Morgan Stanley are out with a vague “Sell in May, but don’t go away” research note, implying a “difficult summer” (read: our winter) ahead for markets as they get complacent due to a mild form of normality returning to developed economies post COVID.
- First, our global economics team has consistently argued that this will be a strong, ‘V-shaped’ recovery, a view that underpinned our strategy preference for early-cycle winners. But following the arrival of better data, not to mention the US$1.9 trillion American Rescue Plan, better growth is now more widely expected. Meanwhile, the rate of change for that growth will soon peak, given that we’re passing the one-year anniversary of the largest global economic drawdown on record.
- The second fundamental challenge lies in inflation. Our economists forecast US core PCE to hit ~2.5%Y next month, and stay at 2.0%Y or higher for the rest of the year. If that’s correct, inflation will switch from being a far-off concept to something appearing regularly in the monthly data. While we don’t think we’re on the verge of runaway prices, markets are forward-looking, and cyclical, early-cycle winners historically underperform when inflation moves back above trend. My colleague Mike Wilson has been vocal about starting this shift out of early-cycle cyclicality, and increasing quality in the portfolio.
- Then there is the virus. My colleague Matthew Harrison thinks that vaccinations will allow the US to achieve herd immunity by summer, maybe as early as June. While this is clearly a public health milestone to be celebrated, the implications for markets could be more complicated.
Low inflation and a terrible pandemic gave the Federal Reserve two powerful arguments to keep accommodation flowing even as financial conditions improved. Can the Fed sustain this accommodation if the US hits herd immunity and realized inflation is above 2.0%Y this summer? Certainly, and this remains our expectation.
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The real crux of the issue, however, is what’s in the price. The year-to-date rally has increasingly eliminated upside to our targets.
Across four major global equity markets (the US, Europe, Japan and emerging markets), only Japan is currently below our end-2021 strategy forecast. In bond markets, US 10-year rates are near the year-end expectations of my colleague Guneet Dhingra, who also thinks that US inflation breakevens now price in the rise of inflation our economists forecast.
Growth is still improving and liquidity is still abundant. The bull market remains intact, and I struggle to see the type of calamity that defined the summers of 2010, 2011, 2012 and 2015. But a harder, choppier, more range-bound summer does seem likely.
The problem? Inflation is no longer low with a recent 2.6% annual reading recorded in March and much better than expected vaccination rate which is seeing the US economy shoot ahead of other developed nations struggling to enact similar vaccination programs. This week’s Fed meeting maybe crucial in how they intend on managing this better than expected growth and tailwinds and could provide a catalyst for risk markets to take some profit off the table if they tighten too soon. Liquidity is key.