Here are the top market developments we have been watching in June.
1. Inflation is favored. Inflation is currently winning. Is it going to win?
The narrative appears to be yes, inflation will win out. However, the Euro 2020 (European football) round of 16 games played this past Monday serve as an excellent metaphor of where we are today regarding inflation. The games are also a reminder that a heavy favorite, even one with momentum and a lead, may not always win.
Fans of European football (soccer) were treated to two riveting games, with sudden reversals of fortune. Spain, a soccer powerhouse over the last 15 years, faced Croatia in the first game. France, the reigning world champions, faced Switzerland in the second game. Spain and France, each heavy favorites, had strong momentum and commanding 3-1 leads heading into the last ten minutes of their games.
Spain and France looked like certain winners. Stunningly, Spain and France suffered reversals of fortune. Croatia and Switzerland each scored two goals near the end of regulation to send the games into extra time at 3-3. Inflation looked like a certain winner 45 days ago. Since that time, the inflation narrative has suffered a loss of momentum and arguably some setbacks.
Spain ultimately won 5-3, while Switzerland prevailed in a shootout after extra time expired with the score still deadlocked at 3-3. So the big question is whether the favorite, inflation (e.g., Spain) will ultimately win, or whether the underdog, deflation (e.g., Switzerland) will surprise us.
This chart illustrates the 12 month change in CPI-U index over the last 12 years ending May 31, 2021. The chart also shows the “Core” CPI-U index, which excludes food and energy.
The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.6 percent in May on a seasonally adjusted basis after rising 0.8 percent in April. The “core” index (excludes food and energy) rose 0.7 percent in May after increasing 0.9 percent in April. Over the last 12 months, the all items index increased 5.0 percent before seasonal adjustment, the largest 12-month increase since a 5.4-percent increase in the summer of 2008.
We all know inflation was transitory in 2008. The situation today is different and inflation has more tailwinds. However, there are a few data points over the last 45 days that give us pause.
This chart shows the market’s implied inflation rate (on average) over the five-year period that begins five years on various dates over the last two years from June 28, 2019 to June 30, 2021..
While measured inflation (CPI-U) continues to rise, the market’s expectation of future inflation has stopped rising. In fact, it has declined slightly over the last two months.
This chart shows the market’s implied inflation rate (on average) over the five-year period that begins five years on various dates over the last twelve years from June 30, 2009 to June 30, 2021..
In addition, the market’s current expectation of future inflation has yet to exceed the 3% level that was reached a few times in the 2011 - 2014 period.
Source: treasury.gov
Longer maturity Treasury yields have risen since the beginning of the year, driven by higher economic growth and higher inflation, but have fallen from their second quarter peak on May 12. Ten year Treasury yields have fallen 25 basis points since then while thirty year Treasury yields have fallen 25 basis points.
Source: treasury.gov
Despite inflation fears, longer maturity Treasury yields are currently below the levels of two years ago. Admittedly, Federal Reserve purchases of Treasuries and demand from foreigners attracted to the relatively higher US interest rates have exerted downward pressure on US Treasury yields.
This chart shows the value of a US dollar index versus a basket of six currencies, where the Euro has the highest weight. A higher index value indicates the US dollar has appreciated in value.
We would also expect the US dollar to depreciate in an environment when inflation is accelerating and expected to surge to a sustainably higher level, especially with short term interest rates constrained by the Federal Reserve to near zero levels. However, the US dollar has appreciated modestly since mid-May and since the start of the year.
In conclusion, while we don’t anticipate deflation, we believe high inflation, by that we mean sustained CPI increases greater than 4%, will be transitory. So to use our soccer analogy, we expect a tie.
2. What would change our mind in the near term about the possibility of much higher inflation?
Inflation is extremely difficult to forecast. That said, we are carefully monitoring catalysts that could sustain the recent rise in inflation.
An ongoing contraction in supply due to a reversal of globalization: As we explained in last month’s update (here), trade tensions have been increasing, the global labor force expansion driven by China is waning, transportation costs are rising, and national security concerns about supply chains remain a hot topic. We see this issue as the most plausible rationale for inflation.
Shortage of low cost agricultural, industrial and energy commodities: Always possible, but innovation and technology are an offset.
Excess bank reserves at the Federal Reserve being designated as currency: Currently prohibited by law and for good reason.
Acceleration, not just year to year increases, in fiscal expenditures: Requires willingness of Congress to increase the rate of spending (not just the level) year after year. Unlikely in a two party system.
3. US equities have outperformed non-US equites year to date. Will that outperformance continue?
The graph shows the total return for the iShares MSCI Emerging Markets ETF in purple, the iShares MSCI EAFE ETF in red, and the S&P 500 Index in blue year-to-date through June 30, 2021.
US equities have outperformed non-US equities by several hundred basis points, year-to-date through June 30. They look frothy on various valuation measures, including forward Price / Earnings ratios.
Source: Yardeni Research, Inc.
Emerging market equities trade near their biggest valuation gap (cheap) relative to US equities over the last 25 years. As of late June, the S&P 500 Index trades near a 22x forward P/E multiple, while emerging markets trade a much lower 14x multiple. Emerging markets look cheap and primed for outperformance. However, as a former colleague once said to me, “A vacation at the swamp is cheap, but it is not a bargain.” In a world where the US dollar remains strong and rising food and energy prices consume an increasingly percentage of emerging markets consumers budgets, there may be no near term catalyst to generate strong performance of emerging markets equities.
On the other hand, other than increasing cost pressure for US companies, there is likely no catalyst to put downward pressure in the near term on the high valuation of US equities. The pandemic related consumer spending caution and the current fiscal stimulus have boosted US household savings, likely driving consumer led US economic strength into 2022. In addition, the Federal Reserve has signaled it won’t be tightening monetary soon. The economic boom, even if short lived, and the ample liquidity, are near term supports for US equities.
All that said, we are increasingly attracted to non-US equities, especially emerging markets equities.