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Reflation stays the course in January

Nathalie BENATIA

In this article:

    After the first three weeks of January, the MSCI AC World index in US dollar terms had posted gains of 3.6%. In the last week, global equities fell sharply, posting a slight 0.5% decline over the month. A short squeeze led to the sell-off in equities. The consensus scenario whereby vaccination campaigns pave the way for an economic rebound remains intact.

    Despite increasing concerns about new, more contagious variants of the coronavirus, investors held faith with a scenario of steady reflation. Expectations of massive fiscal stimulus in the US led to a sharp rise in equity valuations, tighter credit spreads and a rise in long-term bond yields.

    Positive factors such as Chinese GDP growth and better-than-expected economic data at end 2020 overrode negative news on the pandemic and a fretful start to the vaccination campaigns. As a result, valuations of risky assets were not significantly hit.

    An encouraging start to the US corporate earnings season was also supportive of equities.

    A very unusual phenomenon

    In the last week of January, global equities fell sharply. A feverish buying spree by retail investors, coordinated via social networks, led to an exponential rise in valuations of some hitherto neglected, illiquid small-cap stocks that had been the object of short selling.

    As a result, several hedge funds were forced into buying these stocks to cover their short positions. The equity market fell as some investors were forced into liquidating positions to raise cash and cover margin calls.

    The S&P 500 set a record high on 25 January, then lost 2.6% over the next two days. Implied volatility sharply rose (Exhibit 1). Poor economic data, a worsening of the pandemic caseload and renewed uncertainty over the availability of vaccines then fuelled the drop.

    The ECB’s and US Federal Reserve’s commitments to maintain accommodative monetary policies and ease further if necessary failed to reassure investors. A more cautious prognosis on the economic outlook from central banks did not help sentiment.

    Performance of the major developed market indices in local currency terms was as follows: -2.0% for the EuroSTOXX 50, -1.1% for the S&P 500 and +0.8% for the Nikkei 225. Globally, the technology sector’s semiconductor segment saw the biggest monthly gains, while financials and consumer staples saw the biggest declines.

    Fixed-income markets: torn between fiscal and monetary policy

    Yields of US government bonds rose slightly in January. The 10-year US T-note yield (0.91% at the end of 2020) had risen to 1.07% on 29 January, a rise of 16bp.

    By mid-month, the yield of the US 10-year Treasury bond had returned to its highest since March 2020 at almost 1.15% due to expectations of increased fiscal spending. The assumption of aggressive fiscal policy steadily gained ground after the Democratic Party won the two remaining Senate seats and thus, in practice, a majority.

    Joe Biden and his administration are pushing for a new USD 1.9 trillion stimulus package, with newly appointed Treasury Secretary Janet Yellen saying ‘the smartest thing we can do is act big’ on government spending in the face of a longer and harder recession.

    If the size of this stimulus package is added to the package voted through in December, it would amount to the equivalent of 13% of US GDP. The reaction in bond markets, however, was surprisingly restrained.

    The change in the Federal Reserve’s monetary policy framework does go some way in explaining why bonds have not sold off more. The Fed’s commitment to continue purchases of securities ‘until substantial additional progress has been made towards the objectives of full employment and price stability’ offers visibility and reassurance on a buyer for new government debt.

    In the coming months, however, the Fed will have to ensure that inflation expectations do not rise too fast and that speculation about a tapering of securities purchases this year does not start.

    Reflation is good for you

    The reflation scenario has prevailed since early November. It, along with the prospect of vaccines, largely explains the rally in risk assets since. The same conviction will likely be underpinned by the latest vaccine development news and the initial encouraging results on acquired immunity, even though questions remain over the pace of vaccination.

    From an economic point of view, the International Monetary Fund’s analysis largely concurs with the consensus view of ‘expectations of a vaccine-driven strengthening of activity later in the year and additional policy support in a few large economies.’ The IMF reminded markets of central bank statements and government commitments that ‘policy actions should ensure effective support until the recovery is firmly under way.’

    In the short term, the pandemic has forced governments to impose further restrictive measures and looks set to further disrupt economic activity and financial markets. Given the medium-term economic outlook, equity market corrections should be viewed as repositioning opportunities enabled by a highly flexible approach to asset allocation.

    In the bond markets, investors will need to pay attention to consumer price indices. A sustained acceleration in inflation seems unlikely, but erratic data at the start of the year due to quirks in measuring the rate of inflation could prompt reactions that upset central banks’ plans. Investors will require further evidence of central banks’ determination to maintain highly accommodative monetary policies and prevent inflation expectations from upsetting sentiment in bond markets.

    Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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