Is the latest economic data starting to show a slowdown in economic growth in response to the spreading Delta variant? Data over recent weeks seems to support that view. First there was the drop in consumer confidence in the US and Europe, then the fall in US retail sales from June to July. Most recently, several of the flash Purchasing Manager Indices (PMIs) disappointed relative to expectations (see Exhibit 1).
As is often the case, however, one can interpret data in various ways. While it is true that five out of the eight PMI series came in below expectations (notably in the US), the absolute levels remain quite high. Bearing in mind that a PMI reading above 50 indicates expansion, the average across the four countries was 59.
Other indicators show at least a slowdown in the rate of economic recovery as Covid infections rise, though the pattern is better than was the case last winter. The more contagious Delta variant has certainly led to an increase in the weekly infection rate in the US and several large countries in Europe. Yet, in contrast to what occurred during the previous winter wave, activity has not fallen. That said, the recovery that had been underway has stalled (see Exhibit 2).
The comparative resilience of economic activity is likely due to governments being reluctant to re-impose restrictions and people having so far remained mobile, reflecting the conclusion of many that we need to learn to ‘live with’ the virus as opposed to hoping to eliminate it. (The apparent exception in Exhibit 2, France, reflects more the start of the August holiday period).
Economic growth expectations had already been falling since April, as the enthusiasm in the first quarter following Democratic victories in the Georgia Senate elections, the passage of another fiscal stimulus package, and proposals for more infrastructure spending to come, gave way to stubborn politics and an equally stubborn virus. The advent of the Delta variant served to reinforce this trend and explains why 10-year Treasuries yields have struggled to break the recent 1.20%-1.35% range they have been in recently.
The most likely catalyst for a breakout from this trend is the Fed, either via something that occurs during the upcoming Jackson Hole summit, or more likely, as a result of the Federal Open Market Committee meeting on 21-22 September. Next month, the Fed will release its economic forecasts, including the ‘dot plot’ that shows the committee members’ expectations for the future level of policy rates.
Bond yield movements will have impact on equity markets
Remember that it was the surprise forecast of a 50bp hike in the June release which caused the market to quickly reprice its expectations of the rate outlook. If the Fed were to show further increases predicted for 2024, rate expectations (and real rates) may jump again. The impact on nominal yields, though, could be mitigated by the implications for inflation. If the Fed is forecasting yet more hikes in policy rates, this could lead to lower market inflation expectations.
How the components of nominal bond yields ultimately move will have a meaningful impact on equity markets. Recall that during the reflation trades of the first quarter, there were two distinct periods during which the components of nominal yields moved differently, and so did equity markets. From late November 2020 until early February 2021, 10-year Treasury yields rose by 29bp, but this was driven largely by inflation expectations. Subsequently, from February until early March, yields rose by a further 47bp, but this time it was mostly real yields that increased.
In the first period, most equity indices (be it country, style, sector or size) rose. In the second, this was much less the case. The S&P 500 fell by 2.1%, and most growth-oriented indices declined. In contrast, value-oriented indices — such as Russell Value, energy, materials, financials, UK — gained. The reflation trade may be coming back, but the impact on equities will depend greatly on the composition of the increase in yields.
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