July Market Update
Strong returns were generated by diversified portfolios during FY2021 as equity markets rebounded after the COVID shock of March 2020, with the Dow Jones up 33%, the NASDAQ 44% and the ASX 200 at 24%. Monetary and fiscal stimulus reached eye watering levels with more than USD 20 trillion pumped into the system during 2020, with economists suggesting global debt having now expanded to USD 280 trillion or 365% of global GDP. This is quite a remarkable outcome considering the range of market views circulating during Q2 2020.
Source: Yahoo Finance – Dow Jones v NASDAQ v ASX 200 – 12 months
Unfortunately, our economic and social world now seems to be controlled by COVID-19. By June 2021 23.5% of the world population has received at least one dose of COVD-19 vaccine, with 40 million being administered daily, but the jury remains out if this allows the return to normality, as we knew it. Australia has been put into the slow lane for supply of vaccines, which may reflect the lack of urgency relative to global needs. So, as we see it, significant advancement has been made during the last year. Vaccines are being rolled out, markets are steaming ahead, interest rates remain close to historical lows and global growth forecasts remain strong. On the geo-political front a few issues are developing from the closed economies of Russia and China, while the Trump era chaos in the United States and elsewhere such as the Middle East have subsided. The chart below highlights the vaccine achievements of several zones and the delay for Australia. We still do not know if vaccines will be the panacea, however, the history of the Spanish Flu would suggest we are likely to need to learn how to live with this virus.
The degree of uncertainty remains high for investment markets, with high equity and fixed interest valuations, as the world transitions through this most abnormal period. The OECD considers the outlook to be brightening, albeit uneven across countries, and consider cost pressures to be temporary, although market views on the latter vary considerably.
While equity markets continue in an unabated rally, it would be more comforting if a degree of consolidation were to appear. We have discussed the apparent stretched valuations below and there are strong arguments that under current conditions the apparent high valuations are justified, although sentiment or a black swan event can affect that at any time. Interest rates do appear to have found a base level, while the curve shape is in question, and market forces are competing with government debt funding preferences. The obvious wild card in our minds is inflation. Is the current increase in inflation transitory or a medium-term reality? Depending on the outcome this will significantly influence equity and interest rate prices. We remain of the view to focus on risk management and to develop resilient portfolios of quality assets.
GDP and economic output
The OECD revised GDP growth projections upwards in May 2021, expecting global economic growth to be 5.8% this year, a sharp upwards revision from the December 2020 projection of 4.2% for 2021. The vaccine rollout and fiscal stimulus has driven this improvement. The forecast global growth reduces to 4.4% for 2022 which is USD 3 trillion less than was forecast for 2022 before the crisis hit. Interestingly, the entire French economy is apparently about USD 3 trillion.
Australian real GDP growth was -2.5% for 2020, and the projection for 2021 is 5.1% and, 3.4% during 2022. China, our largest trading partner achieved 2.3% growth during 2020 and the projection for 2021 is 8.5% and 2022 is 5.8%. While these figures are off a low base, they remain very encouraging.
Monetary and fiscal policy
Global monetary and fiscal stimulus are at levels never seen before. It seems that the OECD was the pivotal organisation that formulated the synchronised global policy response. The OECD have suggested governments avoid removing stimulus too early and focus on structural reforms, which generally should continue to support equities. The chart below shows the movement of total assets of several key central banks, which provides an observation window of the global stimulus provided. Australia has dialled back Job Keeper and Job Seeker support, but other countries have maintained support to individuals due to continued lockdowns. Let’s hope a generational change to work ethics does not develop. The persistent unanswered questions are; how will governments successfully unwind the debt expansion, and how can they possibly fund the interest cost at current or higher levels?
The wildcard in the system is the outlook for inflation. Many have painful memories of the late 70’s and early 80’s when high inflation crippled the economy. That was a period when inflation was in the high teens. The current thoughts are that high inflation would be in the range of 4% to 5%. Central banks, the infusion of technology into industry and cheap goods from Asia have flattened inflation to below optimal levels of the central banks 2% target. Textbooks will tell you that monetary supply expansion, wage expansion and supply constraints will lead to increased inflation. We currently have all three factors in play, but the big question is, will it be transitory or will it be embedded for the longer term. Considering the central banks have struggled to fire the economy back to optimal levels of inflation, at what level is inflation a problem for the economy. There is no doubt that we can all see inflation in the street today, and that is spooking markets.
The monetary supply expansion has been somewhat of an experiment. During the GFC it was to save the banking system, and now during the pandemic it is to save lives and extreme poverty.
The effect of the massive expansion of global debt and money supply, while the objective is to generate (or save) economic activity, it can suppress economic growth, without which demand cannot rise enough to generate inflation to push up interest rates over the medium term. Think of a rock being dropped into a swimming pool versus the ocean. These concepts become quite complex, and the outcome can be hard to define, however, suffice to say that deflation or disinflation is also possible. The other key longer-term influence is technology continuing to improve efficiencies and driving prices down.
The chart above shows an interesting correlation between PE’s and inflation. When inflation rates are between 1%-3% PE’s can be justified between say 10x and 45x. The Shiller PE is the annual earnings of the S&P 500 over the previous 10 years, adjusted for inflation, which is quite different to today’s forward looking PE ratios. However, it does provide a form of a guide when considering the current high PE ratios, current levels of inflation and perceived high equity valuations. If inflation were to rise for the medium term, then equity markets would likely turn down quickly. This is what spooked the markets in February, however by May/June they were not so convinced. We are not currently convinced high levels of inflation will be a medium-term influence, however, we strongly believe that forms of inflation hedging in portfolios is prudent. We need to watch the inflation space!
Equity markets have produced significant returns during the last year. The Dow Jones +33%, NASDAQ +44% and ASX 200 +24%. These are serious returns, but from low levels post-COVID. The mixed reactions from key and respected financial markets participants during Q2 2020 were voiced across the full range of possibilities for equity markets. The stimulus effect soon became obvious to most and the markets took off. In the simplest terms, equity valuations are often a direct correlation to interest rate levels compared to dividends, and therefore relative earnings has driven equity prices. Early in 2021, as interest rates turned upwards, and the longer duration growth stocks fell while value stocks rotated into favour, after being unloved for several years.
The chart above (DJ – dark blue; NASDAQ – light blue; 12-month period) shows the NASDAQ stall during early 2021 and more recently developing a dominant growth pattern again during May and June. The big money will influence the outcome.
The chart below highlights the outperformance of the US markets, represented by the S&P 500, compared to Australia, with the performance of the MSCI slightly ahead of Australia during the last year.
As quarterly inflation numbers increased during February 2021, the interest rate markets became spooked and sold off to slightly over 1.8% for the US 10-year Treasury Bond (see the chart below). As we have discussed above, at this stage the market is not convinced about the long-term shift in inflation rates and more recently the long-dated US 10-year Treasury Bond has now settled to under 1.5%. There are two significant forces influencing the interest rate market, the market, and the central banks/governments. Both are significant players and therefore the likely outcome is uncertain, at this stage.
Source: Macrotrends – US 10YR Treasury (last 5 years)
The yield curve has steepened during the last year (see chart below) albeit it has flattened slightly since the bond market sell-off in February. Economic activity, inflation outlook, investment banks and dominant central banks will influence the curve shape.
A steeper curve does indicate a healthy economy, but the question remains if central banks prefer a flatter curve to reduce the interest cost to government and industry or if inflation fears drive a steeper curve. We also note from the chart above that those borrowing costs remain well below the levels of 2018 and 2019 which is positive for company earnings, however, this is not so good for retirees and others relying on intertest rate earnings. The current curve shape also provides for positive returns to be generated from longer duration bond portfolios, as holding maturities shorten and provide capital gains from the carry and role trade.
The chart below shows the impact of monetary policy on US and ECB central bank assets and bond rates.
The issues between China and much of the world continue to negatively escalate. The US and Australia have been the more obvious impacts but now the G7 is voicing an opinion on the influence of China. Australia is front and centre with regards to the magnitude of problems caused by arguing with its largest trading partner (see chart below). Several industries have seen pointed tariffs invoked, while our largest, being iron ore, has yet to be impacted, however, it seems that Chinese funded African projects are on the way to development.
The press is full of commentary, with one recent article suggesting we need to ‘get used to China’. The moves with regards to Hong Kong and Taiwan are a concern when we look back on history. As for industries that export to China, Business 101 would suggest diversifying the customer base was how it should have been from the start, and now seems to be a much bigger focus.
Domestic house prices and debt
An area that could provide a degree of stress in Australia is domestic debt. Note in the charts below show the surge in house prices and debt during 2020/2021. If interest rates were to rise significantly, we would expect this will be uncomfortable for new owners and recent borrowers.
The AUD had been trending higher until the Federal Reserve indicated rates could rise and stopped the fall of the USD, impacting the AUD. Is this a turning point for the AUD will the strength return? The long-term average is 76 cents.
Source: Macrotrends – AUD over 5 years
Global tax rate
Wow, it is really starting to happen. 130 countries and jurisdictions have recently agreed to a minimum corporate tax rate of 15%, before loopholes. There is a long way to go to finalise the details, however, this is much more significant than the Panama Papers or anti-money laundering and terrorism funding laws. The OECD has estimated as much as USD 150 billion a year in extra global tax revenue, previously lost because of tax avoidance by international companies. The larger tech companies will be the likely losers, while governments will receive extra revenue to help pay for the pandemic funding. The OECD was the central organisation aligned to the pandemic funding package. It is also suggested that Australia will be a winner, as it will have more taxing rights targeting digital commerce.
Responsible investing has been around for many years, however, a tectonic shift with investment thinking seemed to occur about 3 or 4 years ago, and the COVID-19 pandemic year has sealed the rise in this demand. There are many forms of responsible investing which focus on process and impact. The approach and acceptance of responsible investing is new and developing, it is complex, lacks transparency and consistency, and is subject to green washing. We have done a lot of work in this area and feel a ‘balanced approach’ is preferred as the sector matures.
Equity markets are likely to continue to remain firm, however, risks increase as prices increase. Black swan risks remain at an elevated level. Long duration bonds do not offer the same degree of insurance when rates were at higher levels. We maintain a view to trim some equity risk and shift it into lower volatility sectors such as infrastructure and alternatives, while maintaining the equity like exposure. We also feel that the inclusion of inflation hedges is prudent while the inflation risk is to the upside. To lock down the risk and uncertainty in fixed interest by shifting some holdings to shorter duration and maintain quality.
We consider that exposure to equity upside should be maintained, while being conscious to limit downside risks. Although this may seem to be wishful thinking, it is a sensible starting objective to consider in these times.
Quality (balance sheet and cashflow) and liquidity are the key attributes required for equity and fixed interest assets, and in turn investors should look to develop resilient portfolios for the longer term.
Index Returns – 30 June 2021
|Sector Returns (%)||FYTD||1-month||3-month||6-month||1 year||3 years||5 years|
|International Shares (unhedged)||27.50||4.71||9.33||16.30||27.50||15.80||14.50|
|International Shares (hedged)||35.80||2.40||7.56||14.20||35.80||17.27||13.50|
|Listed Property (ASX)||33.20||5.54||10.50||9.94||33.20||2.38||7.74|
|Global Property (hedged)||30.20||1.76||9.03||17.00||30.20||3.56||4.93|
|Global listed infrastructure (hedged)||18.10||-0.14||2.02||6.38||18.10||-0.13||4.24|
|International Bonds (hedged)||-0.17||0.49||0.94||-1.61||-0.17||2.47||4.03|
|CRB Commodity Index USD||54.70||3.74||15.40||27.20||54.70||8.57||2.12|
|Aust CPI (at previous quarter)||3.46||0.20||0.38||0.98||3.46||1.54||1.55|
Source: Lonsec, Bloomberg
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