Market Update - May 2021
1. The overall market picture remained relatively unchanged in May, although stock markets did display some volatility in the middle of the month after inflation figures were higher than expected.
2. Much of the answer to whether these price pressures are brief or something more lasting depends on whether the economy believes it to be temporary or not. For now, both market and consumer measures of expected inflation suggest they are leaning toward the temporary rise scenario.
3. Abundant liquidity and rising inflationary fears are a breeding ground for cryptocurrencies, but that hasn't stopped these digital assets from plunging in recent weeks. For pessimists, this marks the beginning of the end. For optimists, it's just another day at the office. For us, it is mostly a demonstration that the volatility of cryptocurrencies is significantly too high to justify a material weight in a portfolio that is subject to reasonable risk constraints. In addition, the claim that Bitcoin provides diversification from traditional risky assets isn’t so clear anymore, unlike its distant cousin already aged by a few millennia: gold.
4. Turning to traditional currencies, the Loonie has shown a lot of strength recently, but a look at its key drivers suggests that it may be nearing its final destination.
5. Going forward, the key element to watch will be the evolution of the Federal Reserve guidance in tandem with the labour market recovery.
The overall market picture remained relatively unchanged in May where equities with greater cyclical exposure posted gains, growth stocks posted small losses, and bonds treaded water.
Nonetheless, stock markets did exhibit some volatility in the middle of the month. It was nothing particularly dramatic for the S&P 500 (USA), which has not experienced a decline of more than 5% in 7 months now, but still noteworthy for high-flying indices such as the Nasdaq (heavy in technology names) and the Russell 2000 (U.S. small-cap), which nearly reached the 10% correction threshold.
We’ve mentioned for months now that inflation was likely to prove uncomfortable for markets at times. This is indeed what happened in May after Consumer Price Index (CPI) figures turned out to be significantly higher than expected just as economic surprises were registering their lowest level in over a year. Such a divergence between inflationary and economic surprises has rarely been observed in the last 14 years—a period almost exclusively characterized by downward surprises for prices. Is this the beginning of a new era for inflation?
The process of “reopening” an economy after more than a year of restrictions and generous government handouts is inevitably putting upwards pressure on prices. This is exactly what we see when we examine the details of the latest core CPI inflation figures. Just over half of the monthly increase comes from exceptional jumps in prices of tourism-related categories (airfares, lodging away from home) and used cars and trucks (due to the shortage of semi-conductors affecting the supply of new vehicles)
It is reasonable to assume that price increases in these three sub-sectors are mostly temporary adjustments. Regardless, the next few months are likely to see other bottlenecks emerge, occasionally generating other "abnormal" price jumps whose timing and magnitude are hardly predictable, and sometimes even anecdotal (e.g.: hockey tickets for game 6 of the Canadiens vs. Leafs in Montreal were said to be selling for upwards of $12,000!).
The most important inflation metrics to monitor may not be those that give us a reading on the past, such as CPI reports, but rather those that reflect our own expectations for the future. The reason is simple. If a majority of consumers are confident that long-term inflation will remain stable, any abnormal rise in prices should incline people to delay their purchases (when possible) until prices stabilize. Conversely, if a majority believes that prices are bound to continue to rise significantly faster, we are likely to see a self-reinforcing dynamic where consumers accelerate their purchases, businesses raise prices to preserve their profit margins, and workers demand higher wages to protect their purchasing power.
For now, both market and consumer measures of expected inflation suggest they are leaning toward the temporary rise scenario as the rate expected beyond the next year remains consistent with the Federal Reserve's long-term inflation target.
For this to remain the case, the U.S. Central Bank must ensure its credibility remains intact. The focus now is to ensure a complete recovery in the labour market without too much regard for inflationary pressures in the short term. Like any policy, this approach is not risk-free, especially in a context where, although the employment rate remains low, demand for labour is at an all-time high.
This "anomaly" should be remedied in part by the expiry of government support measures and the gradual recovery of the service sector, assuming that the pandemic continues to fade. How much wages will have to adjust remains to be seen, but for now, their growth also remains contained.
A backdrop of abundant liquidity and near-zero interest rates not only raises inflationary fears, it also fosters demand for assets perceived as providing protection against a potential devaluation of "traditional" currencies. Such is the case with cryptocurrencies, whose explosive gains since the beginning of the year are catching the attention of an increasing number of investors.
However, it was actually for its sharp fall that cryptocurrencies’ poster child, Bitcoin, made headlines last month after Elon Musk announced his company no longer planned to accept payments in Bitcoin, citing environmental reasons, while China signalled increased oversight of the relatively new class of digital assets.
For the pessimists, this marks the beginning of the end for the asset whose real utility remains nebulous. For the optimists, it's just another day at the office for the cryptocurrency which has already undergone 3 episodes of 80% drawdowns in its 10-year history.
For us, it is mostly a demonstration that the volatility of cryptocurrencies (about 22x that of bonds, 12x that of traditional currencies such as the USD, and 6x that of commodities/stocks), is significantly too high to justify a material weight in a portfolio that is subject to reasonable risk constraints. Moreover, the argument that Bitcoin provides diversification from traditional risky assets isn’t so clear anymore. Case in point: its correlation with the global stock market has increased significantly in the past year, unlike its distant cousin already aged by a few millennia: gold.
After a challenging start to the year, gold prices have rebounded by 10% over the past two months, supported by the Federal Reserve's commitment to maintain accommodative monetary conditions until the economy finds its balance.
We continue to hold a positive view of the precious metal, not in the perspective of hitting a home run, but for its diversification properties in a market environment where a strong recovery in global growth combined with accommodative monetary policies could continue to cause inflationary pressure and downward pressure on the U.S. dollar.
The U.S. dollar decline in recent months has been particularly evident against the Canadian dollar (down 1.9% in May and 5.5% so far in 2021). Should we expect the Loonie to continue to gain altitude at this rate?
A look at the primary driver of the CAD vs. the USD—the spread between our respective interest rates—tells us two things. First, the recent rise in the Loonie looks like a catch-up since the interest rate differential between Canada and the U.S. narrowed at the end of 2019. Second, this process appears to be nearing its final destination, assuming that the Bank of Canada will avoid going its own way by raising rates significantly above that of its neighbour to the south.
Overall, our base-case scenario assuming:
(1) a sharp recovery in economic activity driven by a significant reduction in the constraints imposed by the pandemic, (2) strong upward pressure on prices, and (3) the maintenance of an accommodative stance by major central banks, continues to bear out.
As the summer progresses and some form of normalcy sets in, economic data will likely continue to produce surprises given that there is simply no precedent in modern history to provide meaningful insight to a post-pandemic world. Nonetheless, the volatility that followed the announcement of high inflation figures last month has already somewhat tempered the market's optimistic sentiment suggesting a more limited downside risk for stocks.
As always, please feel free to reach out to any of our team members if you have questions about your individual portfolio.
Current Mortgage Rates Update:
5 - year fixed: 2.19%
4 - year fixed: 1.99%
3 - year fixed: 1.84%
2 - year fixed: 2.04%
1 - year fixed: 2.49%
5-year variable: Prime—1.15% (effectively 1.30% right now)
Rates are as of today with 90-day rate guarantee; based on $500,000 mortgage; 25 year amortization; owner-occupied; 80% loan-to-value;
Disclaimer: These rates are for information only and are not guaranteed until an application has been submitted to the bank. Rates are subject to change at any time without notice.
Have a great start to the summer!
-The Creed Capital Management Team