Market Drivers - May 2021
Risk assets rose again in April amid more signs of strong global economic growth. Bond yields fell, with little evidence of strong growth spilling over to higher inflation that might cause an early end to very low official interest rates set by central banks. During April, Q1 GDP reports from the US (+6.4% annualised) and China (+18.3% y-o-y) illustrated the strength of the current global economic recovery and with momentum to carry forward. While COVID-19 outbreaks remain a threat to strong global growth, it is a diminishing threat as vaccination rates increase.
In April, most major share markets rose with one notable exception, Japan’s Nikkei, down by 1.3%. Otherwise, major share markets rose between 0.8% for the German DAX index to 5.2% for the US S&P 500. Quarterly reporting season in the US again showed most companies beating analysts’ forecasts. Australia’s ASX 200 rose by 3.5%, assisted by upside surprises from monthly economic reports relating to everything from housing activity and retail trade to business and consumer sentiment and employment.
Credit markets rallied in April as investors chased yield. Potential risks were limited, with evidence of strong economic growth lowering likely default rates. Australian credit remained well supported even with margins falling to the lowest levels in more than a decade. Default rates on Australian home loans continue to fall, assisted by persistently low borrowing interest rates, stronger-than-expected growth in employment, lower-than-expected unemployment and rising house prices.
Given the strength of risk asset prices in April another fall in bond yields was surprising. The US 10-year bond yield fell by 11 basis points (bps) to 1.63%, while the 30-year Treasury yield also fell 11bps to 2.30%. Australia’s 10-year bond yield fell by 7bps to 1.74%. Helping to explain the surprise, bond markets were supported by the US Federal Reserve’s reaffirmation that it would continue to hold down official interest rates even as it upgrades its outlook for the US economy. Also in focus is the Fed’s earlier indication that its 2% inflation target is an average target, meaning that it will live with upside inflation surprises for a period without responding by hiking rates.
As far as Australian bond yields are concerned, the RBA maintained its guidance that conditions that would support higher inflation and the need for a rate hike are unlikely to occur before 2024. A secular rise in inflation in the RBA’s view cannot occur without higher wages (4% y-o-y or more) which will not be supported until the unemployment rate falls and stays at 4% or lower. We feel that higher inflation may occur before the unemployment rate falls to 4% but that will take time, at least another year, to prove one way or the other.
The RBA had some support for its slow inflation rise view with the release of the Q1 CPI in April. The CPI rose a lower-than-expected 0.6% q-o-q, lifting the annual inflation rate to 1.1% y-o-y. The two main underlying inflation measures were also lower-than-expected, with the trimmed mean up 0.3% q-o-q, 1.1% y-o-y and the weighted median up 0.4% q-o-q, 1.3% y-o-y.
The low annual inflation readings in the Q1 CPI report mean that the RBA will repeat with some confidence its guidance of official interest rates on hold through to at least 2024 in both today’s policy meeting and the quarterly Monetary Policy Statement on Friday. The RBA will also be able to again revise higher its economic growth forecasts and lower its unemployment rate forecasts without undue questioning of its low wage growth and inflation forecasts.
Low interest rates will continue to support stronger Australian economic growth. Government spending looks set to continue to support growth for another year at least as well. The May 11 Federal Budget looks set to spend more in areas creating more jobs adding to the cycle of fast employment growth, driving up household spending and in turn leading to more business activity and more employment and more spending. We will write a more extensive preview of the Federal Budget next week.
More government spending and continuing low interest rates will add fuel to an already fast-growing economy. It is also reasonable to expect those periodic disruptions from COVID-19 will become fewer and less-pronounced with the rising vaccination rate. Even though some risk assets look richly priced, fast improving economic activity is still running in their favour and for the time being without restraint from rising bond yields.
At some point, longer-term bond yields will push higher to reflect the risk of rising inflation, but it will be a battle against the central banks for at least the remainder of this year.