In mid-June, the Federal Reserve reaffirmed its shallow rate-hiking plans and that it would also start to slowly shrink the US monetary base soon. Interestingly, after several months in retreat, commodity prices and inflation expectations have responded positively. With a promising earnings season underway, the stage seems set for a summer rally.
The market’s response to the Fed’s most recent decision was benign. After almost half a year in retreat, long-term inflation expectations have started to recover somewhat. Commodity prices are also tentatively stabilizing and stock markets are proving resilient, while volatility remains very low.
The so-called 5y/5y forward breakeven rate - the expected inflation rate derived from the five-year forward contracts of nominal and inflation-linked US government bonds of the same maturity - has risen from about 1.8% in mid-June to 1.91%. Brent crude oil is up from $45 per barrel to about $48 today, after trading rising as high as $50 earlier this month.
In equities, many of the very popular technology stocks have corrected from recent all-time highs, but the broader markets are little changed since mid-June, with slight losses in the US and Europe balanced by gains in Asia and elsewhere. Moreover, financial shares have rallied to post-2008 highs globally, implying that general economic conditions will keep improving in the foreseeable future.
All this suggests that the US in particular and the global economy in general are moving toward eventually hitting their 2% inflation target, which has positive implications for nominal global economic growth and hence corporate earnings. Investors thus appear to be coming around to the Fed’s view that the soft patch in the inflation data will indeed prove temporary.
As far as the latter issue is concerned, we maintain a degree of caution. Inflationary pressures remain weak in our view, and the mentioned rebounds in commodities and inflation expectations are still tentative (see page 2). However, that does not exclude a rally in the coming weeks. On the contrary, the following factors have improved the case for a spike up in equity prices:
Concluding, we remain overweight in equities and certain selected categories of risk assets (see graph, page 4), and keep a modestly raised cash position for opportunistic purchases going forward. Our relative caution mainly concerns the richly-valued lower quality credit segments, such as high yield bonds, rather than equities - which are still well supported by economic fundamentals.
Note: The next edition of the LGT Beacon is scheduled for 8 August 2017.