Is another ‘taper tantrum’ on the way?
Inflation, the U.S. Fed, and financial markets
This is where things get real. As everyone is settling into summer and ready to head to the lake, the next few months could shape the path forward for financial markets. One very notable difference between the pandemic and other recent disasters has been how quickly and freely global central banks and governments deployed stimulus and fiscal measures to protect the economy. This is a direct learning from the global financial crisis of 2008/09 when they were slow to respond, and the world tilted on the brink of financial collapse. For all intents and purposes, this strategy worked this time around.
Now that the tide is appearing to turn against the virus, due to the remarkable speed and deployment of vaccines globally, the debate will begin as to how and when to remove these government measures and begin to normalize. This will be tricky and could cause the second half of the year to be much more volatile than the last 12 months.
Economy opens, spending balloons, inflation looms
Every country has had its own approach to dealing with this pandemic, and in many places, it is far from over. But as far as financial markets are concerned, how events unfold in the U.S. will be most important. The Americans were hit extremely hard by the virus, and officials can be criticized for many things, but one area they got right was in vaccine production and distribution. As everyone who wants their vaccine is getting it, we are now looking at the probability the U.S. economy will be fully open by July.
With consumer balance sheets flush with stimulus cash, as the economy opens, spending is following at a dramatic level. It appears everyone is planning a vacation and some sort of home improvement project. This is pushing the demand for everything through the roof and prices are following as supply chains struggle to keep up.
The word “transitory” has been used more in the last few months than in the last few years. Whether our economy is in a “transitory” stage is at the heart of the debate. Central banks commonly have an inflation target in mind. If the rate of inflation gets too high, they will take off measures such as quantitative easing to address this. Early in the pandemic, central bankers were out telling everyone they would be prepared to let “things run hot” and not be too quick to tap the brakes. But as signs of inflation are appearing everywhere, have we hit the point it can’t be ignored? Do prices normalize as supply chains resume normal production levels? Was this a blip? These are the questions on everyone’s mind as they monitor the central bankers’ next move.
Another “taper tantrum”?
The fear for investors in an inflationary environment is all around keeping their purchasing power. This has created demand for “real assets” that can be seen in the price of real estate and other commodities. The moves in currencies is also a sign of this as the U.S. dollar has been under pressure all year, and notably commodity currencies such as the Canadian dollar have outperformed. Will these trends continue if banks reverse course? Has the market already priced this in? Or has the inflation ship sailed, and it is now too out of control too easily control?
To control for inflation, the emergency measures will need to be removed. This is where the talk about “tapering” is coming from. The term “taper” joined the financial conversation in 2013 as the central bankers attempted to take off the stimulus from the 2008 crisis. At that time, this change in course seemed to catch investors off guard, and markets corrected in what has been referred to as the “taper tantrum.” Are we setting up for a repeat this time around? That is the fear that has crept into the market.
Focus on the macro
As a result, the next few months will all be about the macro environment. The recently reported corporate earnings season was impressive, and many companies are back to pre-pandemic levels. Equity markets are at or near all-time highs. Lastly valuations, while not stretched, are not cheap either.
What will happen when the flow of government money is slowed down is anyone’s guess. Over the summer, each economic data point will be scrutinized for signs of inflation or a hint the central banks will need to adjust their course. While markets should be higher into year end, how we get there is still a question. The next few months may see increased volatility as we move from one data point to the next. Sector rotation will continue to be key – in a period of rising rates, different sectors will win versus others.
Summer markets should be quiet and offer investors a much-needed vacation, but they may also be volatile with low liquidity. This could be the toughest part of the pandemic for the central banks: How to message the taper without giving back all their hard-fought gains.
Greg Taylor, CFA, is the Chief Investment Officer of Purpose Investments Inc.
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