Monthly Market Update — August 2021
This month’s newsletter looks at the recent decline in US bond yields, the US economic outlook and unpacks the US Inflation basket.
The main points are as follows:
Share markets have had much to contend with in recent months but have continued to rally.
High but potentially less sticky inflation, strong US earnings and the likely extension of support measures as COVID threats persist have kept the bulls in charge.
US bond yields (interest rates) have retreated in recent weeks, more likely signalling peak growth than the start of a new economic downturn.
There is still much short-term uncertainty, and we continue to advocate a diversified investment strategy.
The ASX200 posted its 10th consecutive monthly gain in July. Any weakness seen as a buying opportunity as the bulls continue to climb the “Wall of Worry”. Reasons to worry there definitely was.
COVID-19 cases spiked across the globe. The good news is the new case counts appear to have peaked in the UK. Most encouraging is this occurred with much fewer hospitalizations and deaths than previous waves. In the US the resurgence of new cases is yet to peak. Less encouraging at this stage is a surge in hospitalizations in lowly vaccinated states. Australia continues to experience lockdowns with significant economic impact. The past month has shown lockdowns that are implemented hard and early are shorter and do have less of an economic impact.
Another challenge for the month was China’s clampdown on technology, education, and real estate companies. Ride sharing company, Didi Global is now under cyber security review by Chinese regulators. The past months also saw China ban for-profit tutoring in core education reining in the country’s private education industry. China also moved to increase scrutiny in the real estate sector echoing President Xi Jinping’s famous words that “housing is for living in and not for speculation”.
What is driving markets higher? Elevated inflation figures are still driven by categories that are likely to be transitory which has eased inflation fears. The US reporting season has been very good. Of reported companies, 88% delivered profits higher than what analysts expected. Another positive for markets over the months is the likely extension of support measures in response to the surge in COVID-19 cases in many parts of the world.
In this newsletter we step back from the short-term news and explore two important factors driving markets and the economy. Firstly, what is the cost of money (interest rates) and where is it heading. Secondly, where are we in the business cycle and for how long can the economy continue to deliver such strong earnings.
We remain cautious in the short-term and optimistic about the long-term. Navigating the current uncertain landscape is critical. One way to do this is by utilizing one of the most effective wealth protection tools available to investors, diversification.
It is boring, but it is an important number.
The most important number in finance is the yield on the 10-year US Treasury note. This is the interest rate at which the US Government borrows money over a 10-year period.
What this rate is, is important to investors for several reasons. It provides a gauge as to what expectations are for growth and inflation over the next 10-years.
Every other financial instrument is then compared to and priced off this rate. Generally speaking, as the yield on a 10-year treasury note declines (as it has), other investment values increase (as they have).
It is clear, US bond yields (interest rates) have been moving lower for a long time. Hopes of higher growth dashed by high levels of debt, ageing demographics, disruptive technology, and growth in global trade.
There were hopes that the response to the COVID-19 pandemic could change this. Super charged growth from warlike stimulus programmes and the onshoring of several industries.
As the global economy started to open it was not surprising to see bond investors demand a higher income yield from safe bonds (green line).
The story has however changed over the past 3 months. The excitement of growth is fading, and bond investors are adjusting their growth (inflation) expectations downward (red line).
The question on everyone’s mind, Why? The exact reason is unknown. Slowing growth expectations being top of mind. More important to us is, where to from here?
This is likely more of a correction against a rising trend in yields as we saw in 2017. In that instance bond yields went on to reach +3.0%. It is difficult to think that the highest yield we achieve this time is +1.70%.
We continue to keep a close eye on this market. At this stage, we do not think the bond market is warning of a new economic downturn.
Many reasons to be bullish on US Economic growth!
It is easy to get sucked into the short-term noise surrounding financial markets. Some data will disappoint whilst other data will be more encouraging. More important is the broad direction and a long-term view.
The past year has seen us write about the improving global economy and more specifically the booming US economy. As we all know booms do not last forever, so it is well worth unpacking where we are today.
The boom may be fading, but a multi-year phase of strong economic growth is still highly likely. One of the best ways to illustrate this is by looking at business cycle. (Fidelity business cycle).
From the above, the winners are those regions, sectors and businesses who benefit most from a growing economy. Banks write more loans in boom times, whilst Supermarket’s sales growth remains more muted.
After 7 months we are now considering whether the Reflation trade has more room to run. This cannot go on forever, so we need to consider where to from here?
China continues to lead the recovery often with distinctly different policies. The US has now entered the Mid-stage of the cycle which is the longest part of the cycle which will see growth peak.
The questions on our mind. Will this time be different? Will this cycle be shorter? There are several positives which give us confidence the cycle has room to run.
The corporate sector has an additional US$1T at their disposal whilst households have US$2.2T in savings (US$1.2T pre-COVID). Fair to say, they are in good financial shape.
The wealth effect of the past year also lays the foundation for strong growth over the next few years. US house prices are up +14.6% over the past 12-months with US share markets are up close to +35% over the past 12-months.
The Banking system is in much better shape today. Much stronger than it was after most recessions, especially after the 2008-GFC. This should see a willingness to lend to both households and businesses.
All of this is happening at a time when the US Central Bank and Government are still providing highly supportive policy measures. With massive momentum behind the US economy and little resistance from Central Banks to slow it we expect continued growth in the short to medium term.
The risk to all of this is inflation. Persistently higher inflation will see a reversal of highly supportive policy measures. This may take time to impact the broader economy but happens much faster in the share market.
Many investors are concerned about the continued emergency support from the US Central Bank. Jerome Powell recently conceded that inflation has come in higher than expected and has lasted longer.
He did not fail to revert to the same mantra of inflation will be temporary. The nervousness is growing that the US Fed is in unchartered territory. Investors concerned due to the lack of answers as to why they are printing money when the economy is booming.
As long-term investors, we see the cycle as having more room to run. We do however think it will pay to be prudent and well balanced in the coming months as policy direction remains uncertain.
Inflation, still marching higher.
Investors have their eyes fixed on the US inflation data. Paying attention is critical as this is the same data being watched by the US Fed as they plan their next moves.
The US Central Bank (the Fed) prefers Core Inflation which excludes food and energy. They are focussed on price inflation in goods (grey) and services (yellow). The two largest categories below.
The relative importance of Services inflation (58%) outweighs the importance of Goods (20%) inflation. Both these categories are facing challenges of their own.
We have already seen price inflation in the Goods basket. This is driven by higher input costs (commodity prices) and supply chain issues (lockdown and shipping challenges). Service price inflation has been more muted as lockdowns impact movement and demand. This is changing as vaccinations rates ramp up.
With increasing movement, we would expect to see a continued shift in consumer spend from Goods to Services.
A clear driver of inflation over the last 12-months has been “Transport”. New car and truck prices up +5.3% and used car and truck prices up +45.2%.
The Fed and the market have taken the view that this will be transitory. Our question is what could potentially gain momentum as the service sector fires up.
Services (not goods) such as medical care, education, transport and recreation. What will medical professionals charge for a visit? What happens to tuition fees? What will car repairs, car insurance and public transport prices do? What will club memberships cost? What will sporting events cost?
The relative importance of the above 4 categories are just over 22% of the basket. Add eating away from home and we are close to 30%. And now we have still not addressed the biggest factor being “Shelter” which equates to a further 32%.
The single most important factor in the monthly Inflation read is “Owners Equivalent Rent (OER)”. The Consumer Expenditure Survey asks consumers “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?”
Owners equivalent rent is currently +2.3% (Jun20-Jun21). All of this whilst house prices are up +14.6%.
Australian Equities
The S&P/ASX200 Index posted a +1.10% return for the month of July resulting in a marginally improved +28.56% return over the last 12-months.
Top-performing sector was the Materials sector gaining +7.13% in July. Sector heavyweights BHP Billiton gaining +10.1%, Rio Tinto gaining +5.4% and Fortescue Metals gaining +6.7%. The elevated iron ore price has seen improved cash flows resulting in chunky dividends for shareholders.
The Industrial sector delivered a +4.25% return in July. Much of the strength driven by the takeover bid for Sydney Airport which saw its share price gain +34.9% over the month.
The weakest sector was the Technology sector which ended the month -6.88% weaker. Afterpay saw its share price -18.2% weaker in July. In early August Afterpay announced a takeover offer from US listed digital payments company Square.
International equities
The MSCI All World Index gained +2.47% for the month of July and +35.97% over the year. The strength of the last month once again driven by large US tech stocks.
The US S&P500 Index gained +2.38% over the month with the S&P Europe350 Index also posting a strong +1.92%.
The Asian region was out of favour with the S&P Japan500 Index ending the month -1.62% weaker. The S&P China500 Index gave back -8.88% as economic and regulatory uncertainty mounts.
The weakness in Chinese stocks impacting the performance of the S&P Dow Jones Emerging Market Index which gave back -6.51% over the month (12-monthly gain of +18.18%).
Property and Infrastructure
Australian Property Index posted a modest +0.28% gain for the month of July as COVID-19 lockdowns dampen investor sentiment.
More upbeat was the Global Listed Property market (Hedged) gaining +4.04% partly being fuelled by falling bond yields.
Hedged Global Listed Infrastructure gained +1.27% over the month. The recent takeover bids show the high degree of appetite for infrastructure assets which should be a positive for the next 12-months.
Fixed income
The Bloomberg Australian Bond Index gained +1.88% over the month recovering much of the weakness from earlier in the year.
The 10-year Australian government bond yield is much weaker, currently paying investors +1.19% per annum compared to 1.51% a month earlier.
GENERAL ADVICE WARNING
The advice contained within this document does not consider any person’s particular objectives, needs or financial situation. Before making a decision regarding the acquisition or disposal of a Financial Product, persons should assess whether the advice is appropriate to their objectives, needs or financial situation. Persons may wish to make their assessment themselves or seek the help of an adviser. No responsibility is taken for persons acting on the information within this document. Persons doing so, do so at their own risk. Before acquiring a financial product, a person should obtain a Product Disclosure Statement (PDS) relating to that product and consider the contents of the PDS before making a decision about whether to acquire the product.