Market Drivers - July 2021
The risk on trade showed no signs of fading in June despite signs that inflation may be higher near-term than forecast by global policymakers. Key central banks such as the US Federal Reserve (Fed) although recognising that growth and inflation are running higher than expected are in reactive mode. They continue to reassure markets that monetary policy change will be slow and modest when it arrives. Meanwhile, mostly positive global growth signs through June fueled risk asset buying even in the face of periodic COVID-19 shutdowns in parts of Australia.
In most major developed economies, however, the news relating to the pandemic was good in June. High vaccination rates in the US and Europe have allowed relaxation of restrictions including those on international travel for some. In Australia, with its policy of elimination rather than containment, the COVID-19 flare ups still forced shutdowns but national cabinet in early July has agreed a staged plan towards changing the elimination policy to one of living with the virus over time where business crippling shutdowns become a last resort not a first one.
Returning to market performance, major share markets made further gains except for Japan’s Nikkei, -0.2% in June. Other major share markets delivered gains ranging from 0.2% from Britain’s FTSE 100 to 2.2% for the US S&P 500 that also made record highs repeatedly in the month. Australia’s ASX 200 gained 2.1% in June. In the fiscal year just ended the gains in most share markets were the highest in 30 years and ranged from 14.3% for Britain’s FTSE 100 to 38.6% for the US S&P 500. Australia’s ASX 200 rose by 23.2%.
Credit markets enjoyed another good month with spreads narrowing again. Strong economic growth is improving credit quality. In Australia, housing credit metrics continue to improve with rising house prices, still low borrowing interest rates and a falling unemployment rate allowing mortgage borrowers to service higher debt with greater ease. Default rates on Australian home loans continue to fall.
One potential spoiler of the positive risk asset environment would be if interest rates rise too sharply. Normally in strong economic growth phases driving up investment in risk assets, government bonds come under selling pressure. Bond investors seek higher yields to compensate for the higher inflation that comes after a period of rapid growth. Asset allocators increase their weighted purchases of risk assets funded by reducing their allocation to government bonds. Typically, the bond yield curve steepens with longer-term bond yields rising more than shorter-term yields still anchored by low official cash rates.
Early-stage steepening of the bond yield curve remains a positive environment for risk asset investment, but as central banks respond hiking official interest rates and leaning against growth prospects to contain inflation, prospects for risk assets sour.
An anomaly of the current investment environment is that longer-term bond yields are not rising as much as might be expected given the potential drivers of higher yields – rapid economic growth and fast rising producer prices threatening a substantial near-term blip upwards in consumer prices. Part of the reason bond yields are not lifting is the bond buying activity of central banks. Even though central banks are starting to taper their regular bond purchases the tapering process is modest and protracted.
Another part of the reason for bond yields not lifting is that central banks are promising to be reactive to inflation. The near-term upside producer and consumer price inflation surprises are viewed as being temporary and mean that central banks do not need to react by hiking interest rates. The US Fed has brought forward a forecast rate hike to 2023 from 2024 but that is a modest and delayed reaction to annual CPI inflation that lifted to 5.0% y-o-y in May 2021.
Despite the build-up of reasons for bond yields to rise, the US 10-year bond yield fell by 12 basis points (bps) in June to 1.47% while the 30-year treasury yield fell by 19bps to 2.09%. The rise in US bond and treasury yields over the past year, 81bps for the 10-year bond yield and 68bps for the 30-year treasury yield is small given that the US economy is experiencing the sharpest recovery since World War II.
In Australia, bond yields also fell in June with the 10-year bond yield down by 17bps to 1.52%. The COVID-19 lockdowns temporarily dent growth prospects providing some assistance for the bond rally. The economic releases during the month, however, were still robust. The Q1 GDP report came stronger than expected at +1.8% q-o-q, +1.1% y-o-y. May employment growth beat expectations lifting 117,000 and the unemployment fell to 5.1%, lower than at the start of the pandemic.
Australian bond yields are staying down because there is no near-term pressure on the RBA to hike any of the interest rates it controls, in particular the 0.10% official cash rate and the cap on the three-year government bond yield. The economy is growing more strongly than the RBA forecast and the unemployment is falling faster than forecast. There is a risk wages will rise earlier and faster than forecast by the RBA, but these forecast misses will lead to minor monetary policy tweaks at most in the near-term, a tapering bond buying program and not much more.
The RBA is under little pressure to change monetary policy where it will count, official interest rate settings. The unemployment rate will take many months to fall below 4% and generate conditions conducive to 4%+ annual wages growth the preconditions the RBA believes necessary to generate consistent 2-3% annual CPI inflation. Nevertheless, these preconditions are likely to occur before 2024 the RBA’s current thinking for a first interest rate hike. Our view is that the conditions will be met in late 2022 and we pencil in a first interest rate hike in Q4 2022. Even our rate hike timing is 15 months away, a long time for risk-asset markets to enjoy rapid economic growth with low interest rates.