Global Markets Overview: North America
by Elliot Sanders, Analyst at the York IFS Global Market Telegraph
It seems that every week the North American markets overview is discussing inflation. Some may wonder why inflation is so important to financial markets, what the fuss is about rising yields and why investors are so fixated on the actions and sentiment of the Federal Reserve. This article will go to some extent in explaining why inflationary fears are causing such volatility on Wall Street and the particular parts of the market to watch out for.
Theoretically, the relationship between inflation, yields on 10-year US Treasuries and interest rates is as follows. Inflation causes Treasury yields to rise as investors move out of Treasuries to protect real returns against inflation. Therefore, the price of US Treasuries falls and hence prices and yields are inversely related. Borrowing costs in many financial markets globally are benchmarked against US Treasury yields, so a rise in Treasury yields increases borrowing costs globally and not just in the US. As yields are strongly correlated to interest rates, rising yields will be followed by a rise in interest rates. A rise in interest rates should limit credit availability and deter inflation.
Inflation is definitely not unexpected. The speed of the vaccine rollout and the economic potential for the reopening of economies globally will naturally bring economic growth and intuitively inflation. Earlier this week the Federal Reserve increased their expectations for economic growth from the forecast in December 4.2% to 6.5%, while airline stocks globally have gained on average a fifth since the start of the year, a signal that investors are becoming more confident in a return to a ‘normal’ world that includes international travel. The quicker the economic rebound, theoretically the more inflation can be expected. But current inflation concerns really go beyond the economic rebound and vaccination rollout. The issue is stimulus. The COVID-19 pandemic has seen unprecedented levels of stimulus by the Federal Reserve, who have increased the money supply in the US to over 19,395 billion USD in January 2021. For comparison, the money supply in the US was under 16,000 billion USD at the start of 2020 and under 10,000 billion USD during the financial crisis of 2007/8.
Furthermore, the January 2021 figures do not include the recent $1.9 trillion stimulus deal under the Biden administration signed into law this week. The extent of stimulus by the Federal Reserve, particularly compared to other central banks, has contributed to the depreciation of the dollar throughout the latter half of 2020 and 2021. The depreciation of the US dollar coupled with large increases in the money supply has caused large increases in both current inflation and crucially inflation expectations, which are 2.2% by the end of 2021.
Finally, high inflation expectations have become fears on Wall Street due to the relaxed attitude of the Federal Reserve towards taming inflation. After the Federal Reserves’ two-day summit this week, Jay Powell reiterated that the Federal Reserve would not raise interest rates to combat inflation until there was full employment, or in other words the wider US economy was healthy again. This hands-off stance led to another sell-off in US Treasuries, pushing yields to 1.719, as investors fear that uncontrolled inflation will provide a threat to their real returns. That threat is a lot more real when inflation expectations for the end of 2021 exceed the inflation target of 2% set by the Federal Reserve, and Powell said he would not look to combat inflation until 2023. To summarise, inflation expectations are high on Wall Street due to unprecedented levels of stimulus by the Federal Reserve and expectations of a quick economic recovery. Investors are currently fearful of inflation due to the hands-off approach of the Federal Reserve and the subsequent threat to real returns.
In my last piece I wrote about the rising demand for inflation-hedges assets such as commodities as investors look to protect real returns. Another major trend has been the bearish nature of high-growth stocks. As borrowing costs in financial markets globally are benchmarked against US Treasuries, borrowing costs have been rising globally in accordance with Treasury yields. Higher financing costs are far from ideal for growth stocks that require a high level of financing for their growth. Without access to financing, the future earnings expectations of high-growth stocks are eroded which reduces the share price as the present value of future earnings is smaller. Furthermore, as borrowing costs rise, high-growth stocks are forced further into equity financing rather than debt, which puts investors at risk of dilution. Combined this makes high yield environments unfavourable for high growth stocks and many favourites of the pandemic. Tesla’s share price has fallen 7.2% for the year to date and Netflix 5.3%.
Another major trend on Wall Street has been the rise of blank cheque companies, also called special purpose acquisition companies (SPACs). So far in 2021 blank cheque companies have raised more than $79.4 billion through 264 SPAC launches already eclipsing the $79.3 billion raised in 2020 through 256 SPAC launches. The rise in popularity of SPACs in 2020 was in part due to the record low-interest rate environment, which attracted investors looking for a higher return, but also the appeal to growth stocks of using a quick public listing to take advantage of inflated equity valuations for equity financing. However, an inflationary environment and the potential for higher interest rates has increased bearish sentiment against SPACs. The defiance Next Gen SPAC Derived ETF, an ETF which tracks blank-cheque companies, has dropped more than 14% since February and short bets against SPACs have tripled to $2.8 billion.
This article was first published in the University of York Investment and Finance Society's Global Market Telegraph (GMT) Edition 4 in late March 2021.
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