Forest for the trees
With each passing week, we see more headlines discussing inflation and how it's driving valuations. The argument goes something like this: US 10-year yields are declining below 1.5%, indicating that business activity will not meaningfully increase demand and won’t require the Federal Reserve to raise interest rates. It’s a plausible position, but when the precis goes on to justify a top in equity and commodity prices based on ‘lower rates for longer’, the narrative breaks down.
First and foremost, inflation can be used effectively as a factor for forecasting asset price levels, but it’s certainly not the only measure. It’s also logical that its efficacy in any model will vary depending on the economic circumstances. For example, early this year, when vaccination efforts were first being viewed as a proxy for increased business activity, inflation was a useful measure. A steep increase in demand was seen to validate the underlying dynamic of reopening economies, driving valuations higher. So, understanding the path of inflation surge would provide a good input for firms' values and inputs of business activity (raw materials, energy, etc.). Fast forward six months and most of these dynamics are already captured in asset prices, so any small change in inflation expectations will have, at best, a passing relevance to market price movements.
Bottom line: It seems to us that the preoccupation with inflation is more noise than signal when trying to understand market dynamics right now. To paraphrase a macroeconomic strategist, inflation will either be a bit higher or a bit lower, but in the meantime, the market is not pricing equities off rate expectations. For instance, a shift from Covid-time tech favourites—e.g. Netflix or Zoom—to post-covid relative value is providing a more relevant lens for market movements, especially when most economists readily accede that the inflation outlook is pretty friendly for the foreseeable future. This also suggests that analysing a depreciating Dollar in an inflation and rates context doesn't make too much sense either. We need to change the story.
The week ahead
The UK is one week away from the final stage of its planned reopening; however, it now appears this date could be pushed back by four weeks. This will allow all adults to be vaccinated by the end of July to prevent a large spike in cases driven by the Delta variant. Sterling has held strength fairly well considering this news, finding comfortable support around the $1.41 level against the US Dollar. Inflation data is due out on Wednesday and is the main focus for the UK this week, forecast to come in at 1.8%, fast approaching the Bank of England’s 2.0% target. Any movement toward this headline figure should be good for the Pound as the expectation for monetary easing grows.
- Bank of England Governor Andrew Bailey is due to speak today and tomorrow, focusing on the growth prospects of UK-based financial services.
- The UK Unemployment Rate stat will print on Tuesday and is forecast to dip to 4.7% in April vs 4.8% in March.
- UK Consumer Price Inflation y/y looks set to rise on Wednesday to 1.8% for May vs 1.5% in April. Core CPI y/y also looks to be creeping higher up to 1.5% from 1.3% in the same time period.
- Retail Sales m/m will be released on Friday and are forecast to fall heavily to 1.6% for May vs 9.2% in April.
Last week, the ECB made no changes to monetary policy, holding interest rates at record lows and keeping its bond-buying scheme steady at €1.85tn. ECB President Christine Lagarde emphasised it would be too early to begin raising rates or tightening spending just as economies throughout the EU begin to show signs of recovery. The outlook for the bloc has improved significantly since the start of the year as coronavirus vaccinations have accelerated and consumer sentiment has ticked higher, boosting EUR/USD by around 1.3% since April. According to Lagarde, consumer prices are expected to rise in the short term, but these effects will remain temporary.
- German final CPI m/m looks to be unchanged for May at 0.5%, while France CPI also remains unchanged at 0.3% for the same month.
- Eurozone final CPI y/y and core CPI y/y both look set to remain unchanged at 2.0% and 0.9% for the month of May.
- German PPI m/m is forecast to fall slightly for May to 0.7% from 0.8% in April.
- The ECOFIN Meetings will take place this Friday and will run all day.
Last week, the US Dollar Index managed its best weekly performance since the end of April, gaining 0.42%. However, as risk-on appetite improves and US bond yields move to the downside, Dollar strength could be undermined. The Federal Open Market Committee meetings will be in focus this week as expectations of formal taper talk increases. The talks could throw up any number of outcomes, one being the same message of wait and monitor or a shift to discussing inflation more seriously, such as tightening monetary policy sooner than expected. Retail Sales and inflation data out at the start of this week could set the tone for these taper talks.
- Core Retail Sales m/m are pegged to rise to 0.4% in May vs -0.8% in April, while Retail Sales m/m are forecast to move lower to -0.6% from 0.0% April to May.
- Headline core PPI m/m is predicted to fall to 0.5% in May vs 0.7% in April.
- The Federal Open Market Committee will meet this Wednesday and publish Economic Projections along with any interest rate decision.
- US Unemployment Claims are to be released on Thursday and are forecast to fall to 360K vs 376K in the previous week.
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