Market Drivers - February 2021
Risk assets rose through much of January before giving up gains towards month-end. Good news related to COVID-19 vaccines, the new presidency in the US and potential for stronger global economic growth was countered by concern about substantial losses of US hedge funds from stock shorting gone terribly wrong, due to the collective buying power of millions of small investors using social media to act as one.
The battle between US hedge funds and small investors complicates the outlook for risk assets. Excessive stock prices or “bubbles” occur as the small investor cohort force hedge funds to cover their shorts. At some point discipline breaks down among small investors as unjustifiably high stock prices mean that first sellers lock in biggest profit and later sellers face plummeting stock prices and large losses. Stock market trading suffers massive volatility. Another increasing risk is greater stock market regulation as regulators seek ways to limit excessive volatility that risk turning the stock market to a source of household wealth destruction, capable of destroying an otherwise promising economic outlook.
Broad economic and investment fundamentals have not changed. As the global pandemic reduces in 2021 because of more effective containment through restrictions and vaccinations, the power of fiscal stimulus combined with accommodating monetary conditions will be reinforced. Global economic growth, including Australian economic growth, should accelerate in 2021, especially in the second half.
This fundamental outlook would normally allow risk assets already richly priced in some cases to forge higher, with occasional set-backs providing bases for further buying. The battle between US hedge funds and a swelling army of linked small investors and the potential fallout clouds the investment outlook.
Returning to January, major share markets mostly surrendered early gains. During the month, losses for the US and European share markets ranged from 0.8% for Britain’s FTSE 100 to 2.1% for Germany’s DAX. The US S&P 500 fell 1.1%. Asian and the Australian share markets fared better; Japan’s Nikkei rose by 0.8% while Australia’s S&P 500 was up 0.3%.
Credit markets reflected the forces driving share markets in January and rose through much of the month before surrendering gains at month end. While Australian credit will be influenced by events in the US it should also benefit from positive local developments. Continuing Australian housing market improvement is allowing the number of housing borrowers on suspended repayments to reduce more rapidly than expected. Business borrowers are also returning to regular loan repayments more rapidly than expected on the improving economy.
Australia stands out by international comparison both in economic performance and in containing COVID-19. Australia’s Q4 GDP report when released in March will be among the strongest in the world and will ensure that the fall in 2020 GDP is among the smallest, a fact recognised in the latest IMF global economic forecasts. Factors extending Australia’s economic out-performance in 2021 include policy support from stimulus spending and complementary monetary settings, continuing housing recovery, and a household sector primed to spend more after months of rising employment and after lifting savings to a 40-year high in the pandemic. Australian exports are also rising more strongly than expected on increasing demand for commodities as manufacturing continues to lead global economic recovery.
Small outbreaks of COVID-19 in Australia in December have been contained effectively and quickly, providing confidence that the latest community infection in Perth will be no exception. Australia’s hotel quarantine system for returning travellers became the gold standard for infection control in January and is being copied in other countries including the US and the UK.
Australia’s out-performance is starting to place upward pressure on longer-term interest rates. The 10-year bond yield rose in January by 16 basis points (bps) to 1.13%. Australia’s 10-year bond yield traded 6bps above its US counterpart at the end of January despite lower government debt than in the US and lower annual inflation. Australia’s 10-year bond yield premium is a factor driving a stronger Australian dollar an unwanted encumbrance to economic recovery.
In early February, the pullback in risk asset markets on concerns about battling small investors and hedge funds should cause some bond-buying and lower yields. The reprieve from rising bond yields may be short-lived. As positive economic growth fundamentals reassert, bond yields start to rise again. The RBA will not want longer-term bond yields to rise too fast but it is one of a range of problems the RBA faces as it tries to keep interest rates low to assist economic recovery.
The RBA’s stated position is that Australian economic recovery is occurring more strongly and faster than earlier expected although progress reducing unemployment and lifting wages and inflation will remain slow. The RBA intends to leave low official interest rates in place for at least three years to assist sustainable economic recovery.
Low official interest rates – the 0.10% official cash rate and cap on the three-year bond yield – have underpinned record low home loan interest rates that together with various government initiatives to assist the housing industry have kick-started a huge lift in housing demand and an accelerating escalation in house prices. If current low official interest rates stay in place as the economy gathers pace through 2021 and 2022 house prices will be bid much higher and to levels worsening social equality and forcing greater policy adjustment down the track.
It is hard to see beyond the RBA’s current position of the cash rate staying at 0.10% for the time being. Low annual inflation (0.9% y-o-y in Q4 2020) and low annual wages growth persistently around 1% y-o-y would normally support a view of persistently low official interest rates. However, if house prices continue to rise fast the RBA may shock markets at some stage with a small “stitch-in-time" rate change or control to avoid a much bigger and more devastating policy adjustment two or three years down the track.