As we start a new trading week there are a few things to consider. Firstly, what does the Fed think about the sharp rise in Treasury yields after its meeting last week? 10-year Treasury yields are comfortably above 1.7%, and volatility in the sovereign debt market spilled into other markets post last week’s Fed meeting, for example, oil tumbled more than 7% at the end of last week, before eking back 2% on Friday. Inflation concerns and where treasury yields go next are key concerns for financial markets right now. Also, on our mind as we start a new week is how far will tech sell off, and what does the rise in Covid infections and the latest lockdowns announced for Italy, Germany and France, along with the potential for more widespread lockdowns in the EU, mean for the European economy. UK growth prospects could also be impacted later this week if leaders of the EU nations agree to halt exports of vaccines made in the EU when they meet for a European Summit on Thursday and Friday. This is a big week for markets, and we will help you to decipher what is important, and what is not.
Gauging inflation pressures
Looking at inflation first, there is a raft of price data coming out this week, which could add a dose of much-needed reality to the sovereign bond markets, who may have let inflationary fears run away with them. As we mentioned above, 10-year US Treasury yields surged at the end of last week, after the markets started to fear the Fed’s seemingly blasé attitude towards inflation. Fed chair Jerome Powell suggested that any inflationary impact from President Biden’s stimulus plan could be temporary and thus the Fed will look through spikes in inflation. This caused markets to rush to the worst-case scenario: what if inflation spikes to 3-4%, will the Fed then have to hike rates quickly, causing unemployment to soar and abruptly slamming the breaks on the US economy? This type of calamitous paranoia would be diagnosed as a mental health issue in a person, in a financial market (which is essentially the equivalent of millions of human neuroses) this is par for the course. Markets get ahead of themselves and then work themselves out. The 5-year, 5-year forward inflation expectation rate, as measured by the St Louis Fed, shows inflation expectations at 2.11%, which is down from the 2.14% reached in February. This may not seem too detached from reality, Afterall the Fed’s target is 2%, surely a 0.11% overshoot at some point in the future is exactly the kind of overshoot that the Fed is hoping for? Thus, the rise in inflation expectations over the past year does not mean that interest rates are going to go through the roof anytime soon, in our view. Added to this, 10-year Treasury yields are only 1.72%, they were above 3% in the summer of 2018. Thus, based on inflation expectations, Treasury yields are about where they should be, albeit there is the potential for a little more upside, and we could see a return to 2% by the end of Q2. However, this move in the bond market, when put in context, does not support a sharp selloff in oil or a dramatic switch from growth stocks (tech) to value stocks, which tend to be the less loved sectors of stock market.
Our three events to watch this week all revolve around important data that will help us to determine how strong the inflation impulse is right now, and how much spare capacity there is in the US economy. It will also help us to gauge the differing growth prospects for the countries with the highest vaccination rates vs. those with the lowest vaccination rates.
1. US data to watch: inflation and consumer confidence
The Fed’s preferred measure of inflation, core personal consumption index for February, is released on Friday at 1230 GMT. The annual rate is expected to come in at 1.5%, which is below the Fed’s target rate of 2%, and seems to suggest that US interest rates and asset purchases are safe where they are. Thus, will a reading of 1.5% be enough to assuage financial markets, causing Treasury yields to fall and US tech behemoths to reign supreme once more? We think that inflation hawks may rest a little if the data is in line with expectations, however, a weaker number than expected, a 1.3% or 1.4% could cause volatility to drop and some sectors of the market, tech stocks, to roar back to life. Weaker inflation equals more spare capacity in the US economy, thus a drop in the PCE rate for February may see consumer discretionary stocks suffer further after a fall at the end of last week.
The Michigan Consumer Sentiment Survey is also released on Friday, at 1400 GMT. The market expects a rise in this index to 83.5 from 83 in February. This is a timelier data point, thus watch for any sign that inflation expectations are shifting. If inflation expectations are rising, then this is a sign that the inflationary impulse is getting stronger in the US, and it could trigger another surge in Treasury yields. However, if respondents on lower incomes continue to report lower levels of confidence than their wealthier counterparts, this could knock the wind out of the consumer discretionary sector in the S&P 500 for a second week.
2. European economic woes
On Wednesday we get the preliminary reading of global Markit PMI’s for March. We will be watching the European figures closely. The manufacturing sector is expected to have held up well, at 57.9, however the service sector is expected to have fallen at the same time as there has been a large jump in the number of Covid cases across the major economies of the EU. The service sector PMI for March is expected to rise a touch to 46, however this is still well below the expansionary level of 50. Added to this, recent lockdowns in Germany and France could see even weaker growth for April, and potentially beyond if the 4-week lockdown in France is deemed to be ineffective at bringing down the infection rate.
The economic fallout from the EU’s slow vaccine rollout is in contrast to the UK. The faster vaccine rollout is most likely going to lead to a better economic performance in Q1 2021 and beyond. The UK PMI figures are also released on Wednesday, and the UK is expected to see 55 for manufacturing and rise back into expansionary territory for the service sector PMI to 51, which is not bad considering the UK is still in lockdown. Whether or not the EU will catch up with the UK in terms of vaccination rates, or if the EU will employ trade barriers to try and stop exports of vaccines going to the UK, and thus denting economic prospects for the UK in Q2, could well depend on the outcome of this week’s European summit, which will focus on the EU’s vaccine rollout. However, we believe that the UK’s head start is pretty much insurmountable, that trouble in the EU member states, and at a federal level will continue, and sadly, that the EU will continue to see a lower vaccination rate (partly due to EU mishandling, and partly due to vaccine hesitancy), which will weigh on the EU’s growth rate this year. Some economists now think that the EU will grow at 4% this year, we believe that the rate could be closer to 3%, which is likely to leave the euro at risk in the coming weeks. While the G10 is facing a stronger dollar, we think that further losses could be on the way for EUR/GBP, and a move back to 0.82 – the Feb 2020 low – could be on the cards.
3. Stocks to watch: Tesla or Volkswagen?
Tesla has had a pretty large sell off this year, although it stabilised on Friday, there are still concerns about the future for Tesla – large production delays, chunks of its revenue coming from selling on carbon credits, and decent competition finally coming from some of the world’s largest car markers. We still see Tesla being dogged by problems in the coming months, along with the issue of rising Treasury yields making its future profit forecasts, which are very generous, vulnerable to a higher discount rate. This is in contrast to solid, German carmaker Volkswagen. It may have finally put the emissions scandal behind it, and its pledge last week to double the percentage of electric vehicles that it will produce in 2030 to 70%, is impressive. The fact that Volkswagen has a much more efficient and timely production process compared to Tesla, along with more stable management, and an impressive array of car brands, could lead to Volkswagen’s share price rising further in the coming months. It is already above pre-Covid levels, but we think that this doesn’t fully price in the potential of Volkswagen’s ability to produce EVs and car batteries at scale, something that Tesla struggles with. Tesla is trading at a P/E ratio above 100, while VW has a P/E that is not yet at 30, thus from a value and a growth perspective the future look’s bright for VW.
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