23 Apr 2021
Q1 Economic Review & Outlook
Article written by PSK's Chief Investment Officer Chris Lioutas
March was one of the oddest quarters we’ve seen in some time. Given all the things happening (or not happening) in the periphery, you’d be forgiven for thinking that it wasn’t a strong quarter for markets, but boy would you be wrong.
It wasn’t all plain sailing on the markets front with one of the biggest government bond market sell-offs since the 1994 bond market crash. To make it all the more confusing, Australian listed property fell, global listed infrastructure and property rocketed higher, Australian large company stocks outperformed small company stocks, global equities saw the strongest returns (almost a years’ worth of return) surprisingly boosted by European equities in contrast to the continuation of lockdowns, all whilst the Aussie dollar retreated a little largely on unexpected US dollar strength. In another big change, there was a large rotation into Value stocks, including those stocks left behind or beaten down by Covid-related government-imposed restrictions in 2020.
The quarter started off with a bang on the US political front with the Republicans losing both senate seats in the Georgia run-off which resulted in a split 50-50 senate. The result means a likely logjam for legislation requiring a super-majority which would need a number of senators from either party to cross the floor, but also means that other legislation that can pass with a simple majority can do so relatively easily with VP Kamala Harris having the casting vote. The overall outcome is somewhat vexed in that it allows a non-Republican controlled senate to push through greater spending to support Covid recovery efforts but also somewhat enables the Democrats to ram through some of the most “progressive” policies the USA has ever seen. The Democrat party of old is not the same as the current Democrat party, with that picture becoming clearer for moderates and liberals as the quarter went on.
At the same time, we saw the beginnings of an impressive vaccine rollout by certain countries, particularly Israel, the UK, and the USA, whilst the Europeans got swept up in their usual bureaucratic red tape, though they may have even outdone themselves this time around, regarding vaccine ordering and distribution. That resulted in a lessening of restrictions for those countries with either strong vaccine rollout or strong previous efforts to curb the spread of the virus, but an increase in and lengthening of restrictions for those countries and regions that did neither well. That trajectory progressed in the same fashion as the quarter went on.
In the background, we first had the “GameStop” controversy which saw retail punters (investors) battle it out against hedge fund managers (the so-called professionals), with retail punters using a toxic but somewhat effective combination of social media, derivatives / leverage, free brokerage on trades, government stimulus cheques, and boredom (given government-imposed restrictions) to pile into stocks, and commodities for that matter, to counter short positions (ie. betting that a price will fall) from the professional investors. Whilst the latter was right to be positioned short given some of the rubbish quality of these investments, they largely got caught out at their own game. The result was a significant increase in volatility in markets, particularly on an intra-day basis, which led to broad investor concerns regarding the stability of the market.
We then rolled from that straight into one of the largest and fastest increases in government bond yields seen in decades. It’s worth pausing to note (and impress) that whilst rising bond yields mean higher income returns in the future, it can also mean large capital losses given a bond has a fixed maturity which means that the price of a bond and its yield move in different directions. It’s also worth noting that the bond’s coupon (what the bond issuer promises to pay) is not the same as the bond’s yield, with the yield calculated as the coupon divided by the prevailing market price for the bond. Whilst bond yields were likely to rise over the course of this year due to a combination of rising inflation expectations (founded or unfounded), improving economic outlook, and large government fiscal support programs, US President Biden’s US$2 trillion package along with the mention of more to come and some better than expected economic data, was all that was needed to trigger a significant and fast rise in government bond yields to the levels seen prior to Covid beginning. In contrast, developed economy central banks like the US, Europe, Japan, and Australia all strongly reiterated and re-confirmed that their loose policy stance (ie. rates at or near zero plus money printing) would be in place for some time to come (ie. at least for the next 2 years, but likely 3 years). The result was a more than 4% fall in Australian government bond returns in the quarter.
In contrast, equity markets looked straight through the bond market carnage, in effect turning a blind eye to their all-important nearest relative, and powering through any obstacle that could be thrown at it. Not totally surprising given the quantum of both central bank and government stimulus that is finding its way into the market, in addition to vaccine optimism. But, and a very big BUT at that, the bond market is largely used as a valuation and pricing mechanism for the equity market. That is, if bond yields are higher, either equity earnings must rise to account for the price, or the price must fall to account for the higher bond yields. Given the strong returns from equities, with global listed property and infrastructure joining the party, it’s fair to say investors are currently betting that earnings will rise to justify the rising equity prices. Time will tell.
It’s fair to say we’re at a juncture of sorts in terms of inflation expectations versus inflation reality, with the US doing its best to stoke (or poke) the inflation monster with unnecessary government spending and potentially profligate infrastructure spending. Inflation is critical as it then dictates how central banks will act in the future – ie. either as a handbrake or as fuel for asset price growth. We’ll know more on this front in the months to come, something we will be watching critically, because a very different inflation outlook can dictate or require very different portfolio settings.
We’ll also be watching closely vaccine efficacy (including safety), vaccine distribution, and vaccine take-up, as this then dictates the pace of country re-opening and hence the pace of the economic recovery effort. The faster the pace, the quicker the improvement in corporate earnings and balance sheets, whilst a slower pace than currently expected could result in earnings disappointment and stressed balance sheets which can then precipitate a market correction. A watchful eye on both data and corporate earnings updates will be key.
If you’d like to discuss any of the points raised, please do not hesitate to contact us on 9324 8888.
PSK Financial Services Group Pty Ltd (ABN 24 134 987 205) are Authorised Representatives of Charter Financial Planning Ltd (AFSL 234666), Australian Financial services Licensee and Australian Credit Licensee. Information contained in this article is general in nature. It does not take into account your objectives, needs or financial situation. You need to consider your financial situation before making any decisions based on this information.