Rarely does the release of an inflation report capture as much attention as it did last week. For a few weeks investors have been on tenterhooks about the risk of rising inflation changing the course of monetary policy around the world. Well last week’s April inflation report from the US wouldn’t have helped their mood as headline inflation accelerated to 4.2% in April, the highest since 2008 (see our Chart of the Week).
Base effects (comparing prices in April 2021 with April 2020) are having an impact here – oil for example (a key component in the inflation basket) has nearly doubled over the last year. This has pushed headline inflation around the world sharply higher of late, prompting many central bankers to stress that they will be patient with their monetary policies as they believe the current price rises are “transitory”.
However, when we look at inflation rates excluding oil (so called ‘core’ inflation rates), they have also picked up of late so it could be that price gains in the economy are broadening. If that proves to be the case and central bankers have to react, equity and bond markets could face more bouts of short term turbulence similar to last week.
The theme of accelerating inflation was also visible in April Chinese Producer Price Inflation (prices at the factory gate) which hit a near three year high in April. This is important for the rest of the world insofar as China is the manufacturing capital of the world economy. If prices are rising there, it is likely that manufacturers will try to pass them onto consumers, potentially keeping the price rises coming for consumers.
Historically equity markets have shown they can perform reasonably well in moderately inflationary environments. But during episodes where prices move sharply higher and stay there, such as the 1970s, equity markets can struggle. Therefore it wasn’t hugely surprising that the US inflation data noted earlier spooked stock markets, especially considering how central low inflation and interest rates have been to equity market performance in the past few years. The technology sector bore the biggest brunt of declines last week but in truth most markets suffered declines. Japanese equities were also particularly weak with a rapid rise in COVID case numbers there adding to the downbeat sentiment elsewhere.
As with the equity market, bonds also took some pain given that the income generally paid to bond investors is fixed and is therefore prone to being eaten into by rising inflation. Even inflation linked bonds (bonds that compensate investors for inflation) weren’t spared in the selloff although this sector has been one of the better performers in the bond space so far this year.
Commodities tend to be positively correlated to inflation rates so they performed relatively well last week compared to other risk asset classes like equities. Despite this, some commodities weren’t immune from the weak backdrop in other markets with oil and silver in particular giving back some of their recent gains.