Investment markets and key developments over the past week
Share markets saw a bit of a roller coaster ride over the last week – initially rallying as fears around rising bond yields briefly eased, then falling after Fed Chair Powell reiterated the Fed’s dovishness but failed to signal significant concern or action to deal with rising bond yields only to then see the US share market stage a strong rebound Friday afternoon as strong payrolls encouraged dip buying. This left share markets mixed for the week with US shares up 0.8% and Eurozone shares gaining 0.5%, but Japanese shares falling -0.4% and Chinese shares falling -1.4%. Australian shares also had a good bounce into mid-week as bonds settled and Australian economic data surprised on the upside before gains were largely reversed as bond yields rose again. The ASX 200 still managed to gain 0.6% for the week despite missing out on Friday’s US share market rally. Australian health, IT, material and industrial stocks had a bad week, but this was more than matched by strong gains in financials, property, energy and utility stocks. Bond yields rose sharply in the US but through the week were down a bit in Europe, Japan and Australia. Oil prices rose 7.6% as OPEC+ kept output unchanged and iron ore and copper prices also rose but gold fell. The A$ fell slightly as the US$ rose with Powell being seen as not dovish enough and as US payrolls rebounded.
Despite a brief pause the upwards pressure on bond yields in the US resumed over the last week with a flow on to Australia, albeit the Australia 10-year yield remains below the previous week’s high. These bond market tantrums often take a while to settle down as bond yields play late catch up to a rally in shares and often go too far too fast in the process. In the 1994 bond crash it took around 9 months in Australia for bond yields to start to settle down. Yields could still go higher in the short term as bond selling feeds on itself and inflation spikes in the months ahead, possibly taking Australian 10-year bond yields through 2%, before it settles down perhaps through a combination of central bank bond buying and the realisation that underlying inflation is not taking off. The faster and longer this continues the greater the risk of a more severe correction in share markets if earnings struggle to keep up with the rise in bond yields. So far though the back up in bond yields is mainly contributing to an ongoing rotation in share markets away from last year’s winners like tech stocks to cyclical shares like financials and resources that will benefit from stronger economic conditions. From their February highs to their lows in the last week or so the US S&P 500 has corrected -4.2% and the ASX 200 has had a -3.5% fall, but the tech heavy Nasdaq fell -9.7% and Australian IT stocks fell -19%.
However, it’s still too early to expect an end to the cyclical bull market in shares that started in March last year given still spare capacity in jobs markets and still low underlying inflation, shares still offering a decent earnings yield gap to bond yields all combined with the economic and profit recovery and central banks including the RBA being a long way away from rising interest rates (even if it may turn out to be earlier than what they are currently saying).
Deep V rules - with the Australian economy continuing to recover faster than expected. Australian December quarter GDP rose 3.1% thanks to strong gains in consumer spending, housing investment, equipment investment and public spending and has now recovered 84% of the hit to economic activity seen in the first half of last year as a result of the pandemic. As a result, economic activity is now just 1.1% below its pre coronavirus level. This is a far better outcome than seen in most other comparable countries and reflects Australia’s better virus control and better protection of the economy. With the household saving rate remaining high, indicating pent up demand, consumer and business confidence strong, incentives likely to boost dwelling and business investment and vaccines set to allow a further reopening of the economy the recovery is set to continue albeit at a somewhat slower pace with the easy gains behind us.
There are a number of implications flowing from the rebound in the Australian economy:
• First, Australia’s better health and economic performance through the pandemic highlights that the alternative approach of letting coronavirus rip would have made no sense. Better health has led to a better economy. Sweden tried the let it rip approach and ended up with more deaths per capita and a bigger economic hit, ie, a big fail.
• Second, Australia is easily on track to get back to the pre-coronavirus level of economic activity by the June quarter and we may in fact already be there right now.
• Third, given the rebound the economy is well placed to withstand a winding down in government support (including from JobKeeper and HomeBuilder from month end). Of course, significant policy support is still needed as the economy is still nearly 3% below where it would have been without the pandemic and some sectors like travel and higher education still have a long way to go.
• Finally, the RBA is likely to be able to remove stimulus a bit earlier than its currently foreshadowing, although less than the bond market may be pushing for.
Turning to the RBA, the key message from its March meeting is that it still has a long way to go to meet its inflation and employment goals so it still doesn’t expect a rate hike until 2024 and has accelerated its bond buying to keep bond yields down and will do more if needed. We agree that the RBA needs to push back against the sharp rise in bond yields as it could threaten the recovery and that a premature removal of monetary stimulus as suggested by the bond market (which is now factoring in nearly 4 rate hikes by early 2024) will risk seeing the RBA ending up continuing to fail to meet its inflation and employment goals. That said, if as we expect the economy continues to surprise on the upside - it was around 1% stronger in the December quarter than the RBA expected just a month ago – the first rate hike is likely to come in 2023, at least a year earlier than the RBA is allowing. That’s still a long way away though and in the meantime – maybe later this year or if not through next year – the RBA with APRA is likely to start tightening lending standards in the face of an increasingly hot residential property market in order to head off another potential threat to financial stability.
While it’s getting to be a drag talking about coronavirus, it remains the single most important issue for markets. If it doesn’t come under control as investment markets are now assuming, then forget about sustained recovery and overheating and bond yields will fall right back. Fortunately, coronavirus news remains mostly positive. New global coronavirus deaths continue to trend down and new cases are running around half of their January peak.
However, new cases have continued to edge up a bit in Europe (Germany, France, Italy, Sweden, etc) and new cases in Brazil have broken out to record levels not helped by the new Brazilian virus variant. The trend is still down in the other two new variant countries though – the UK and South Africa.
Vaccine supply is now also ramping up with new vaccines like Johnson and Johnson’s joining in, so rollout is likely to accelerate. 54% of Israel’s population has now received one dose, 31% in the UK and 16% in the US. And the evidence suggests that the vaccines are working in Israel and the UK where there have been broad based studies – to head off new infection, severe cases and deaths. Europe has seen an edging up in new cases but note that only 5% of its population has had one dose so far. Brazil is a concern but it has never done a good job in controlling coronavirus, only 3% of its population has been vaccinated and while vaccines are not as effective in preventing infection from the new variants they still appear to be highly effective in preventing severe cases.
New coronavirus cases remain very low in Australia – with no new local cases for the last week. Australia is now on the chart above but can’t really be seen because vaccination is at just 0.2% of the population. Despite the headline news about Italy banning the shipment of 250,000 AstraZeneca vaccine doses to Australia, local distribution is likely to ramp up rapidly in the weeks ahead with 50 million doses due to start rolling out from CSL production in Australia.
Our Australian Economic Activity Tracker saw a sharp broad-based gain over the last week, as the removal of Victoria’s snap lockdown impacted, suggesting that the economy is continuing to recover. Our US Economic Activity Tracker also rose sharply suggesting a reacceleration in US growth and our European Economic Activity Tracker continued to recover albeit it remains very weak. All our trackers will benefit from easy year ago comparisons in the weeks and months ahead.
If you want to know why music is so good The Beach Boys partly explained it in a song way back in 1970. And with band members and their children a new version of Add Some Music To Your Day has just been released, and it will be the lead single in a new album. It was a sad week for Australian music though with the passing of Michael Gudinski who gave a whole bunch of Australian artists their start in the music industry including Kylie.
Major global economic events and implications
US data was mostly strong. While the services sector ISM fell in February it remained strong, the manufacturing ISM along with PMIs were all very strong, construction spending rose and payroll jobs rose a much stronger than expected 379,000 in February with unemployment falling to 6.2% from 6.3% and January employment revised up. The US jobs market still has a long way to fully recover with only around 58% of jobs lost due to the pandemic now recovered (in contrast to 93% in Australia), permanent unemployment staying elevated and participation continuing to run well below its pre coronavirus level. That said, it seems to be picking up again after several soft months and will be helped by a reopening in the US economy and significant additional fiscal stimulus. Leisure and hospitality employment is still down by 3.4 million on a year ago and so has significant potential to recover as reopening occurs with the rollout of vaccines.
Meanwhile, Fed Chair Powell reiterated that the Fed is still a long way away from conditions that would justify a tightening in monetary policy but he didn’t seem too concerned about the rise in bond yields and failed to provide any hint that the Fed may do anything in response in contrast to the RBA which has accelerated bond buying and indicated that it may do more. As a result, his comments saw US bond yields spike higher.
Eurozone business conditions PMIs were revised up for February but still remain soft with the composite PMI at 48.8, January retail sales fell sharply due to the lockdowns and core CPI inflation in February fell back to 1.1%yoy from 1.4%yoy. Meanwhile, in contrast to the Fed, ECB officials continue push back against the rise in bond yields.
Japanese business conditions PMIs were also revised up for February but remain soft with the composite at 48.2, labour market data improved in January and consumer confidence rose in February. Meanwhile the Bank of Japan has indicated it remains prepared to defend its bond yield targets.
Chinese business conditions PMIs fell again in February, but they remain at levels consistent with reasonable growth and strength in Korean exports would suggest that Chinese growth remains solid.China’s economic targets for this year announced at the National People’s Congress were not particularly surprising: GDP growth to be “above 6%”; inflation around 3%; the budget deficit at 3.2% of GDP; credit growth in line with nominal GDP growth; and “no sharp turn” on policy. GDP growth will probably come in around 10% reflecting the recovery from last year’s growth of just 2% and so the “above 6%” target is more of a lower bound. The deficit projection is lower than last year’s 3.6% of GDP but more than most had expected. Nothing to get too excited about here.
Australian economic events and implications
Australian economic data was strong: December quarter GDP rose a stronger than expected 3.1%qoq as discussed earlier; retail sales rose 0.5% in January and are up 10.6% on a year ago despite a snap lockdown depressing Queensland; PMIs are either solid or strong; the current account surplus widened further to nearly 3% of GDP and the trade surplus rose to a record in January on the back of strong commodity prices; job ads rose strongly again in February telling us the jobs recovery continues; housing finance rose to a new record; and house prices rose at their fastest pace in nearly 18 years. While home building approvals fell sharply this reflects volatility driven by the HomeBuilder incentive scheme with dwelling construction still on track for strong growth.
There was some other good news too with the share of housing and small business loans in payment deferrals collapsing further to just 1.8% and 1% respectively in January.
The Melbourne Institute’s Inflation Gauge for February remained weak at just 1.6%yoy for headline inflation and just 0.3%yoy for trimmed mean (or underlying inflation).
What to watch over the next week?
In the US, the key focus is likely to be on CPI inflation data (Wednesday) which is expected to show a rise in headline inflation to 1.7% year on year on the back of higher energy and food prices but core inflation remaining at 1.4%yoy. Data for small business optimism (Monday) and job openings (Thursday) will also be released.
The ECB at its policy meeting on Thursday will likely further pushback against the back up in bond yields and may move beyond jawboning to increase its QE program.
Chinese CPI inflation for February (Wednesday) is expected to remain negative at -0.3%yoy and credit and money supply data is also expected to be released.
Australian business confidence according to the NAB business survey (Tuesday) and consumer confidence according to the Westpac/MI survey (Wednesday) are both likely to remain strong. A speech by RBA Governor Lowe (Wednesday) on “The Recovery, Investment and Monetary Policy” is likely to reiterate the key dovish messages from RBA’s March meeting – that the economy has recovered faster than expected, but it will be some time before the RBA meets its inflation and employment goals, that it does not expect to raise rates before 2024 at the earliest and that it stands ready to further boost its bond buying if necessary.
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.
Still 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 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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