Milton Friedman misled the current generation of economists into believing that inflation was “always and everywhere a monetary phenomenon”. But correlation is not causation. And outside this charmed circle of policymakers, most people know it is normally due to a shortage of supply, or an excess of demand.
Oil
Increased tension in the Middle East allowed Brent to close up 55c/bbl at $68.83/bbl.
✦ HIGHLIGHTS
- These prices are easily enough to encourage new production, and the US rig count is now up 31% from the beginning of the year – more than double August’s low point
- There remains plenty more capacity to brought online as profits increase. The rig count was 677 in 2019, at similar prices, but just 352 today
- Over-optimism has been a market feature over the past year, and then followed by a return to reality
- Demand issues are now starting to take centre stage. The IEA has already cut its 2021 forecast by 270kbd
- Given the slow removal of lockdowns, and the growing crisis in India (the world’s second largest importer), further downward revisions seem likely.
- Air travel remains badly affected – US passenger numbers are down 40% on 2019 levels and European flight numbers are down 63%
WATCH FOR
WATCH FORA gradual realisation that talk of a “commodity super cycle” is just an effort by brokers to generate trading volume.
S&P 500
Last week’s bad jobs report was followed by bad inflation data this week, with the S&P ending down 1.4% at 4174, after 4057 on Wednesday. The VIX volatility index hit a high of 29, but ended virtually unchanged at 19.
✦ HIGHLIGHTS
- This week’s market “shock” came on Wednesday, with US April inflation of 4.2%
- It again raised questions over the logic of the Fed’s “lower for longer” rate policy
- Tech bubble-stocks continued to weaken, as valuations were further pressured by rising interest rates
- Increased market nervousness led to last-minute IPO postponements during the week
- Friday’s US retail sales data also disappointed: they were flat month-on-month, versus consensus expectations of at least 1%
WATCH FOR
Market nervousness to increase further as Covid variants threaten recovery assumptions
Interest rates
The 10-year rate ended the week up at 1.64% (from 1.58%), having closed at 1.70% on Wednesday, after April’s inflation data. The MOVE volatility index rose just 1 point to 55.
✦ HIGHLIGHTS
- Analysts tried to blame “one-offs” in the April report, e.g. semiconductors, as drivers for highest 12-mth rate since 2008
- But the European Central Bank sees “upside risk” to inflation and economic activity, bringing longevity of Euro-QE into question
- Recent price falls mean that all European sovereign 10-yr rates are now positive, except German Bunds (which have risen to -0.1%)
- In junk bonds, Cathay Pacific saw good demand for $650m bonds, due in 2026, priced at 4.875% (vs 5.2% expectation). Yet it needed a $5bn bail-out last June from the HK government and key shareholders
- Airline bond issuance YTD is a remarkable $14bn, led by American’s $10bn in March.
- Gold continued to rally, closing at $1843 versus its early-March low of $1675
WATCH FOR
- Inflation narrative to be the key determinant of bond yields for the next several weeks
Inflation
As we noted last month, “the rise in China’s Producer Price Index is now starting to roll through into Western Consumer Price Indices”.
✦ HIGHLIGHTS
- Policymakers have been baffled for years as to why their dramatic increase in the money supply has not fed through into inflation
- Now, a major rise is finally underway – and markets are struggling to understand it
- The Friedman myth around monetary policy is blinding them to the obvious cause – the ongoing rise in China’s PPI, as supply chain chaos results in product shortages
- China is still the manufacturing capital of the world, so its PPI increases must inevitably feed through into Western CPI
- China’s April data showed a further jump to 6.8%, so US CPI will likely rise over 5% in the summer, putting major upward pressure on the benchmark 10-year yield
WATCH FOR
Markets continuing to struggle to understand the inflation data, given their focus on theory rather than supply/demand reality
Summary
Last week saw some investors starting to worry about the reality behind the hype that has dominated financial markets. But most are still (wrongly in our view) assuming the Fed will never let markets fall.
Oil
S&P 500
Interest rates
Market view today
Some concerns
All news is good news
Expecting modest inflation
Our current view
Negative
Reversion to mean inevitable
Expect long-term deflation
Positioning began
March 2021
March 2021
December 2020
Confidence level
Initial
Today
.
.
.
Relevant positioning
Reality starting to dawn
Waiting for reality to dawn
Expecting higher rates for the 10-year and longer-dated Treasuries
Confidence level: 
= 100%, = 75%, = 50%, 
= 25%
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