European equity markets posted nice gains this week as conviction continues to grow that the vaccine rollout will propel economic growth in the coming quarters. The FTSE 100 was in fact the best performer of the indices I track this week (+2.3% W-o-W), reflecting the fact that the UK economic recovery is starting to really gain steam as businesses reopen. Although the EU stumbled in the initial stages of its vaccine rollout, the broader European index – the STOXX 600 – also chalked up a nice 1.7% gain for the week. Both the UK and EU might be trailing the US economic recovery, but they are catching up. European equity markets also represent better value plays vis-à-vis the more expensive US equity markets, as you can see here:
FTSE 100: forward P/E ratio of 15.6 (adjusted, based on CEIC data at 12/31/20)
STOXX 600: forward P/E ratio of 17.3x (source: stoxx.com)
S&P 500: forward P/E of 21.8x (source: Yardini Research)
The Chinese and Japanese equity markets were closed the first three days of the week. When these markets reopened on Thursday, the trajectory was similar to what they have been experiencing most of the year – the Nikkei 225 delivered solid gains in its shortened week (+1.9%), whilst the Shanghai index was slightly down (-0.8%).
The week in US equities was far more dynamic, with sentiment turning sour on Tuesday and remaining mixed until the disappointing April jobs report was released Friday pre-market open. Until then, the theme was similar to that of prior weeks as investors continued to tilt towards cyclical companies and reflation beneficiaries. Concurrently, technology shares sold off sharply, pushing the NASDAQ index down as investors were worried about potential future inflation, considered a negative for technology stocks. Tech stocks sold off sharply even though many high flyers, similar to the FAMAG stocks the week before, delivered strong 1Q21 results (e.g. TWLO, ROKU, UBER, PTON, ETSY). Many of these are excellent companies well placed for the future, but their valuations have simply gotten so high that they are and remain in need of “growing” into their earnings, which could take time. The unexpectedly disappointing April jobs report on Friday morning caused sentiment to shift fairly dramatically prior to the session’s open. Inflation concerns suddenly gave way to concerns about US economic growth, as tech stocks (and US Treasuries) skyrocketed . However, as the day wore on, the equity market rally broadened eventually taking all of the US indices higher, including pushing the S&P 500 and the DJIA to record closes on Friday (with the DJIA hitting record closes on Wednesday and Thursday, too). The laggard YtD is the NASDAQ, as you can see in the table below.
The US Treasury market was well-behaved much of the week even though there were more indications that inflationary pressures are bubbling below the surface. Commodity prices, including oil, continue to push higher, and higher input costs will eventually translate into higher prices of finished goods. Moreover, there is increasing evidence that some US companies are finding it difficult to rehire workers. An admittedly cynical view is that these problems could be partially attributable to overly generous unemployment benefits which are set to continue in the US through September (at the federal level). The difficulty in hiring workers seems most acute in the hospitality and leisure segments. The Fed remains committed to its (near) 0% interest rate policy and ongoing QE programme spanning from US Treasuries to corporate high yield bonds, whilst the US government is about to unleash $4 trillion (or some subset thereof) of new spending. Treasury Secretary Yellen said early in the week that the Fed might have to raise rates to address brewing inflation (not a surprise), and then the Fed released its Financial Stability Report (here) later in the week that warned of asset bubbles, saying: “Asset prices remain vulnerable to significant price declines should the pandemic take an unexpected course, the economic fallout prove more adverse, or financial system strains re-emerge.” These statements did little to rattle the US Treasury market as bonds remained firm all week, with the 10-year UST yield improving 5bps W-o-W. Still, Friday was a wild ride with the yield on the 10-year UST falling near the open to around 1.50%, before the weak jobs report was slowly digested and accepted, and Treasuries sold off the rest of the day.
According to the BLS (see website here), only 266,000 jobs were added in April, versus expectations of 1 million jobs. Unemployment held steady at 6.1%. In some respects, this data vindicates the on-going super-accommodative approach of the Fed and the spending proposed by the Biden Administration, although I suspect this slowdown is nothing more than a speed bump that means little about the intermediate-term trajectory and strength of the US economic recovery. By the end of the day, equity and bond investors seemed to have thought the same.
In Europe, both the UK and EU are seeing slow but steady improvements in their economies as vaccinations increase. London is buzzing again. Restaurants – which reopened to outdoor dining in mid-April – will reopen to indoor dining on May 17th, signalling another step forward in the economic recovery of the U.K. In the States, the NY/NJ/CT tri-state area will fully reopen on May 19th. Still yet, the global economy is not out of the woods, because even though developed markets are experiencing the positive effects of increasing vaccinations, warmer weather and business re-openings, there remains the very influential issue of the pandemic running amuck in some countries, especially in many emerging economies like India. It is a rude reminder to investors that this pandemic is far from over.
Oil was on a tear most of the week, following the broader trend of prices of (industrial) commodities. Gold also seemed to finally react to inflationary pressures and was scarcely bothered at all about the April jobs report as gold closed the week at its highest level ($1,832.90/oz) since early February. Of course, as I have mentioned before, it is difficult to say whether gold moves due to inflationary expectations, general commodity trends, or because of its "safe haven" status.
Now what?
My views remain generally unchanged. There are inflationary pressures building, most acutely in the US, but inflation is – after all – the objective of the many central banks at the moment. The challenge in every case will be winding down the massive support coming in the form of artificially low interest rates and quantitative easing so as to slow inflation but not tip economies into recession. Tightening is coming, whether it's in 2022 or 2023, but investors will inevitably react poorly even though the writing is on the wall. Before we get there though, short-term conditions mean that risk assets will continue to push higher, although there will be growing choppiness and the trajectory will not be as steep as in the last year. This will be a favourable environment for recovery / reflation plays (e.g. cyclical stocks and base commodities), and a hostile environment for investors in intermediate- to longer-duration government bonds. Corporate bonds (credit) will tread water, although BBB (investment grade) bonds remain vulnerable to rising yields and could drift lower. High valuation equities, equity sectors and markets remain vulnerable, too. This is often attributed to higher interest rates, especially when tech shares get hammered. However, I believe these stocks / sectors / markets are especially vulnerable because they are simply too expensive, a short way of saying that value might be the best strategy at the moment whether it be in specific stocks, sectors or country markets that are, relatively speaking, cheap.
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