George Lucas, Raiz Group CEO
Last week saw global stocks as measured by the FTSE All-World Index hit an all-time high as investors balanced expectations that the economic recovery will remain robust with caution ahead of the upcoming US Federal Reserve meeting on June 15-16. While it has not been the most exciting rally and the global equities benchmark has only risen 1 per cent so far in June, it’s another sign of global economic data continuing to improve.
Looking ahead, the focus is still on inflation and how central banks behave based on inflation expectations, especially in the wake of the surprising recent decline in US Treasury yields in the face of very strong inflation numbers in the US and broader signs of mounting price pressures.
Bond market in spotlight over inflation
Since the end of Q1, the 10-year US yield has fallen by nearly 30 basis points and in that time we’ve seen a couple of headline-grabbing CPI prints, suggesting that wage growth is picking up in the US, and that firms’ input prices are rising strongly. This fall in yield has supported equity market prices globally and is one of the reasons we’re seeing all-time highs. It indicates that the bond market is not overly concerned about inflation but view the current high inflation numbers as transitory that will not persist for long.
The bond market is probably more pessimistic than the equity market about the longer-term prospects for the real economy, with the labour market recovery not as fast as widely hoped, and signs of supply bottlenecks emerging in some key sectors. The bond market is always right. We’re also seeing velocity of money slow in markets and this cash is instead being parked in treasuries in May and June. This is not good for the economy as cashed-up banks are not lending money, and people are not spending but saving. Remember the bond market is always right.
Attention turns to emerging market central banks
Despite rising inflation, emerging market (EM) central banks will likely tighten policy more slowly than investors currently expect as the banks look past the temporary factors driving inflation. On this point, most broad-based supply chain bottlenecks will be largely resolved over the course of this year, and demand for goods will moderate as global consumption patterns shift away from goods and towards services as economies reopen. Also, the rise in commodity prices has been an important driver of inflation, especially food prices, over the past few months, but when this rally loses steam then inflation pressures will ease.
Simply put, inflation will be largely driven by how quickly domestic demand recovers. Given the limited fiscal policy support and the continued difficulties containing COVID-19 many EMs economies will have sluggish recoveries and not generate sustained inflationary pressures. Hence, in our view, most EM central banks will tighten policy more slowly than is currently discounted in markets in order to support domestic economic recoveries, while exporting commodity countries like Indonesia will look to loosen policy, if possible, to weaken their strengthening currencies. However, Indonesia’s central bank will likely be concerned about the stability of the rupiah, which will stop it cutting rates at its policy meeting this week.
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