Investment markets and key developments over the past week
Global share markets fell over the last week as the selloff in bonds accelerated raising concerns about valuations. Bond yields increased significantly, particularly in the US and Australia and 10 year yields at their highs on Friday were up by around 100 basis points in the US from last year’s low and by around 130 basis points in Australia, before settling back a bit helped in Australia by aggressive RBA bond buying to defend its 0.1% 3 year bond yield target. The rise in bond yields and falls in global shares weighed on the Australian share market with IT, telco, retail and health care stocks seeing the biggest falls. Oil, metal and iron ore prices rose over the week which helped briefly push the $A to a three year high at $US0.80 before it fell back with share markets. Bitcoin suffered another sharp correction as it increasingly resembles a cult at the mercy of comments from various gurus.
The spike in bond yields is providing an increasing challenge for central banks, including the RBA. Rising bond yields are normal in an economic recovery as investors move away from defensive assets and anticipate stronger nominal growth. This has been accentuated by recent good news on coronavirus combined with the ongoing boost provided by policy stimulus (with more on the way in the US) and anticipation of a short term spike in inflation due to base effects, higher energy prices, etc. The problem for central banks like the RBA is that they have seen this all before and worry that without a much tighter labour market and faster wages growth then the anticipated near term pick-up in inflation won’t be sustained and so they will continue to undershoot their inflation goals if they raises rates too early or end bond buying prematurely as the bond markets is implying will be warranted. In otherwords, central banks worry that the bond market may be jumping at shadows – at least in part – and if they follow bond markets into premature tightening they will be too! So at this stage we see the Fed and RBA sitting tight.
Fed Chair Powell indicated last week that while the medium term outlook is improving, the US economy is still a long way from the Fed’s goals, getting there will take time and the Fed is nowhere near close to pulling back support. A similar message is likely from the RBA in the week ahead. If anything, the RBA is likely to continue to step up its bond buying to defend its 3-year bond yield target. Interestingly, in the US, the Senate Parliamentarian ruled that the Biden Administrations’ $15 minimum wage hike is ineligible to pass as part of a reconciliation bill. The minimum wage may still rise, but it will need to be much smaller to pass Congress, which in turn removes what some may have seen as an inflationary threat.
Bond yields could still go higher in the short term though, as bond selling begets more bond selling, possibly taking Australian 10 year bond yields through 2%, before it perhaps settles down through a combination of central bank bond buying and the realisation that underlying inflation is not taking off. The longer this continues, the greater the risk of a more severe correction in share markets, particularly if earnings upgrades struggle to keep up with the rise in bond yields. That said, it’s worth noting that so far the backup in bond yields is mainly contributing to an ongoing rotation in share markets away from last year’s winners, like technology stocks, to cyclical shares like financials and resources, that will benefit from stronger economic conditions. Looking beyond near-term bond driven uncertainties, the big-picture backdrop of still-low underlying inflation and spare capacity in job markets, combined with economic and profit recovery and low interest rates, is a positive one for growth assets, particularly shares (including in Australia).
Australia is unlikely to follow New Zealand (NZ) in requiring the RBA to “have regard to government policy on housing in relation to its financial policy functions.” The move to require the Royal Bank of New Zealand (RBNZ) to do so saw a knee jerk 18 basis points spike in NZ 10 year bond yields, with Australian 10 year bond yields spiking 12 basis points in sympathy, on the grounds that the move could bring forward a rate hike in NZ and maybe the same could happen in Australia. It however seems more likely that the RBNZ would go more heavily down the path of tougher lending standards to control house prices rather than hike rates, if it felt that such a move was not warranted by the broader economy. At this stage, it’s hard to see the Australian Government requiring the same of the RBA. Further, while the Australian housing market is hotting up, capital city house price growth (at around 2% year-on-year) in Australia is well below that in NZ (where it’s near 20% year-on-year) and housing credit growth in Australia (see the next chart) is still relatively subdued - although it’s likely to accelerate, which is likely to push the RBA into tighter lending standards too – but likely not till next year.
What now for the $A? Our expectation has been that the $A was on its way to $US0.80 this year and it briefly went through it on Thursday night. Its been a classic reflation trade with the $A up on higher commodity prices as the defensive $US falls. Right now, the $A is overbought and there is a bit of technical resistance around $US0.80 as we saw in 2017 and 2018 so it could see a bit of a short-term pause. But as long as the global recovery continues and commodity prices keep pushing higher as we expect then the $A is likely to see more upside and so we are raising our year end forecast to $US0.85.
The downtrend in new global coronavirus cases stalled over the last week due largely to a slight increase in cases in Europe and a stalling in the decline in the US and Canada.
Vaccine news remains positive. Various studies out of the UK and Israel confirm that the vaccines (with most results around the Pfizer vaccine) are highly effective in reducing infection, hospitalisation and deaths and in preventing transmission from vaccinated people. And this is even after a single dose. Vaccine supply is also starting to ramp up. More than half of Israel’s population has now received one dose of vaccine, 27% in the UK and 14% in the US. Consistent with this Israel is now seeing a sharp decline in new cases. Europe is lagging but likely to start speeding up as vaccine production accelerates. Our view remains that the US will reach herd immunity around mid-year, most developed countries including Australia will reach it by the December quarter with most emerging countries in the first half next year.
New coronavirus cases remain very low in Australia. Vaccination is starting up, but at 0.1% of the population is too low to include in the above chart.
Our Australian Economic Activity Tracker dipped a bit further over the last week largely reflecting Victoria’s snap lockdown, but it remains relatively strong and is likely to resume its upswing as the lockdown is over and restrictions are being further eased. Our US Economic Activity Tracker surprisingly fell and our European Economic Activity Tracker rose slightly again over the last week but remains very weak.
One of the best bits in the 2019 film Yesterday was when the Himesh Patel character, Jack Malik, “comes up” with Something on the James Corden show. Unfortunately it never made the final cut of the film because a subplot involving a whole character was removed from the film but it was in the trailer and I thought it was super clever and waited in anticipation through the whole film to see it but to no avail! Anyway Something is one of the best songs ever with George Harrison performing it brilliantly in Japan in 1991 and Elvis taking it beautifully over the top in Hawaii in 1973.
Major global economic events and implications
US data was mostly robust, with strong gains in personal spending, new home sales, house prices and durable goods orders, and a rise in consumer confidence and a fall in initial jobless claims. Personal income rose 10% in January on the back of the $600 stimulus checks and spending rose 2.5%, but the saving rate surged again to 20.5%, pointing to strong spending ahead. Pending home sales fell though and new mortgage applications have turned down, possibly reflecting the impact of higher mortgage rates. Core personal consumption inflation rose to 1.5% year-on-year but excluding a rise in Medicare payments was very weak, at just 0.07% month-on-month. Base effects will see it rise above 2% year-on-year in the months ahead.
Eurozone economic confidence and the German IFO rose.
Japanese industrial production rose strongly in January, but core inflation in Tokyo for February remained soft, at 0.2% year-on-year.
Australian economic events and implications
Australian economic data came in a bit mixed. Business investment rose a strong 3%qoq in the December quarter but non-residential building and engineering remained soft and capex plans for the next financial year provided a confused picture with one interpretation pointing to a slight fall but another approach pointing to a 10% or so rise led by a 20% rise in mining investment. Given the government’s instant asset write off, solid business conditions and high commodity prices we lean to the latter. Wages growth was stronger than expected in the December quarter at 0.6%qoq but this looks to largely reflect the reversal of short term pay cuts for some workers and if this is allowed for then underlying wages growth remained weak at 0.3%qoq. Still high levels of labour market underutilisation are expected to keep wages growth soft. Finally, credit growth remained subdued in January with housing credit growth running at just 3.6%yoy as new lending is offset by the rapid paydown of existing mortgages. Expect credit growth to pick up in the year ahead though.
Tax Office data showed a further reduction in the number of workers on JobKeeper from 1.5 million in December to 960,000 in January. So this means that around 2.7 million jobs have now left JobKeeper protection since September last year. But thanks to economic recovery unemployment has gone down (from 6.9% to 6.4%), not up. A collapse in the number of workers on zero hours which is a proxy for jobs needing JobKeeper protection along with the likelihood of continuing economic recovery also adds to confidence that the ending of JobKeeper at the end of March won’t cause a big spike in unemployment. Our expectation is that it will cause a small rise in unemployment to 6.7% before the declining trend resumes.
The drop in unemployment benefit payments to around $44 a day from April 1 from around $51 a day will be tough for those on JobSeeker, but at a macro level its only equivalent to around 0.15% of GDP with a bigger step down (equal to 1.2% of GDP) having already occurred last year with little economic impact.
The Australian December half earnings reporting season is now wrapped up confirming a sharp rebound in profits and dividends. While the strength of results tailed off a bit at the end of the reporting season 56% of companies have seen profits rise which is up from just 36% six months ago, 51% have beaten expectations compared to just 32% six months ago and 47% have increased dividends compared to 55% cutting dividends six months ago. Notably the banks have been pushing dividends back up as they reduce bad debt provisions and the big miners have announced record dividends. As a result of the strong rebound in profits, more beats than misses and positive guidance consensus expectations for earnings growth in 2020-21 have now been revised up to 34%, from +21% a month ago and just 8% six months ago. Resources companies are now expected to see 52% earnings growth this year. Expected 2020-21 earnings growth for banks has now been revised up to 46%, with industrials expected to see 9% earnings growth led by IT, media, health, gaming and other material stocks. The biggest upside surprises and earnings upgrades have been for media companies, banks and retailers, attesting to the cyclical upswing in the economy.
What to watch over the next week?
In the US, expect February payrolls (Friday) to rise by a solid 160,000 after a couple of weak months but with unemployment rising slightly to 6.4% as participation rises. Business conditions ISMs for February (due Monday and Wednesday) are expected to remain strong at around 58-59.
Eurozone core inflation for February (Tuesday) is expected to remain around 1.4%yoy and unemployment for January (Thursday) is likely to have edged up reflecting lockdowns.
Japanese jobs data for January will be released Tuesday.
Chinese business conditions PMIs are expected to come in around 51.5.
In Australia the RBA is expected to leave monetary policy on hold having announced an extension to its bond buying program at its February meeting. While it will no doubt welcome the continuing improvement in economic indicators it will likely try and push back against the rise in bond yields by reiterating that the economy still faces uncertainties and has a fair way to go to meet the RBA’s inflation and employment goals and that it does not expect the conditions to be met for a rate hike until at least 2024. Its also likely to confirm that it has stepped up its buying of 3-year bonds in order to maintain the yield target of 0.1%. I doubt the RBA will shift its bond buying from the April to November 2024 bond though. While the back up in bond yields is posing a clear challenge to the RBA’s dovishness and 3 year bond yield target, the RBA will be worried that the bond market is jumping at shadows – at least in part – and if it (the RBA) follows bond markets into premature tightening it will be too. Particularly given that if they give in and remove easing too quickly the $A will spike even higher!
On the data front in Australia, the focus is likely to be on December quarter GDP which is expected to show a solid 2.6% quarter on quarter gain driven by another strong rebound in consumer spending, housing construction and strong public spending. This will still leave GDP down -1.7% from its December quarter 2019 high, which compares to the US at -2.5%, the Eurozone at -3.1%, Japan at -1.3% and China at +6.5%. In other data, expect CoreLogic to report a strong 2% rise in average home prices for February and ABS housing finance to have increased by another 2% in January (both due Monday), building approvals to have fallen back by 5% after a surge in December (Tuesday), January retail sales to have increased 0.6% in line with preliminary data and the trade surplus to remain around $6.5bn consistent with already released goods trade data (both Thursday).
Outlook for investment markets
Shares remain at risk of a further short-term correction after having run up so hard in recent months – with the back up in bond yields possibly being a trigger. But looking through the inevitable short-term noise, the combination of improving global growth helped by more stimulus, vaccines and still low interest rates augurs well for growth assets generally in 2021.
We are likely to see a continuing shift in performance away from investments that benefitted from the pandemic and lockdowns - like US shares, technology and health care stocks and bonds - to investments that will benefit from recovery - like resources, industrials, tourism stocks and financials.
Global shares are expected to return around 8% this year but expect a rotation away from growth heavy US shares to more cyclical markets in Europe, Japan and emerging countries.
Australian shares are likely to be relative outperformers helped by: better virus control enabling a stronger recovery in the near term; stronger stimulus; sectors like resources, industrials and financials benefitting from the rebound in growth; and as investors continue to drive a search for yield benefitting the share market as dividends are increased resulting in a 4.5% grossed up dividend yield. Expect the ASX 200 to end 2021 at a record high of around 7200.
Ultra-low yields and a capital loss from rising bond yields are likely to result in negative returns from bonds this year.
Unlisted commercial property and infrastructure are ultimately likely to benefit from a resumption of the search for yield but the hit to space demand and hence rents from the virus will continue to weigh on near term returns.
Australian home prices are likely to rise another 5% to 10% this year and next being boosted by record low mortgage rates, government home buyer incentives and the recovery in the jobs market but the stop to immigration and weak rental markets will likely weigh on inner city areas and units in Melbourne and Sydney. Outer suburbs, houses, smaller cities and regional areas will see relatively stronger gains in 2021.
Cash and bank deposits are likely to provide very poor returns, given the ultra-low cash rate of just 0.1%.
Although the $A is vulnerable to bouts of uncertainty and RBA bond buying will keep it lower than otherwise, a rising trend is likely to remain over the next 12 months helped by rising commodity prices and a cyclical decline in the US dollar, probably now taking the $A up to around $US0.85 by year end.
Subscribe below to Oliver's Insights to receive my latest articlesShane Oliver, Head of Investment Strategy & Chief Economist
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