Having been expected to peak in Q2, the US inflation rate topped out during the summer. It climbed from 1.4% at the start of the year to just over 5.3% in June and started to flatten out in July. Although its current level is well above the Federal Reserve’s target, we would agree with Fed officials that price pressures are temporary in nature and do not present any real risk to the American economy at this stage. Jerome Powell himself confirmed this view at the recent Jackson Hole Economic Policy Symposium, when he said that the Fed could tighten monetary policy slightly after year-end but that nothing dramatic was on the cards. We are therefore sticking with our conviction that there is little likelihood of a bond market crash in the short, medium or long term and that sovereign debt yields will stay low for longer than generally expected. This implies that current equity market valuations are sustainable.
In contrast with China and the USA, the euro zone (and the EU as a whole) suffered a second wave of recession in Q4 2020, when real GDP contracted by an annualised 0.6%. It was therefore the last of the world’s main economic blocs to stage a post-Covid recovery, and it is only now that purchasing managers’ indices are upbeat. The European economy can also count on budgetary stimulus from now on, which ought to bolster a recovery that has so far thrown up a number of mixed signals. Needless to say, there is even less chance of a change in monetary policy in Europe than there is in America. It all lends credibility to our own scenario of the ‘Japanisation’ of Europe.
By virtue of its temporary nature, the pickup in inflation is not a major risk for the world’s big economies. But it could amount to a real blow to weaker emerging countries. China is not among that number: it is increasingly capable of dealing with inflationary pressures and its economy now looks more like a rich than an emerging one anyway. Derailing the Chinese economy at this point would require an accelerated shift in the division of value added domestically, which looks improbable in the near term as the authorities are focusing instead on cracking down on the big Chinese trusts.
As far as the microeconomy is concerned, corporate newsflow has demonstrated resilience for quarter after quarter, especially in America. Q2 results have been record breakers: 97% of S&P 500 companies have published to date and together are posting a 93.8% increase in earnings. If we include the 3% of firms that have not yet published their results, we obtain a 91.9% gain for the index, far greater than analysts expected even at end-June (an estimated 63% increase).
Equity indices are pursuing their inexorable rise. Since our previous strategy letter, the American and European markets have appreciated 5% and 4%, respectively, in local currency terms. That should be placed in the context of a significant decline in bond yields since the end of June, although corporate earnings estimates have continued to rise. 2021 as a whole is revised sharply higher, too. Even so, our valuation model still suggests that consolidation is possible in the US market. We will continue to overweight European stocks to the detriment of their American counterparts.
