suit in the UK by the FTSE250 if not yet the FTSE100 blue chip stocks.

What explains the divergence between bonds and equities? The answer would appear to be a mix of economic forecasts, policy decisions, portfolio decisions, and currency movements. Starting with the forecasts, the highpoint of this week was the major upgrade to global GDP estimates by the IMF. On the back of the massive fiscal stimulus, existing and promised, from the Biden Administration, the Fund now expects US economic activity to return to pre-pandemic levels by the end of this year. Indeed, most advanced economies saw upgrades to their GDP forecasts, although the IMF was quick to warn about the sharp divergence with relatively weaker emerging market countries, partly related to their lack of success in vaccinating their populations. Global economic growth close to 6% this year would be a very good backdrop for company analysts to raise their forecasts for corporate earnings growth. A not unimportant side effect of the Biden stimulus cheques is also a very sizeable amount being invested into US stocks by American households; en masse their allocations to equity are the highest on record.

Where growth goes, will inflation follow? Certainly there is considerable debate amongst economists about the long-term effects of the massive expansion of global money supply as a consequence of the pandemic stimulus and the acceleration in debt issuance by corporates and governments. However, the latest minutes of the Federal Reserve once again signalled that they are happy to look through the approaching pick-up in headline inflation whilst emphasising the underlying dis-inflationary forces in the economy. It must be said that the money markets are not yet convinced; expectations are growing that the Fed will need to start raising rates by late 2022, despite central banker protestations to the contrary. This week’s ECB minutes also showed a central bank more concerned about the impact of rising borrowing costs on a weak European economy than worried about impending inflation. In the UK, headline inflation is only 0.5% higher than a year ago, restrained by sizeable discounting on the high street – and the IMF’s forecasts are that even with a strong rebound in GDP growth in 2021, activity will not return to pre- pandemic levels before next year.

Capital is flowing towards risk assets and away from defensive or fragile ones. As the outlook for the US economy and stock market improves, so cross-border capital is moving into US assets supporting an appreciation of the US dollar, which helps restrain import prices. At the same time, there are concerns about a variety of emerging markets, Turkey would be a prime example, which together with a narrowing spread between US and emerging bond yields has encouraged investors to pull money from EM bonds.

If the equity story looks too good to be true, then it usually is. Underneath the surface there are a variety of worrying issues for the more bearish investor to ponder on. The first would be euphoric state of the stock markets: many investment bank models are warning that equity positioning and flows data are approaching extreme levels; buying of equity on margin is the highest since 2007; corporate share buybacks are the strongest since 2019, yet President Biden is proposing a major increase in US corporate taxes; an important measure of stock market volatility known as the VIX is its lowest since Feb 2020.

The timing of any correction cannot be forecast. Equity markets could well make progress for some time to come on the back of positive news about vaccinations, the return of consumer spending, and continued government largesse to its citizens. At present, there is not enough evidence for bond markets to move decisively either way – central banks are still attempting to restrain any sell-off in government bonds through QE programmes, whilst inflation data only flash amber warning lights. Bond, currency and equity markets can follow different paths until some event or shock forces investors to being to focus once again on the same story.

Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial ma;ers and should not be considered as financial advice in any form.