May 2021 9 Minutes
Economic and Asset Performance Comment – April 2021
Global markets and economies continue along the path of recovery, supported by a staggering quantity of fiscal and monetary support. Stock markets continue to rally while interest rates are now trading above the record low yields. The fuel has been stimulus along with the development of vaccines. While the quantum of stimulus has been at levels never seen before, the rate of development of several vaccines has been remarkable and probably the key ingredient for a meaningful recovery, albeit the vaccine rollout and global economic recovery is likely to be uneven.
While there are positive developments for economies and health, risks and uncertainty continue at elevated levels. The charts below highlight the upside and downside scenarios forecast of global GDP from work generated by the OECD.
The continued strength of equity markets does cause strategists and forecasters concern. The stock market rally has been supported by the massive stimulus, economic growth, and low interest rates. In particular, the first two factors coming off a very low base since March 2020. Longer maturities not included in the government bond buying programs have risen during February 2021, rising modestly as an actual percentage but significantly in relative percentage terms. The chart below shows the US Treasury yields breaking above the S&P 500 Dividend Yield. Although both yield percentages are low numbers the crossover may cause the larger investors to rethink strategies, while asset and liability matching requirements could see the bond rates as an opportunity which may cap the upside movement of these rates.
Source: Jamieson Coote Bonds / Bloomberg
Two major corporate collapses have occurred over the last month, Greensill Capital and Archegos Capital. Without going into the details our read is that these firms have been in the middle of poor investments, while being funded by investors primarily looking for a higher than realistic return. Interestingly, Credit Suisse have been caught in the middle of both events. Two points come to mind. How many more are out there? Investors should be more careful when looking for returns. This phenomenon was evident leading up to the GFC in 2008.
Over the last quarter we have seen economic forecasts improve, equity markets continue to rally, and rising bond rates developing some form of conflicting effect. We continue to believe that investors should be vigilant regarding risk management and should aim to develop resilient portfolios of quality assets that are well diversified across asset classes and regions. The ‘whatever it takes’ support does come with unintended consequences, whether they surface in the short or medium term. Quality assets historically are more likely to survive over the longer period.
The Vaccine Rollout
The rate of vaccine development has been impressive, to say the least. Although there appears to be a degree of self-interest creeping into the distribution phase it would be expected that this time next year the global deployment of vaccines will be similarly impressive. The OECD stated this month: “Faster and more effective vaccination deployment across the world is critical”, which indicates there will be a strong push for effective global vaccinations.
Monetary and fiscal policy
The high level of liquidity support is creating distorted asset values. The money supply (M1) stepped up significantly (chart below), rising from USD4 trillion in early 2020 and currently more than USD18 trillion and still increasing.
The Federal Reserve continues to expand its balance sheet, rising from USD4.3 trillion in early 2020 and currently approaching USD8 trillion (chart below).
So, if we think the US has pushed the limits, the chart below compares the US Federal Reserve outcome of quantitative easing with that of the European and Japan central banks. These are all very large numbers, and it is hard to see how the unwind will play out.
Central bank balance sheets as a % of GDP
Source: ClearBridge Investments (data as at Dec 2020)
GDP and economic output
We have highlighted the OECD forecast GDP growth (noted above) provided this month, which is an amazing recovery story. The chart below from the RBA provides more context of the history. While current forecasts are promising, the real situation should be considered vulnerable to negative shocks.
China is an important economy for the world and certainly Australia. The trade tensions between China and the US may not be escalating but improvement is not obvious. During the last year, the bullying tactics against Australia have caused some short-term impact, however, a recent report indicates that most exports, except wine, have successfully developed alternative markets, while demand for iron ore remains strong.
The following chart highlights that key indicators from China remain strong, which ultimately provides support to global and Australian economies.
The RBA index of commodity prices is showing a steady recovery from 2015. It is interesting to note the divergence of commodity prices provided by the IMF in the chart below, which does favour Australian economic output.
Strong metals and food prices are supportive for Terms of Trade and the Australian dollar.
The inflation discussion has surfaced because of the quantum of stimulus that has been pumped into the system. While the textbooks would point to money supply growth fuelling inflation, the absurd volume of funds in the system also smothers growth and returns, while the technology infusion into mainstream business generates efficiencies. There is likely to be a catch up burst of inflation, but central banks are not sure this will be a long-term trend, at this stage. The chart below from the IMF provide some context and the view that ‘inflation will remain contained in most countries”, with market-based expectations having increased slightly.
Trimmed inflation in advanced countries
Five-year, Five-year swap inflation
Household savings and confidence
The inability to spend and government support and stimulus receipts have resulted in an abundance of consumer savings. As the economy recovers it would be expected that these reserves provide a strong tailwind for global economies.
While consumer confidence has not fully recovered, according to the OECD, the trend is promising.
Equity markets have been rallying since 2008. The chart below shows the US and Australian markets since January 2020. The March 2020 selloff was severe, and the recovery has been V shaped.
Source: Yahoo Finance (S&P 500 – black v ASX All Ordinaries – blue)
The chart above is over a 20 year period, from approximately the dot-com boom days, however, the Nasdaq divergence only started around 2010. It is possible to consider that the single largest influence on equity markets has been technology and the influence it has had as a business disruptor and a driver in efficiencies in old business.
Rising bond rates and a blow-off of high priced tech stocks has supported a rotation from growth to value in recent months (see the chart below). We do consider the longer term equity market performance will be influenced by quality stocks that show value and/or growth features.
Source: Van Eck
Long interest rates increased relatively sharply during February causing some angst for investors. The chart below shows the movement of the US 10-year Treasuries for the past 10 years.
The chart below shows the changes to the shape of the yield curve for the Australian 10-year government bond, highlighting a strong steepening movement during 2021. A steep yield curve often highlights a perceived strong economy; however, it also does cause long-term borrowing costs to increase abruptly which is not on the wish list of the borrower. Currently the largest borrower group are the governments, therefore, it does put in question whether governments will try to contain long rates to keep borrowing costs down.
Source: Jamieson Coote Bonds / Bloomberg
Of more concern to us is the actual yield and margin over bond rates of high yield and corporate credit. The interest rates for high yield and corporate credit have been driven down by investors searching for more attractive returns. The risk here is that if/when bond rates rise, the impact on corporate bonds could be a double whammy negative. Our concern is that investors do not understand the current lack of compensation for risk and liquidity within current market pricing. When these markets shudder, they can become quite illiquid, causing rates and margins to gap. The presumed defensive assets can become less liquid than equities.
Source: Jamieson Coote Bonds / Bloomberg
There is nothing for sure with investment markets, and now more so than for many previous cycles. The dynamics and tailwinds are in favour of growth assets outperforming defensive assets. However, with such extreme levels of government support in the market, the obvious and not so obvious, unintended consequences will prevail.
We consider that exposure to the 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 – 31 March 2021
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