After a strong start to 2021 for global equity markets, as investors looked toward a post-Covid recovery, sentiment weakened sharply. This was down to fears that the pent-up demand and government’s large stimulus efforts would send inflation spiralling through the roof and lead to a rapid tightening of monetary policy.

Bond yields surged, usually a warning sign of an overheating economy, and in the spring, there was significant volatility in stocks.

It is not as if those fears were unfounded. In the US, inflation hit 5% in May, its highest level since 2008. And if you look at core inflation, stripping out food and energy prices, this hit a 29-year high.

Commodity prices remain elevated, while housebuilder Bellway (BWY) recently became just the latest company to reference rising input costs.

However, investors have largely taken these developments in their stride with US shares moving to fresh record levels and the FTSE 100 is heading back towards pre-Covid levels, while bond yields have subsided.

What is going on? Chief investment officer at asset manager Kingswood, Rupert Thompson, puts forward one possible theory. ‘The old investment adage “buy the rumour, sell the fact” may be part of the answer,’ he says.

‘Bond yields rose sharply early in the year on fears of the inflation spike now underway. Arguably, yields rose too far too fast and are now just correcting this overshoot. The only flaw here is that the surge in inflation is proving larger, not smaller, than expected.’

Ultimately the reason why inflation overshooting expectations is not causing more of a stir is that central bankers’ efforts to assuage fears that rising prices will inevitably lead to a rapid increase in interest rates are proving successful.

The US Federal Reserve has tied its decisions to the jobs market instead, suggesting this may be the more relevant metric when it comes to trying to guess the timing and trajectory of a tapering of stimulus and raising of rates.

However, the likes of the Federal Reserve and European Central Bank have predicated their relaxed attitude to inflationary pressures on them being ‘transitory’ so the longer high levels of inflation persist, the more likely the market’s current relaxed attitude will shift.

The level inflation settles at will also be important, as a relatively mild level of inflation might not be particularly bad news for equities.

As Thompson notes, shares do have an advantage over bonds when prices are rising. He says: ‘As long as it remains below 3% or so, equities have tended to fare reasonably well when inflation picks up. This is because firms can pass on cost increases into higher prices, allowing earnings growth to keep pace with inflation. The coupon payments on conventional bonds, by contrast, are fixed.’

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