Friday 2nd July, 2021
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With June coming to a close, we can look back over the last 6 months and come to the clear conclusion that the first half of 2021 has been a good one for risk assets. Markets have been buoyed by positive headlines as vaccination programmes have been well-and-truly rolled out, economies have started to re-open, and economic data have firmly supported the rosier outlook. The spectres of escalating inflationary pressures and an earlier-than-expected tightening of monetary policy have caused wobbles along the way, but the direction has been unequivocally skywards. Global equities (measured by the MSCI AC World Index) finished H1 up +11.4%, the Bloomberg Commodities Index was up over +20%, and high yield credit (measured by the Bloomberg Barclays Global High Yield Index) was up +2.7%. As would be expected in such an environment, longer duration assets and traditional safe havens have lagged – investment grade fixed income (measured by the Bloomberg Barclays Global Aggregate Index) finished June down -1.5% YTD, while gold was down -6.8% – but this has still undoubtedly been a good start to the year.
This regime continued to hold over the last two weeks and equity markets have risen steadily since our last newsletter. One driver has been some well-received commentary from a number of Fed members, who struck a largely dovish tone that soothed investors following a tumultuous period around the last FOMC meeting. Powell testified before the House of Representatives on the Fed’s response to the pandemic on Wednesday last week and, while he acknowledged that inflation had been greater than initially anticipated, he mostly stuck to his tried and tested script, reiterating the view that the price pressure is transitory and they would have to see evidence of sustained inflation before raising rates sooner than expected. Here, he pointed to the significant – and somewhat unintuitive – rise that we have seen in used car prices, which provides an excellent case study into short-term pandemic driven price pressure. The US has seen demand for autos rebound sharply as lockdowns have eased and people look to get back on the road, while the supply of new cars has been severely constrained in the wake of last year’s production cuts. At the same time, manufacturers have faced major difficulties getting production back online in the face of a semiconductor shortage. The net effect has been a major supply deficit, which, when combined with low base prices in May 2020, led to used car prices rising +30% YoY in May. This accounted for just under a third of that month’s eye-catching +3.8% YoY core inflation rate. We would certainly expect these supply and demand pressures to fade into year-end as the backdrop continues to normalise, which will in turn alleviate a good deal of upwards price pressure at the index level. These effects are firmly at the fore of the Fed’s considerations. There were some slightly more hawkish comments from other members of the Fed – notably James Bullard and Robert Kaplan, who mentioned that they would prefer the tapering process to begin sooner rather than later – but, overall, markets took a breather and rates headed lower, with the US 10Y yield closing yesterday at 1.47%.
Beyond that, we also saw the announcement of an agreement between Biden and a bipartisan group of senators on a $1.2tn infrastructure package. While the package fell short of the $2.3tn plan announced earlier in the year and left out Biden’s “human infrastructure” spending plans, it includes $579bn of new spending and will herald huge investments in America’s public transport infrastructure. That said, after having negotiated the deal, Biden announced that he will look to have his human infrastructure spending plans pushed through via a parallel budget resolution and that he would only sign the bipartisan bill if Congress also approved his measures. He has since rowed back from this statement, but tensions remain and there is a significant chance of delays and disruptions before anything is actually signed into action, particularly as the funding mechanisms are likely to be hotly contested. Nonetheless, the first step has been taken.
The final matter that we will note is volatility. Markets may have been pulled back and forth this year by a variety of conflicting forces (e.g., robust economic growth versus higher interest rates), but volatility has also been steadily declining. The VIX Index, which measures the market’s expectation of near-term volatility on the S&P 500, read 15.5 yesterday… this is its lowest level since the pandemic began. However, this belies a sense of uneasiness that has seeped into markets and we certainly don’t think that now is the time for complacency. Indeed, a lesser-known relative of the VIX called the Skew Index (it measures the difference in cost between derivatives that offer protection and those that benefit from a rally) suggests that other investors agree. This index has hit record highs recently, highlighting that the ratio of investors using derivatives for equity protection is far outweighing those using them for speculation, and by an unprecedented margin too. While we have steered clear of adding puts back to our portfolio as we are conscious of the pitfalls of trying to time a correction (and believe that it is likely to be short-lived), we do think that one is due. Cracks in the calm have started to emerge recently, with the rise of the delta variant and weaker data out of Asia. We have just seen the May Manufacturing PMIs for both Vietnam (44.1) and Malaysia (39.9) – both of whom have had to reimpose lockdowns – indicate a sharp contraction in their manufacturing sectors and this could foreshadow similar outcomes in regions closer to home if the rising caseload is not controlled. We hope that our readers enjoy the summer lull, but we will remain on full alert.
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