Transitory inflation? We will see…

It’s been a slow Monday morning in the UK today as the country nurses its wounds over England’s defeat by Italy in Sunday night’s Euro 21 final. It was a fine line between winning and losing, a tactical error here, a missed penalty (by both sides) there, and Italy were eventually crowned winners. It’s a bit like being a central banker, although Jay Powell and Andrew Bailey will be hoping that their bets that inflation will be transitory will end up like Italy, rather than England. 

A great week for trading 

If you’re not a football fan and have woken up fresh and rosy at the start of this week, then you have a great week of fundamental drivers that could enliven markets during this peak summer week of trading. Last week’s sharp decline in Treasury yields and government bond yields in general, along with a sell-off in risky assets and in EM currencies, will be in focus as financial markets awaits key inflation data for the US and the UK. The reaction in the bond market to Tuesday’s US inflation data, released at 1330 BST, will set the tone for financial markets for the rest of this week, in our view. US inflation is expected to have remained hot last month, as the labour market remains tight and commodity prices rose. The market is looking for an increase of 4.9%, below May’s 5% rise, but still a huge monthly increase that will no doubt be felt by consumers. Prices paid by manufacturers have risen at their fastest rate since 1979, according to the ISM survey, while the service sector has seen prices rise by their highest level since 2008. The questions that we need to ask in the wake of this inflation data include: 1, is this the peak for US and global inflation? 2, will the data force the Fed, and other central bankers, to act quicker than currently expected?  

Why the market is likely to keep faith with the Fed, for now…

The answers to these questions will determine market price action. We think that markets remain confused about the outlook for monetary policy – hence the large swings in bond yields in recent weeks. However, last week’s sharp decline in bond yields suggests to us that momentum remains in favour of the Fed’s view that inflation will be transitory. If we get a reading in-line with expectations or slightly below, then we don’t think that the US bond market will be affected, and the dollar index could remain stuck in its recent range below 93.00. This would also be constructive for stocks and other risk assets in general. 

However, there are a few risks to this complacent view: 

1, the reflation trade depends on consumer strength in the US and around the globe. If consumers are weighed down by inflation then the post pandemic economic recovery could be hindered, and stock market upside limited. 

2, Corporate earnings are also in focus this week, we have already previewed US banks, please refer to our note from last week. The market is expecting another bumper season for US earnings for big companies. EPS growth of more than 60% in the three months to the end of June is expected for companies on the S&P 500 according to FactSet. The market is focussed on the big banks reporting this week, largely because the S&P 500 remains close to a record high after rallying some 16% so far this year. This risk is that when expectations are so high the probability of a disappointment rises, which could knock sentiment if this scenario transpires. We also think that another record-breaking quarter of earnings might not lift share prices too much as the market may start to think that this is the peak. Remember that traders like to price stocks based on what they think will happen in 6-months’ time, good results for the last quarter won’t boost a share price if the outlook is weak. There is also a risk that banks could be caught off-guard by weaker earnings for their IBs, as trading volatility remains weaker than it was in Q1 2021. If weaker earnings at their IBs are not matched by stronger earnings elsewhere, say M&A, then we could see stock markets shudder. 

3, The future outlook: As we mentioned, strong earnings matter less than the future outlook for companies in this earnings season. Last season we saw a large number of CEOs complain about rising prices. If the largest companies in the US talk about inflation hurting future profits, then sentiment could also weaken. 

4, China: last week the markets were thrown by the signs that China’s growth is slowing down. Investors will be watching China’s GDP data closely on Thursday, the market is expecting a reading of 8%, significantly below the unusually high 18.3% reading in Q1. Signs of a slowdown, particularly in consumption, could also knock market sentiment, especially commodity prices and the Aussie dollar. Tightening credit conditions could also weigh on Chinese growth. 

To conclude… 

As you can see, there are a lot of risks to the outlook for stocks, risky FX and commodities this week. However, if US corporate earnings are good and CEOs are not too worried about the future, if US inflation is not too high to spook the market and if China’s consumer doesn’t disappoint then all will be good with the world and stocks and other risky assets may rise. This binary outlook is why stocks remain range bound at the start of this week, and why investors aren’t willing to take any big decisions. We shall have to see what this week brings before we get more direction in markets. 

Chart of the week: energy companies tend to be an historically strong inflation hedge, better than other sectors including financials and utilities, and may do well even if fears about inflation rise this week on the back of strong inflation readings in the US.