For almost two months now, financial commentators have been working themselves into a frenzy over a supposed return of inflation.
Some believe that it will originate in rebounding commodity prices, while others argue that it follows from the liquidity injections involved in massive central bank-subsidised stimulus such as Joe Biden’s ].9 trillion package. Either way, investors have been quick to take up the theme, especially as the inflation expectations priced into bond markets have surged in recent months. We believe that these fears are exaggerated, however, and we are not alone. Both the Federal Reserve and the European Central Bank say that inflation risks arising from higher commodity prices and short-term supply issues are temporary in nature.
A close examination of the macroeconomic data leaves us with a less rosy picture of US economic activity than the inflation-mongers have. In our view, the absence of output constraints is a major factor preventing any sustained acceleration in inflation. America’s capacity utilisation rate is just 73.8%, and the unemployment rate adjusted for people who have given up looking for work and for part-timers is 13.8%, which is much higher than pre-crisis levels. And in any case readers may recall that at that time low unemployment failed to trigger rampant wage inflation, mainly because union membership rates have been falling in most major developed economies for the past four decades.
The short-term impact of stimulus packages on inflation is also limited by the fact that most of the assistance is being channelled into savings. So far, household behaviour could hardly be clearer: gigantic transfer payments have been saved rather than consumed. And in America, the additional household consumption that has been secured has resulted in increased goods imports rather than greater consumption of services. This all explains the weak correlation between domestic demand and core inflation, which is the only measure of inflation liable to influence monetary policy.
Following a far better Q4 2020 than analysts expected, with US corporate earnings growth coming in at 4%, estimates for Q1 are bullish. The consensus view is a 23.3% jump in earnings, which would be the sharpest rise since Q3 2018. The early part of this year is also likely to see a return to favour of some of the sectors that suffered the most in the last nine months of 2020: discretionary consumer goods, basic materials and financials. Energy and industrials are the only sectors still struggling, but their situation should improve.
Fears of higher US inflation continue to put upward pressure on 30-year Treasury yields. As a result, our valuation model is now pointing to the need for consolidation on Wall Street. If yields stabilise at current levels, the correction would theoretically have to be a substantial 16%. Our own target is slightly less alarming: given that the model highlights the need for the S&P 500 to mark a pause after an almost uninterrupted 75% rally since mid-March 2020, and long rates ought to revert to their medium-term level of around 2%, we are retaining a year-end objective for the index at 3,673 points, or 7.5% down on where it is now. The situation is completely different in the euro zone, where neither investors nor Christine Lagarde are concerned about inflation. The weighted average 30-year yield has stabilised and the consensus view has changed little over the past month, leaving our model in fair value territory. We therefore continue to overweight European equities relative to the US market.
