Market Drivers - August 2021
Risk asset performance was mixed in July. The strength of the economic recovery globally and in Australia was cast in doubt by increasing infection rates of the highly infectious Delta strain of COVID-19 in many parts of the world. Countering COVID-19 concerns, rising vaccination rates provide hope that countries can live close to normally. The US, with the strongest policy stimulus, is experiencing rapid economic growth and fast rising company earnings. Elsewhere extending policy stimulus is the stock response to any renewal of restrictions to contain COVID-19.
Australia was quick to initiate a raft of household and business income support measures in July as the COVID crisis intensified in Greater Sydney. Central Banks continue to complement fiscal stimulus by delaying any start to tighten very easy monetary conditions even in the face of higher-than-expected inflation in the near term.
Returning to market performance, major share markets were mixed strength in July. US share market indices continued to forge higher into record territory assisted by another higher-than-expected quarterly company profit reporting season. The US S&P 500 rose by 2.3% in the month and its nearest performance rival was Australia’s ASX 200, up 1.1%. This was helped by the profit bonanza for major resource companies from high commodity prices. Share market performance in Europe and Asia was a patchwork of gains and losses ranging for the major indices from up 0.6% for the Euro Stoxx 50 to down 5.2% for Japan’s Nikkei.
Credit markets were also mixed strength through July with Australian credit giving up a little ground. Australia is about to suffer a growth set-back because of COVID-19 restrictions. The unemployment rate will rise briefly. These negative influences on credit quality will be offset by the positive influence of the income safety net introduced for businesses and households, boosting the likelihood of robust economic growth once restrictions are lifted. Meantime, Australian housing credit metrics remain strong with rising house prices, still low borrowing interest rates and concessions from banks keeping default rates on Australian home loans low.
Government bond markets had a surprisingly good month in July given evidence of higher inflation. The US 10-year bond yield fell by 25 basis points (bps) to 1.22%, while the 30-year treasury yield fell by 20bps to 1.89%. Buyers of US bonds were undeterred by the June CPI report showing annual inflation lifting unexpectedly to 5.4% y-o-y from 5.0% in May. The annual inflation rise is viewed as temporary by the Federal Reserve (Fed) and seemingly by the bond market too. The Fed backed its inflation view at the late July policy meeting leaving the Fed Funds rate unchanged at 0-0.25% and declaring that it is not looking to taper its bond buying program near-term given the uncertainty that COVID still engenders for the US economic growth outlook.
The potential inflation threat to low US bond yields cannot be dismissed entirely. While statistical base effects will lower annual US inflation later in 2021 and during the first half of 2022, a more consistent resurgence in annual inflation looms beyond mid-2022. The extraordinary rise in US house prices (up 17% y-o-y in May) will filter over time into the CPI via the cost of shelter component. The tightening US labour market will also deliver higher wages growth with average hourly earnings up 3.6% y-o-y in the latest June 2021 report and likely to rise consistently above 4% later this year. While temporary factors mean the annual increase in the US CPI falls below 3% y-o-y early in 2022, longer-term influences push it back up above 3% later in the year and force a reactive Fed to hike rates. At some point in the next few months, US bond yields are likely to rise to reflect higher longer-term inflation pressure and the monetary policy consequences.
In Australia, the rally in the bond market in July was stronger than in the US. The 10-year bond yield fell by 35bps to 1.17%. An additional driver for the strong bond rally was the prospect of a pause in Australia’s economic recovery caused by lockdowns; at one stage in July affecting 45% of Australia’s population.
Australia faces a negative growth quarter in Q3 and at this stage a soft start to Q4 depending upon how long the lockdowns last. Beyond the growth pause, the economic recovery should rekindle sharply, fueled in part by the swift introduction of income support payments, but also by the plan endorsed at the latest National Cabinet that provides a vaccination threshold, allowing a more certain and sustainable opening of the national economy. Greater certainty about freedom means businesses and households will spend confidently in 2022.
The Australian bond market, like its US counterpart, ignored evidence of higher inflation. The Q2 CPI rose 3.8% y-o-y up from 1.1% in Q1. The jump in the annual rate is mostly a base effect. In Q2 last year free childcare lowered the CPI 1.9% q-o-q whereas in Q2 this year there was a rise of 0.8% q-o-q. The underlying inflation measures, removing the effects of outlier price changes, show a less pronounced lift in annual inflation, with the average of the trimmed mean and weighted median measures lifting from 1.2% y-o-y in Q1 to 1.65% in Q2. In Q3, the annual headline CPI should fall to around 2.2%, but underlying inflation may lift towards 2%.
Prospective annual inflation hovering on all measures close to 2% will not alarm the RBA, especially with a near-term pull-back in growth and employment in prospect. We see stronger economic conditions developing beyond the next six months causing a renewed push upwards in annual inflation, especially in the second half of 2022. It will be that rise in inflation that eventually stirs the RBA into interest rate action, but the RBA has made it plain that it will not pre-empt the rise but will wait for solid evidence that higher inflation is occurring. We had penciled in Q4 2022 for a rate hike, but we now push that out six months to Q2 2023 although the RBA will still talk of no official rate rise before 2024, at earliest, at least while the current lockdowns last.
The RBA rate outlook is certainly more dovish than the Fed rate outlook. That alone means that Australian bonds continue to outperform their US counterparts.