The Expectations Game

Markets look ahead. So do economic forecasters. What the last two weeks have shown is how easily expectations can turn and how this affects reality, or at least the reality of pricing in financial markets. As April inflation data for the US came in above expectations last week — first on consumer prices and then producer prices — equities and bonds sold off, not just in the US but around the world.

The inflation surprise followed a puzzling unemployment report on May 7. US payrolls showed much slower than expected growth in April, just as markets were settling into the expectation of a strong recovery. These data puzzles serve to remind investors that we are in a period of extreme uncertainty. There is no historical model to guide expectations after a worldwide economic shutdown. A bumpy and uneven restart is going to require steady nerves and an eye for the long-term.
Understanding the policy regime is also crucial. As we said at the time, the Federal Reserve’s new Monetary Policy Strategy marked an important change. Judging from recent market commentary, some are surprised that the Fed is doing what it promised. Rather than using economic forecasts to drive monetary policy, the central bank is going to wait to see recovery in the data before acting. That is why the Federal Reserve did not change signals last week. Expectations of “low for longer” policy rates should remain in place for at least the next few months. 
What happens with fiscal policy also matters for recovery and growth. President Biden has put spending proposals totaling $4 trillion over 8 to 10 years on the table, on top of the $1.9 trillion pandemic relief passed in March. The President wants to pay for $2.3 trillion of infrastructure and $1.8 trillion of social safety net measures, only over 15 years, by raising taxes on corporations and the wealthy. Undoing any of the tax cuts passed by former President Trump is anathema to Republicans. Bipartisan meetings are taking place, including in the Oval Office last week. But don’t hold your breath for bipartisan agreement. Both Republicans and Democrats support spending on infrastructure, but they don’t agree on what that means, beyond traditional roads and bridges, nor on how to pay for it. And while everyone wants to help American families, the partisan gulf on how best to do that is even wider.  

President Biden wants to be a transformative president, putting in place structural changes to address both the future challenges of climate change and the problems of the past that have led to inequality and systemic racism in America. To succeed, he will need the wind of public opinion at his back. So far, polling suggests that he does. But a long summer of disappointing jobs numbers and higher inflation — not to mention fuel shortages, like those that happened last week because of cyberattacks; and issues like confusing CDC mask guidance — could make goodwill evaporate. 
Observations and takeaways for investors:
So, when does transitory become worryingly permanent?

Inflation fears are building, but not yet at the Fed. Federal Reserve Chair Jerome Powell and other senior Fed decision makers have been signaling for some time that they expect inflation to bump up as the economy reopens. They have also repeated the mantra that this bump is likely to be “transitory” and they do not plan to react unless and until there is evidence that their dual mandate of a 2 percent inflation rate and full employment has been achieved. This messaging has not changed with the April inflation surprise. For some observers, the constancy means the Fed is now behind the curve. But what does it mean for the Fed to be behind the curve, and should investors worry?
One former central banker noted privately last week that the accusation of being behind the curve simply ignores — or misunderstands — the import of the Fed’s regime change last August. As former President of the New York Fed Bill Dudley said on May 13, the central bank’s new 2020 strategy marked a big change in the monetary policy framework. Perhaps this was underestimated at the time. The new monetary policy strategy highlights the value for society of bringing unemployment down, beyond the levels previously thought to be sustainable. It also shifts deliberately from acting in advance to ward off inflation to waiting and seeing. 
Tightening monetary and financial conditions only after inflation arrives looks to some like the definition of being behind the curve. They worry that if the Fed waits too long, an inflationary wage-price spiral could become embedded. Inflation expectations, as measured by financial markets, did not move too much last week. But they have jumped this year, in particular for the nearer term. Inflation expectations in the next five years are now above the 2 percent average target. This could be seen as the Fed’s desired catch up after years undershooting. If one looks at 5yr breakeven inflation 5yrs forward, the expectations are more muted, suggesting the market does not expect a structural upward shift in inflation. 
The chart below puts the data in historical context: 5yr breakeven inflation is trading 1.5 standard deviations above its 20+ year average. Meanwhile, 5yr, 5yr breakeven inflation is trading less than one standard deviation above its mean level over the same time period. 
Markets move quickly to reflect what investors and traders expect to happen. What matters most is what wage and price setters — workers and firms — believe and act upon. With reports of rising prices featured on television news and, increasingly, in the political debate, will workers and companies start to raise their expectations and push for higher wages and prices? With this danger in mind, nervous markets wonder just how long the Fed will tolerate above target inflation. Atlanta Fed president Raphael Bostic gave a helpful hint last week. On timing, he indicated patience through the summer. He also pointed to the importance of the trajectory: if inflation bumps along somewhat above the 2 percent target (it hit 4.2 percent last month) that will be less concerning than if the price gauge accelerates from one month to the next and the next. 
The past twenty years have seen economic forecasts systematically overshoot inflation and underestimate the drop in the neutral interest rate that balances savings and investment at full employment. The forecasting errors, in turn, have encouraged the Fed to tighten prematurely. After the sluggish — and unequal — recovery from the Global Financial Crisis, major central banks now regard undershooting their inflation goals as riskier than overheating. For investors, this determination to be patient is double-edged. It means that the Fed, and other central banks, will preserve low interest rates and easy money longer than they would have in the past — boosting equity and bond prices. But it also means a faster, and probably sharper, shift upwards in rates when the time comes. Monetary officials want to move rates away from the zero lower bound and are willing to overshoot and then tighten policy. Equity investors accustomed to low real interest rates may differ.

Europe pulls together
As the world has struggled with Covid-19, nations have mostly turned inwards. In Europe, an attempt to work together across borders to procure vaccines went badly wrong as the European Commission focused on cost saving rather than life saving. But the latest news from Europe is cheering.  Vaccine distribution is now catching up, helping the economy to recover. Europe is now just one quarter behind the US instead of two quarters, as had been feared, according to Jakob von Weizsäcker, the Chief Economist at the German Finance Ministry, who joined RockCreek Senior Advisor Caroline Atkinson in a discussion last week. The historic decision last year to issue EU-wide bonds to support spending across the European Union will begin to bolster the economy this year. Back to expectations: few expect Europe to grow as fast as the US anytime soon. But by beating expectations, with less bad data than expected, Europe is set to attract investors.
As Europe catches up on vaccinations, it should follow a similar path as the UK, which has seen strong foreign equity inflows this year. Data indicates that  the UK has seen its strongest foreign inflows since at least 2006. This has come partly from the conclusion of trade talks with the EU last year, but also due to anticipation of a jump in GDP growth from reopening and greater investor appetite for value stocks. Several large UK companies have also recently announced share buybacks, including Diageo, Unilever, BP, IMI, and WPP.
The rest of Europe has been slower to rebound, and as a result ‘reopening beneficiaries’ have not performed as well as in other markets. Reopening stocks in Europe have recovered to an extent but are still off their pre-pandemic highs and may have more room to run than their counterparts in the US and the UK, where much of the reopening has been priced in already. Positive recovery signs in Europe are starting to emerge. European air traffic remains very depressed, but data shows flight searches picking up significantly across the region. European corporates — significantly impacted by global growth, given how many are related to the industrial and financial sectors — are also poised to benefit. Investors are finding opportunities in areas like environmental technology and industrial software that will see higher top-line growth as the global recovery accelerates. 
The trade front, however, could prove more complicated. With shortages of critical supplies evident during the pandemic, resilience has become a buzzword. But von Weizsäcker was clear that resilience should not be a mask for protectionism. Preparedness for disaster — whether from the climate, a cyberattack, or global health threat — is a government responsibility. But closing off to international trade is not the way to go: capitalism and the private sector actually work well to address shortages, particularly in an open, global world where rules are fair and nations adhere to them. As a former official noted privately last week: remember the concern over PPE? We now have plentiful supplies — mostly imported. If imports had been banned, the US would still be struggling.  
That brings us to the next battle with Covid-19: taking care of the world beyond our borders.
Watching for recovery signs across Emerging Markets

Between inflation fears and new Covid outbreaks, it was a tough week for EM equity. Last week the equity selloff was broad-based but most pronounced in Asian markets. A perfect storm of new Covid outbreaks and lockdown measures in Taiwan and Singapore, coupled with pressures on technology stock valuations, led to losses of 4 percent to 10 percent across Chinese, Korean, and Taiwanese markets. Local Chinese equity markets are now negative for the year, the first time since March 2020. 

In perhaps a surprising development, Chinese stocks that remain under US sanctions and under threat of US stock exchange delisting have so far posted strong returns versus the rest of the Chinese markets. China Mobile, CRRC, and China Telecom are up between 13-25 percent this year. This strong performance may be due to Chinese domestic investors rebalancing into value cyclical stocks — a valuable reminder that foreign investors represent less than 3 percent of the float in Chinese markets.
The selloff spread last week to ASEAN markets as investors digested the region’s poor vaccination rates and the prospect of a prolonged economic recession. The situation seems especially dire in the Philippines, Indonesia, and Thailand. Unfortunately, any recovery in the region will have to wait until well into 2022.
Against expectations, the standout market in the region last week was India, finishing flat for the week and benefitting from net foreign inflows. The public health situation remains dire and economic growth is expected to take a hit. IMF estimates earlier this year were calling for 12.5 percent GDP growth for 2021; most estimates today are well below 8 percent. However, the markets seem to be discounting this bad news in anticipation of an even stronger recovery in 2022. Investors are taking advantage of valuations discounts in consumer staples and other defensive names. Weather forecasters are also predicting a good Monsoon season and the hike in commodity prices (i.e., oil) has not moved the markets, perhaps reflecting India’s impressive efforts to diversify its source of crude oil away from Middle Eastern producers to the benefit of non-OPEC members such as the US and Argentina. 
Despite strength in Indian equity markets, the record streak of 32 consecutive weeks of inflows into emerging markets equities came to an end last week — the first net outflow since September 2020. All emerging markets were not equally hit, however. North Asia markets saw net selling whereas Brazil, South Africa and Indonesian markets saw net inflows, likely reflecting investors’ desire for more commodity and cyclical exposures. 
Forget herd immunity: it isn’t on the horizon
A month ago, it was not clear whether vaccines would win the race against the virus in the US. We can now breathe more easily. Deaths, hospitalizations, and daily infections are all coming down sharply among those who have been vaccinated. A return to normal life beckons. Even the cautious CDC acknowledged last week that those who are fully vaccinated can dispense with masks in most situations. The CDC reported that 59.8 percent of adults have had at least one vaccination shot, and there are plenty of supplies to inoculate the other 10.2 percent of Americans in time for the President’s goal to administer at least one shot to 70 percent of the US adult population by July 4th. With last week’s announcement that teens can get the Pfizer vaccine, and trials underway for younger children, a safe reopening of schools in September looks like almost a sure thing.
So why are public health officials downplaying herd immunity — the nirvana that we have been striving toward since the pandemic began? It turns out that Covid-19 is much harder to contain and vanquish than imagined in early 2020. It has also been much deadlier than official numbers suggest. The Economist reported in an excellent piece, that the official worldwide death toll of more than 3.3 million deaths understates  excess deaths by a factor of three or more. Many poorer countries have not experienced bad outcomes so far, for no obvious or well-understood reason. We have seen in India how an unexpected surge in infections from a new contagious variant can wreak havoc. And poorer countries — from Southeast Asia to Africa — have not got the protection from a vaccine that is gradually making us safer in the West.
It will be a long time before the world as a whole catches up on vaccinations. The better-off countries are doing little so far to help, as the Economist also points out. This is short-sighted. As long as this virus is anywhere it can spread everywhere. In the US — and soon in Europe — vaccine hesitancy is likely to put more of a limit on vaccination rates than a shortage of supplies, including booster shots, are plentiful. For many emerging and developing countries, supplies remain a huge constraint.  In poorer countries with less effective health systems difficulties in distribution and delivery also loom large. As a result, vaccination rates are lagging far behind even the 20 percent aimed at by COVAX, the global body working to direct vaccines. 
President Biden has argued for waiving IP protections on pharmaceuticals.  Even if agreed to by other nations, which so far have been resistant, and approved by the WTO, such a waiver would not be the panacea that some may believe. Manufacturing capabilities are limited in most countries, particularly for the new — and especially effective — vaccines from Pfizer and Moderna. Trade restrictions have, in some cases, put a strain on inputs for those manufacturers that can produce the drugs. Pharma companies have already signed more than 200 agreements to share technology. What is needed is a surge of supplies and other help across borders. This is also in the self-interest of better off countries.
What the past 14 months has shown is that the virus that causes Covid-19 is able to spread very rapidly and mutate dangerously. The concept of herd immunity is murkier and more variable than it may have seemed last year. The more infectious a disease, the higher the level of immunity in a population that is needed to reach herd immunity. For measles, an extremely contagious disease, herd immunity requires vaccination of around 95 percent of the population. New, more infectious variants of Covid-19 have now sprung up around the world. This has raised the level of global immunity needed to quash the disease to unrealistic heights. The good news is that scientific and medical advances are likely to make this a controllable, and much less deadly, disease. But everyone should keep some spare masks just in case: and keep up the pressure to take care of the world and not just the community.
RockCreek Update
Last Tuesday, RockCreek Senior Advisor Caroline Atkinson moderated a discussion at the Peterson Institute for International Economics with Catherine L. Mann – Global Chief Economist at Citibank and former chief economist at the OECD, and Jakob von Weizsäcker – Chief Economist at the German Finance Ministry, on whether the US economy could be a locomotive for global growth. Watch here
Senior Advisor Liaquat Ahamed reviewed Senator Amy Klobuchar’s new book, ANTITRUST: Taking on Monopoly Power From the Gilded Age to the Digital Age, for the New York Times. Liaquat’s book, Lords of Finance: The Bankers Who Broke the World, the story of four central bankers and the lead up to the Great Depression, won the Pulitzer Prize for history in 2010. Read his review of Sen. Klobuchar’s book here.
Team RockCreek

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