The vaccine rollout is gathering pace in most countries and global equity markets have staged a dramatic recovery from the lows of March 2020. Australian and US equity markets are within 1% to 2% of all-time highs. However, over the last few months the rate of this increase has slowed as markets contemplate if high inflation, particularly in the US, is transitory or persistent.
On the positive side, global bond yields have remained low after the spike we saw earlier this year. While we have had large rotations in different sectors of equity markets, we have not had a pullback of even 5% in the US market in 2021. This is a good result considering there is speculation that the US Fed will announce tapering at its September meeting, i.e. reducing its bond buying.
The Australian dollar has been weak, touching 71 US cents, due to the dramatic fall in the iron ore price, a more dovish RBA compared to the US Fed, and markets becoming more risk-averse as the Delta variant sweeps the globe. Markets now recognise that COVID-19 is unlikely to be eliminated and current vaccines will lose effectiveness over time, requiring booster shots.
While the RBA upgraded Australian GDP growth forecast just a few months ago, it has had to back track as a result of the Delta strain lockdowns. In August, it cut the GDP growth forecast to 4.0% from 4.75% for the year to 31 December 2021. There’s now a strong possibility of two quarters of negative GDP growth.
The US CPI (inflation) increased by 0.5% in July after rising 0.9% in June. While the monthly pace slowed, the annual rate of 5.4% was the same annual rate as in June. However, this was also the first time in 3 months it did not significantly exceed expectations. In contrast to the US, Australian inflation is quite well behaved with CPI inflation estimated to be around 1.6% in 2021 and the RBA’s August forecast was for core inflation to only hit 2.0% in June 2023.
Most geopolitical crises are a one-week event, but we think Afghanistan is going to have major repercussions for years to come. The manner of the US withdrawal without informing its NATO allies, and abandoning its Afghan interpreters, positions the US as an untrustworthy ally. The Chinese Communist Party were quick to taunt Taiwan as to whether American will be there to support them in times of need.
Strategically the Chinese have extended diplomatic ties to the Taliban, as they wish to gain access to roughly $US1-$3 trillion of unexplored mineral deposits, including lithium, rare earths and copper, materials critical to battery production and the defence industry.
The RBA has stated for a while that there will be no rate hike before 2024 at the earliest. However, given the strength in the economy, it has more recently backtracked, indicating an earlier rate hike is possible (which was before most of Australia was in lockdown). With the Australian economy needing more support, the lockdowns can only serve to extend the period of lower interest rates, subject to the economic rebound post lockdown. The good news is that the vaccine rollout is gaining steam locally, and it’s likely we’ll have over 80% of the adult population fully vaccinated by late this year.
The consensus is US rate rises are still a long way off, interestingly, a recent survey of global fund managers found that 2/3 believed current US inflation will be transitory. Whether inflation is transitory or persistent, we need to watch US month to month inflation numbers and their composition. While used car prices and travel costs have come back somewhat, we do not want inflation to persist in more ‘sticky” items such as wages and rents, as higher inflation will lead to higher interest rates.
One of the reasons equity markets have done so well is that price-to-earnings (PE) have re-rated higher because of very low interest rates. Equity valuations are still a risk, with the Global equity PE close to 20x. The forward PE for the S&P 500 was 21.4x on Aug 20, 2021 (S&P 500 at 4,406). We’ve had a great reporting season in the US, with second quarter 2021 EPS (earnings per share) expected to be up 94.7% from Q2 of 2020. Companies on average are beating expectations by 15.8%. Comparisons get harder as we get further away from the 2020 lockdowns, for instance, in the first quarter of 2022, EPS (earnings per share) are expected to be up 5.5% from Q1 of 2021 (source Refinitiv). Given this, it’s likely we have passed peak EPS and GDP growth quarters in the US.
In terms of allocations, negative real interest rates continue to favour growth assets over fixed interest. Currently the US 10 year bond yield is around 1.3%, while 10 year inflation expectations are about 2.4%. Any persistent inflation spike will exacerbate this differential.
While index levels are elevated, there is constant rotation between sectors, which should provide opportunities for fund managers, for example, most resource stocks are down by over 15% in the last month. We would not aggressively add to positions right now, but suggest investors remain near strategic asset allocations, with a slight preference to growth assets and maintain a mix of growth and value styles, as the wild swings of the last year showed, it’s very hard to time these moves.
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