Economist – Investment Strategy & Dynamic Markets
Investment markets and key developments over the past week
US shares started the week strongly, but higher bond yields following the US Federal Reserve’s meeting led US shares down 0.8% over the week, on the S&P500 index. Non-US shares performed slightly better, with European shares up 0.1% over the week and Japanese shares 0.2% higher but Chinese shares have been underperforming recently and were down by 2.6% over the week. Australian shares were also down this week by 0.9%, led lower by materials, energy and industrials. The US dollar was up slightly this week and the $A ended the week around $0.774 USD.
US 10-year yields touched 1.75% this week (before settling back down to around 1.72% by the end of the week) but this only takes them back to early 2020 levels. While the recent run-up in global bond yields has been fast, the actual level of yields is not a concern, especially while US real yields are still negative, which means that financial conditions are not tightening too fast. Oil prices fell this week to due to a range of issues, including concern about rising Russian oil production and higher risk of US sanctions on Russia after Biden called Putin a “killer” and worries about lower oil demand from Europe from a slow vaccine rollout. Metal prices were mostly higher over the week, while there was some pull-back in agricultural commodity prices, after some strong gains in recent months.
News of some European countries (Germany, France, Italy, Spain and Portugal amongst others) pausing AstraZeneca vaccinations temporarily because of concern that it causes blood clots didn’t spook markets, as it seemed to be an overreaction; with the European Medicines Agency (EMA) and the World Health Organisation (WHO) saying the vaccine was still safe to use (although the EMA is still investigating the blood clot side effect). There were 18 cases of a “hard to treat” blood clots out of 20 million vaccines. Germany, Italy and France have since resumed its AstraZeneca vaccinations programs. Europe is still well behind in vaccinating its population despite the very high number of cases, having only vaccinated 8% of the population, compared to 57% in Israel, 38% in the UK and 23% in the US (see the chart below).
Global coronavirus cases have crept back up a little again (see chart below), driven by higher cases in emerging markets. Developed countries cases have stabilised over February/March – a sign of lockdowns (especially in Europe) working (Paris is in a lockdown again for four weeks) and the vaccine rollout.
Our weekly Activity Trackers continue to improve for Australia and the US (see chart below), even once we start to take base effects into account, which are starting to become evident in the data. Australian restaurant spending, hotel bookings and foot traffic are the biggest drivers of the lift higher. In the US, the improvement is broad based across indicators and especially in job ads, hotel bookings and mortgage applications. The Europe Activity Tracker is still tracking sideways, as many countries are still operating with strict mobility restrictions in place.
The US Federal Reserve (Fed) meeting was highly anticipated this week, given recent market fears that the Fed would have to taper its quantitative easing program if inflation spiked from the high level of US fiscal stimulus (which has totalled 12.7% in 2021 versus 7.8% in 2020). The Fed squashed any expectations of an early taper at this week’s meeting and the median Fed committee participant still sees no interest rate hikes until after 2023. This is much more dovish than market expectations, which sees three rate rises by early 2024 (see chart below). Although, there were two more members of the Fed (out of 18) that expect rate hikes in 2023, up from 5 as at the December meeting. Gross Domestic Product (GDP) forecasts for 2021 were revised up to 6.5% (from 4.2% in December), but on our forecasts, GDP growth could easily be between 8-10% this year. Core inflation forecasts were also revised up, to 2.2% in 2021 (from 1.8% in December), 2.0% in 2022 and 2.1% in 2023, which shows that the Fed is not expecting a big inflation-breakout and is willing to tolerate inflation above 2% for some time, in line with their new average inflation targeting monetary policy regime (which allows for inflation overshoots and undershoots).
Clearly, the market is sceptical that the Fed will be able to keep interest rates at current levels for the next three years. We think that nominal bond yields can still shoot higher in the short-term towards 2% and above on inflation concerns, especially as annual inflation will push to 3 4% per annum temporarily over the next few months because of base effects from 2020 and markets are likely to worry that this move is permanent, rather than temporary.
Something interesting to keep in mind – the latest Biden fiscal stimulus will distribute around US$1.2 trillion across the country over the next five months. In comparison, the Trump tax cuts of 2017 were worth $700bn over ten years. Of course, the US economy needs more support now because of the pandemic, but this follows a very large stimulus package in 2020 and also comes at a time when the economy is re-opening. The level of US fiscal stimulus this year is extraordinary, especially considering that more is still likely this year.
Major global economic events and implications
US February retail sales disappointed and fell by 3%, but this follows two very strong months of spending and probably reflects wintery weather (storms in Texas), which can affect US data in the first few months of the year. Spending will accelerate as low-middle income households get their $1,400 stimulus checks. February industrial production was down by 2.2% in February, also worse than expected. February housing starts were down by 10.3%, which probably also reflects some bad weather in southern US, although rising bond yields are negative for the housing market.
In Germany, the ZEW expectations index of economic growth by financial market participations was stronger than expected and rose to 76.6, close to its September 2020 highs (before the latest round of lockdowns), which was also the most optimistic reading since 2000.
European February consumer prices rose by 0.2% as expected, with annual growth still low at 0.9%, while core inflation also remained contained at 1.1% per annum.
The Bank of England (BoE) meeting this week didn’t produce any surprises. The BoE acknowledged the improvement in economic conditions since its February projections and maintained its accommodative policy stance. The central bank said that rising bond yields reflected improving economic fundamentals but it would not tighten policy before more spare capacity was reduced, which is a similar sentiment to that adopted by the Fed. The European Central Bank (ECB) and the Reserve Bank of Australia (RBA) have announced more quantitative easing over recent months, but the economic recovery in Europe is much slower than the US. Europe is also further behind on the vaccine rollout compared to the US and the UK. Meanwhile, Australia’s quantitative easing programme only began a year ago, so it is well behind the rest of the world. This puts upward pressure on Australian bond yields and the currency.
The Japanese consumer price index for February was in line with expectations. Headline prices were down by 0.4% over the year, with core prices (excluding fresh food and energy) up only 0.2% over the past year, which was in line with expectations. The Bank of Japan (BoJ) meeting this week was considered “live”, after reports that the central bank is considering widening its 10-year bond yield target from around 0.2% either side of zero, to 0.25%, which was the policy the BoJ confirmed after its meeting. The BoJ also scrapped a buying target for stock funds, which led to some weakness in shares.
New Zealand GDP surprised on the downside this week, falling by 1% in the December quarter, while consensus was looking for a very small increase. This does follow on from a huge 13.9% increase in the prior quarter and leaves economic activity only around 0.9% lower compared to a year ago, so the New Zealand economic recovery has still been very fast and strong.
Chinese monthly activity data showed that there is still solid momentum in the Chinese economy. Base effects are starting to become evident in the data, so I will use adjusted figures (by looking at the two year growth rate) – Industrial production was up by 16.9% over the year to January-February, fixed asset investment rose by 1.9% and retail sales by 6.4%. Retail sales and fixed asset investment still not as strong as industrial production. Solid industrial production is a sign that external demand for Chinese goods is stronger than domestic demand.
Australian economic events and implications
The RBA March meeting minutes mentioned the recent increases in commodity and other input prices which could increase consumer price inflation. However, the Board thought it was unlikely for consumer price inflation to have a sustained increase while there was spare capacity in the labour market and wages growth was subdued. The end of JobKeeper was discussed, with “limited international experience” to draw on, which makes the end of the programme raise some uncertainty. The RBA however judged that the end of the program wouldn’t cause a big rise in the unemployment rate, because those who were on zero hours were now back around pre pandemic levels. From the RBA’s perspective, it was more likely that JobKeeper recipients (especially the self-employed) would suffer a loss of income after the programme finished, rather than employment. Many businesses have already reduced the size of their workforces and are not planning another round of layoffs. The RBA also noted that lending standards remained sound in an environment of rising housing prices and low interest rates, despite the latest data from APRA showing some rise in interest-only and high loan-to-value lending (see chart below). This isn’t surprising in the context of record borrowing rates and the First Home Loan Deposit Scheme, though it’s something to watch.
The rise in bond yields was noted by the RBA, but the central bank didn’t appear panicked by it. The RBA also gave some more clarity about the 0.1% target on the three-year Australian government bond (currently the April 2024 bond), saying it would not remove the target completely or change the target yield of 0.1%. Over the next few months, it would decide whether to maintain targeting the April 2024 bond (which would lead to a lower maturity of the yield target) or move to targeting the November 2024 bond (keeping the three-year yield target in place). We think it’s more likely that they will just continue targeting the April 2024 bond and continue its quantitative easing program.
The Australian jobs recovery remains firmly in place. In February, employment rose by 88.7K, which means that virtually all (99.8%) of the jobs lost in peak-COVID 2020 have now been regained. The unemployment rate fell by 0.5%, to 5.8% in February, which is still higher than the ~5% level it was at before COVID-19, but this is heading down faster than we (and the RBA) had been expecting. There is still some work to be done to lift hours-worked from current levels – which are around 6.4% below pre-COVID levels. There is also a larger than usual share of people working reduced hours (see chart below) as there is either no work, not enough work, or they have been stood down. There will always be people who are working fewer hours due to these economic reasons in any month, so it’s important to compare the current situation to what is “normal” (or we compared to what was happening a year ago, which is technically pre-pandemic). On this metric, around 167.5K people, or 1.3% of employed persons, are working fewer hours because there is no work, there isn’t enough work or they have been stood down. This is a lift from December and January levels and this share of employees would be the group that is most at risk of job loss after JobKeeper expires at the end of this month.
House prices, according to the ABS, were up by 3% over the December quarter, or 3.6% over the year to December. This though is old news, as we know from the monthly CoreLogic data that capital city prices in Australia have recovered back to their September 2017 record highs.
Australian February preliminary retail spending fell by 1.1%, lower than expectations of a 0.6% rise. There were large falls in Victoria and Western Australia, which had some COVID-19 restrictions present during the month. Some increase in retail spending is likely in March, as restrictions have eased in these states. Retail spending is still 8.7% higher than a year ago and is well above its pre-COVID trend level (see chart below) thanks to government fiscal stimulus, RBA interest rate cuts and the redirection of overseas spending to domestic providers.
The Australian population fell in the September quarter of 2020, as net migration was negative (more people left Australia than entered it). This outpaced the natural increase (birth over deaths) in the population. Annual population growth is now at 0.9%, compared to 1.5% pre-pandemic.
What to watch over the next week?
In Australia, March preliminary PMI’s are released and are expected to stay in expansionary levels, around the 53 level. The preliminary merchandise trade balance for February is also due and should show that the trade balance still remains close to record highs because of elevated export growth.
In the US, February existing home sales are likely to fall by 2% over the month and new home sales are expected to be 4% lower. Bad weather in February and higher bond yields is negatively impacting housing indicators. February preliminary durable goods are likely to be up by 1%, continuing the recovery seen over recent months. The Markit manufacturing PMI is expected to edge higher to 59.5 and the services PMI is expected to hit 60, also higher than February levels. The PCE deflator, used by the Fed as the main indicator of inflation, should show well contained inflation rising by 0.1% in February, or 1.5% over the year. The spike in inflation will start to show up from April because of base effects.
European PMI’s for March should show manufacturing remaining high at close to 58, in line with the global recovery, but services still in contraction below 50, given the lockdowns in Europe.
In Germany the March IFO survey of business expectations is due and should show some improvement, in line with this week’s ZEW reading.
Outlook for markets
Shares remain at risk of further volatility from rising bond yields. However, looking through the inevitable short-term noise, the combination of improving global growth helped by more stimulus, vaccines, negative real yields 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 technology and health care stocks and bonds – to investments that will likely benefit from the recovery – like resources, industrials, tourism stocks and financials.
Global shares are expected to return around 8% this year, but we 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: relative underperformance over 2020/21, 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 7,200.
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. Higher bond yields will also weigh on these asset classes in the medium-term.
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. The stop to immigration and weak rental markets however will likely weigh on inner city areas and units in Melbourne and Sydney. Outer suburbs, houses, smaller cities and regional areas will likely 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.
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