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Investors eye labour market inflation risks

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Markets seem to like it hot. The US Federal Reserve is pumping out an additional $120bn a month to buy up financial assets. Congress has agreed a $1tn package of extra spending on infrastructure. The Democrats are hungry to pass an additional $3.5tn budget plan.

As a result, with all this money in the pipeline, this year has been a good one so far for investors in shares in general and US shares in particular. The world index is up by an impressive 17 per cent, led by the S&P 500, which has climbed 22 per cent.

Other major country indices have all underperformed the US and many also the world index. US shares which were already the dominant holdings in the global index are now 67.7 per cent of the total advanced-world market.

The year began with a good catch-up in older, more cyclical industries in anticipation of the recovery from pandemic closures and saw better performance from several parts of the world beyond the US.

The focus then rotated to better performance from the technology areas and the US market that dominated 2020’s good returns. I moved the FT fund more heavily into the World index, which is our biggest single share holding at 20 per cent of the fund, in anticipation of a global recovery. Blessed with hindsight, it would have done even better just to stay in the US. The half of the portfolio in bonds has done little given the low interest rates. The US short-duration inflation bonds that dominate have been mildly positive. As I expected an upturn in price rises, inflation bonds are 20 per cent of the total portfolio.

Why has the US continued to win? The country’s good performance last year was down to its heavy concentration in the technology success stories that received huge additional demand from the Covid-19 restrictions. Microsoft, Google, Apple and Amazon strode the world with their answers to lockdown life.

This year’s outperformance seems to be down to the greater degree of monetary and fiscal stimulus poured into the US economy by the central bank and the Federal budget compared with Europe, Japan and other larger developed economies.

Much of the extra cash created has been US dollars, and those dollars have found their way out of the bond market. As the Fed has bought up so many bonds, American investors have used the money to buy shares at home and whole companies abroad, as corporate America has gone on a buying spree for assets, not least UK companies.

The US remains the largest part of the economy of the advanced world. Its 330m people are more than the populations of the UK, France, Italy, South Korea, Spain and Canada combined, and more than Japan and Germany combined, the next two largest advanced countries. Its annual per capita income last year, clocked at $63,000 by the World Bank, is more than 50 per cent above that of the UK, France or Japan and 130 per cent above Spain’s.

Nonetheless the share of the US in the world stock index is even higher than the US share of advanced country income. Its shares tend to be better-rated reflecting their growth opportunities and more of the country’s economic success is reflected in its quoted companies. It all raises the question how much longer can the US stay in this dominant position and how much longer can it outperform the rest?

We used to look to the emerging world to offer longer term competition to America. As many rightly identified, China was going to become the main challenger.

With more than four times as many people as the US, China will have the larger economy once it reaches a quarter of the income per head of America. So far with many years of strong growth it has reached 17 per cent of US levels of per capita income.

But just as China is coming closer to overtaking the US in economic size, the country is turning inward. It is attacking its own entrepreneurs and freer thinkers and giving greater priority to enforcing uniformity and building the sinews of war at home.

Its stock market has been struggling for several years and has been hit more this year by the negative approach to business of the current Chinese leadership. The SSE Composite index is well down on its 2015 high and only 1 per cent up this year.

China is backing away from trying to match the US in the consumer digital services and is concentrating on alliances and trading partners among lower-income countries within its wider sphere of influence extended through its Belt and Road Initiative.

Some time ago I invested the fund in a Taiwanese index tracker fund rather than in a general Chinese ETF on fears of the direction China was taking and the portfolio has benefited.

The big question ahead is when will the US market run out of impetus? President Joe Biden’s reputation as a good friend of allies and a safe pair of hands has taken a bad knock with his unilateral decision to pull out of Afghanistan.

His economic policy is gaining critics, as he clearly intends to run the economy hot with a massive continuing monetary and fiscal expansion. If running the US economy hot allows too much inflation to build up, investors will become nervous. There is always the danger that the Fed will remove stimulus too abruptly in anticipation, or will be forced to remove it by market concerns it is out of control.

For the time being Jay Powell, the Fed chair, does what the president and treasury secretary Janet Yellen want, arguing that the current higher inflation will be temporary. He carries on creating those new dollars.

I am still running with the large positions in US and world shares while becoming more apprehensive the longer the bull market runs without a correction. Eyes will increasingly turn to inflation and the state of the labour market. If a temporary inflation leads to a wage surge as well the Fed will need to rein things in.

Sir John Redwood is chief global strategist for Charles Stanley. The FT Fund is a dummy portfolio intended to demonstrate how investors can use a wide range of ETFs to gain exposure to global stock markets while keeping down the costs of investing. john.redwood

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