CURRENT ECONOMIC RECOVERY SHOULD STRENGTHEN FURTHER
The March quarter was dominated by a reflationary theme. Global GDP forecasts were upgraded, the US passed another substantial stimulus bill totalling US$1.9 trillion, Covid-19 vaccines started to be distributed more widely, yield curves steepened as concerns of inflation emerged and commodities rose.
In local currency, the ASX200 rallied 4.3% over the March Quarter underperforming the US S&P 500 (+5.8%) and the MSCI World ex-Australia Index (+4.6%) but outperforming the MSCI Asia Pacific ex-Japan Index (+2.3%).
The bond market and emerging inflationary concerns took centre stage during the quarter with bonds selling off aggressively. Yield on sovereign debt climbed globally following confirmation of the US Rescue Plan. Australian 10-year bonds sold off with yields rising 81 basis points (bps) to 1.79% over the quarter. US 10-year yields also rose 83bps to 1.74%. Many had expected 10-year bond yields to reach these levels, but only by the end of the year. Despite the move, Australian 10-year bond yields remain well below the 20-year average.
The Australian dollar depreciated 1.2% to close at 75.98 US cents as the US Dollar recovered late in the quarter supported by its accelerating vaccine deployment and improving growth outlook. Investment Grade Credit spreads continue to trade at tight levels indicative of improving corporate conditions.
Hard and soft commodities rallied. The London Metals Exchange (LME) Index rose 11%, while oil rallied another 22% and is now up 189% over the last twelve months. Within the bulk market, Iron ore rose 3.1% to US$166/t, Hard Coking coal surged 9.6% and Chinese steel prices rallied 16%. Gold fell 10% weighed down by rising bond yields.
Reporting season in Australia led to further earnings and dividends upgrades coupled with improved visibility. By several measures this was the best reporting season in Australia on record with a high level of earnings beats and positive revisions. US and European Q4 earnings season also positively surprised with most companies beating consensus estimates.
Economic indicators continued to firm globally. Housing markets continue to be buoyed by low rates. CoreLogic dwelling prices boomed 2.6% month-on-month in March, the strongest in 33 years to be up 6.1% year-on-year. Consumer and business sentiment are improving and labour market indicators positively surprised relative to expectations. In Australia, the unemployment rate fell to 5.83%.
OUTLOOK AND STRATEGY
We look to the coming year with cautious optimism for a continuing economic recovery as we emerge from the depths of the COVID-19 induced global recession of 2020.
While there are still near-term divergent trends in the rate of Covid-19 vaccinations, there is strong evidence that the vaccines are effective at protecting against the virus. As they are rolled out the number of infections, fatalities and hospitalisations should continue to fall. The vaccine roll-out in the UK and US is gathering pace with both on track to reach key population threshold levels in Q2. Importantly the inoculation of the vaccines has increased at an exponential pace. The improving health situation will further aid mobility, confidence and the lagging services sector.
The global economy is expected to increase by ~6% this year. The immense domestic and global financial stimulus provided by governments and central banks has been effective in boosting demand for goods and services. Despite improving economic activity, central banks globally remain dovish keeping cash rates at very low levels and implementing Quantitative easing where required. Combined with the deployment of a Covid-19 vaccine, the current economic recovery should strengthen further in 2021.
After managing the Covid-19 pandemic impressively, Australian economic growth in 2021 is expected to be in the order of 4%. Consumer and business indicators have rebounded strongly, the housing market is surging, and the unemployment rate has fallen faster than expected. Commodity prices have provided an income boost to the national economy and private demand is expected to pick-up. We are confident that the transition from the End of JobKeeper can be managed as high household savings rates and improving jobs growth offset the supportive impact of that program.
Less restrictions coupled with continued monetary and fiscal policy support and an improving global economic environment bodes well for a recovery of corporate earnings. Dividend levels are also anticipated to rebound strongly as earnings recover and Boards gain greater confidence in the sustainability of the recovery. Despite the recovery in dividends, yields remain below historic levels and will take time to recover.
The bond market, however, is starting to price in the inflationary impacts of a recovering economy and large fiscal stimulus programs. Short term inflation measures will be a lot higher as they cycle a low base, commodity prices have been increasing and global demand for goods and services is accelerating. Policymakers believe this will be “transitory”, however markets may react differently which may cause volatility in bond and equity markets.
We expect that Australian and US10 year bond yields will rise toward 2% by the end of the year. This, coupled with the low yield on offer, means that there remains the real potential for fixed income returns to be very muted over the coming next few years.
A rising and steepening yield curve, coupled with low coupon rates, increases the relative appeal of equities as an asset class. However, this environment has implications for stock selection with “bond proxy” stocks such as infrastructure and REITs and long duration growth stocks facing valuation headwinds. Such moves may also impact on the relative appeal of US stocks that have a larger presence of technology stocks whose valuations are impacted by a higher discount rate.
Despite the improving economic outlook, equity markets have already rallied significantly. It could be argued that equity market valuations have already captured much (if not all) of the expected improved economic conditions, and relative asset class appeal. Therefore, in this environment portfolio returns are more likely to be driven increasingly by stock selection and active investment management rather than macro factors. This should be a positive investment climate for our Quality at a Reasonable Price (QuARP) investment philosophy which is largely a research driven, bottom up process that emphasises stock selection over thematic investing. Throughout this period, our focus will remain on identifying attractively priced companies with strong balance sheets and relatively safe dividends to produce a diversified and well-managed portfolio.