Our base case has been that the surge in inflationary pressures over the summer months to levels significantly above the US Federal Reserve’s long term 2% target is unlikely to be sustained into 2022, although the post-pandemic environment ahead with faster growth means inflation could remain elevated at or moderately above central banks’ target.
This scenario is so far consistent with the US inflation data for the month of July, which showed that many of the factors contributing to elevated inflation since 2Q21 have started to wane.
Headline and core CPI rose by 0.5% and 0.3% month-on-month (MoM) in July versus 0.9% for both measures in the month of June, i.e. the pace of price increases appeared to be levelling off. The biggest contributors to inflation over the past few months such as used autos has stopped rising significantly (0.2% MoM versus 10.5% in June).
Reopening categories like airfares had surprisingly eased off in July as well and shelter prices were also softer than expected. The market reaction to this positive news on inflation was relatively mixed.
The bolstering of the case for transitory inflation helped to keep equity markets relatively calm. The S&P500 closed ~0.1% higher on Wednesday and grinded higher to close the week at ~0.6% above Wednesday’s open.
A calmer inflation outlook also means lower odds of a more hawkish than anticipated path of monetary normalization from global central banks. As a result, after the release of the July US inflation data, the nominal US 10-year Treasury yield fell 2bps to 1.337% on Wednesday, and experienced a sharp move down on Friday to end the week at 1.286%.
The USD dollar index (DXY) was flat on Wednesday but mirrored the 10-year Treasury yield’s decline on Friday to end the week at 92.52 (-0.6% since Wednesday). As the long end of the US Treasury yield curve and the US dollar eased downwards, gold moved steadily higher to reach USD1778.2 (+2.8% since Wednesday) on Friday.
With the latest inflation and labor market data consistent with their base case expectations, the Fed stayed on script as Fed officials continued the pattern over the last month of priming the market for a taper announcement in 4Q 2021. Shortly after the inflation print release, Dallas Federal Reserve President Robert Kaplan said that the Fed should begin to taper its purchases of Treasury bonds and mortgage-backed securities in October.
This is one of the most aggressive calls to-date in a week of heavy Fed speak where we heard several regional presidents calling for bringing forward the tapering timeline.
Kaplan said in a television interview that if the economy unfolds in accordance to his expectations, he would be “in favor of announcing a plan at the September meeting and beginning tapering in October”. His reason was that “these purchases are very well equipped to stimulate demand, but we don’t have a demand problem in the economy”.
Although the taper announcement could come as early as the Fed’s next meeting in September, we are currently leaning towards November and December, and a lot will depend on the strength of the labor market and inflation data for August. Regardless, we believe that the Fed’s exit from quantitative easing would be gradual (between eight to 12 months), which remains over the long term broadly supportive of risk assets, albeit with the scope for sharp short-term volatility.
Our broadly constructive outlook for markets is buttressed by the progress on the massive US fiscal package by policymakers.
On Monday (9 August 2021), Senate Democrats released the long-awaited outline for their antipoverty and climate action plan with proposed spending of USD3.5 trillion for next year’s (i.e. financial year 2022) budget resolution.
This resolution sets out the blueprint for the various Congressional committees to draw up their detailed spending plans and kickstart the process for the final budget reconciliation due to take place at the end of the year, in which the Democrats are expected to utilise their narrow margin in the Senate to push through their spending priorities.
The Senate next passed the bipartisan Infrastructure Investment and Jobs Act (IIJA) by a 69-30 margin on Tuesday (10 August 2021), securing the first step of a major win for President Biden’s economic agenda to ‘Build Back Better’.
The bill comprised USD1.2 trillion worth of infrastructure spending, of which USD550 billion was new, above-baseline funding. The new spending focused on roads and bridges (USD110 billion), power infrastructure (USD65 billion), rail (USD66 billion), broadband (USD65 billion), and water projects (USD63 billion).
On Wednesday (11 August 2021), the USD3.5 trillion budget resolution passed the Senate with a 50-49 margin along party lines, i.e. no Republicans voted in favour and Democrats used their narrow majority to advance the resolution to the next stage.
Both developments are expected to increase the US government’s deficit. The Congressional Budget Office – the federal body that is charged with providing independent assessment of the economic and budgetary impact of the spending plan to Congress – estimated that the bipartisan infrastructure plan is expected to increase the federal budget deficit by USD256 billion over a period of 10 years, even though the lawmakers who put up the bill have stated that the revenues for the plan would come from sources such as the auction of the broadband spectrum.
Under the USD3.5 trillion budget resolution, spending categories amounting to USD1.75 trillion are allowed to be deficit-financed. As a result, the Senate Finance Committee which is responsible for drafting the tax increases to pay for the spending plan has been instructed to come up with a proposal to raise USD1.8 trillion in revenue over 10 years. This is expected to meet with strong opposition, even amongst some Democrats. Moderates such as Senator Joe Manchin (Dem) have already voiced their concerns with the price tag of the ambitious spending plan. The infrastructure bill now moves to Congress, where it is likely that no clear path forward or a timing to vote on the bill will emerge for the next few weeks. In the meantime, the various House and Senate committees will have until 15
September to submit their draft legislative text for the budget resolution. The spectre of Delta-variant risks continues to lurk in the backdrop for investors as daily new Covid cases continue to rise in the US. The 7-day average daily new case count in US has risen from the recent low of 11,299 in late June to 122,788 (as of 12 August), though it remains 51% below the peak of 251,085 reached in early January.
The spectre of Delta-variant risks continues to lurk in the backdrop for investors as daily new Covid cases continue to rise in the US. The 7-day average daily new case count in US has risen from the recent low of 11,299 in late June to 122,788 (as of 12 August), though it remains 51% below the peak of 251,085 reached in early January.
Two bright spots are that, in addition to data so far showing that vaccines are effective in lowering the fatalities and hospitalization rates, the rates of new cases in the UK and Europe also appear to have peaked.
In Europe ex-UK, the 7-day average rose from 11,183 in late June to a recent high of 69,972 in late July and is currently 66,185, which is 61% below the peak of 170,881 reached last November.
As for the closely watched example of the UK, the 7-day average fell from a recent high of 47,696 (21 July) to a low of 26,104 on 3 August. This has ticked up slightly to 28,050.
It remains reassuring that the 7-day average daily death counts in US, UK and Europe remain 85%, 93% and 92% respectively below their peak reached in January. Although the Delta variant has now been reported in ~40 cities in China, the number of infections remain relatively low – the recent 7-day daily case count stands at 112 cases.
In our view, we remain overall overweight in equities through an overweight position in US equities.
In fixed income, we remain overweight in Emerging Market High Yield bonds, where valuations still look relatively attractive and should offer a buffer against the adverse impact of rising rates compared to other fixed income segments.
We stay underweight in both Developed Market and Emerging Market Investment Grade bonds, where historically rich valuations leave little buffer against rising rates.
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