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Quarterly Wrap: March 2021

We’re starting to see the light at the end of the tunnel, writes Senior Investment Manager George Lin, but there’s a fascinating tug of war between markets and central banks on interest rates.

       Written by George Lin
Senior Investment Manager | Colonial First State

Over the three months to 31 March, markets had a lot to focus on – from Capitol riots and geopolitical challenges to vaccine setbacks, a social media buying frenzy, and an increase in global bond yields. During this time, we also saw a dramatic fall in the number of new Coronavirus cases in a number of countries where vaccination programs were successfully rolled out. Further, positive sentiment surrounding strong economic data, the passage of a large fiscal relief bill in the US, as well as optimism over the pandemic had a downside – shifting markets’ focus from reflation to inflation, and pushing bond yields higher. Still, most growth assets remained resilient to rising bond yields. And by quarter’s end, Australian shares were up 4.2%, while the Australian Dollar (AUD) traded at about 76 US cents.

Positive on herd immunity

A year after the world entered a pandemic-induced global lockdown, we are finally seeing the light at the end of the tunnel. A number of countries commenced vaccination programs in January. And while there were the inevitable production bottlenecks, supply shortages and some resistance against being inoculated, nearly 450 million doses have been administered globally. The US and the UK have the most successful programs among the more developed countries. China’s progress has accelerated sharply over the last few weeks though, given its massive population, the proportion of people vaccinated is still low. Meanwhile, Europe has had less success, while the Australian federal and state governments have pointed fingers at one another as to who’s responsible for our so far sluggish vaccine roll-out. Despite some setbacks, markets are increasingly confident that herd immunity can be achieved in developed economies by the end of 2021. The US and UK will likely be the first to achieve this, followed by key European nations.


Vaccination by country as at 31 March 2021 (Source: Worldometer)
Country Doses (per 100 of population)
Israel 115.5
Chile 44.3
United Kingdom 50.9
United States 44.1
Spain 16.6
Germany 16.1
France 15.7
Italy 16.4
Canada 14.5
Russia 8.6
China 7.9


Economic data paints a picture of health

Global economic data pointed to an ongoing (if uneven) recovery over the March quarter. The recovery in the global manufacturing sector strengthened further, with increases in the US and Europe. While still lagging behind the manufacturing sector, the services sector in the US staged a strong recovery over the quarter as social-distancing measures were eased. On the other hand, the European services sector appears to remain weak. In China, the services reading is also disappointing, but remains in expansionary territory.

Australian economic data released over the quarter painted a picture of an economy that is rapidly recovering from the pandemic-induced economic downturn. The level of employment has grown for five consecutive months since September last year, and is now almost back to its pre-pandemic level. The trend in retail trade has also turned relatively positive, while the level of business confidence has recovered solidly as the pre-Christmas lockdowns were gradually lifted.

Elsewhere, US economic data also pointed towards a robust economic recovery. After stalling in the December quarter, the job market recovery resumed. And after falling for two consecutive months, retail trade recovered by a strong 7.6% in January, followed by a small fall in February. A major reason for the optimism on the near-term US economic outlook is the passage of a trillion-dollar fiscal package. Its centrepieces include cheques worth $1,400 for eligible persons and the continuation of a $300-per-week unemployment benefit payment, which should contribute significantly to household spending as the pandemic continues to fade. So far, US households have built up their savings and there is a real possibility of supressed consumption coming through over the next few months. However, private sector economists have aggressively revised upward their economic growth forecasts for the June 2021 quarter to 7.1% and 4.9% year-on-year (yoy) for 2021.

Source: Factset

The downside of the upside

A combination of positive Coronavirus developments, stronger economic data and President Biden’s trillion-dollar stimulus package caused financial markets to re-assess the world’s economic prospects. For the first time since the start of the pandemic, markets shifted their focus from the pandemic to the possibility of higher inflation in the US as the economy recovers – questioning the commitment of the US Federal Reserve (the Fed) to its ultra-accommodative monetary policy. During this time, the US 10-year bond yield rose from 0.91% to 1.74% by the end of the quarter, while the Australian 10-year bond yield rose even more dramatically – reaching a peak of 1.88% in late February before easing back to 1.81% at the end of March. Ten-year bond yields in Australia and the US are now broadly back to the pre-pandemic levels (as seen in late 2019).

There were a number of distractions for share markets. After rising in January and most of February, some indices retreated in March due partly to increasing concerns about higher bond yields. Overall, however, share indices recorded solid gains over the three months. The ASX 200 rose 4.2% and the Euro STOXX surged 8.7%. A pronounced impact of rising bond yields was a rotation from highly valued growth stocks in the technology sector to cyclical stocks which stand to benefit more from an economic recovery. This is best illustrated in US share markets, where the S&P 500 rose 4.1%, while the technology-dominated NASDAQ rose only 0.7%.

Source: Factset
Source: Factset

Overall, share markets stayed relatively resilient, with investor optimism reinforced by the US and Australian quarterly reporting seasons. The Australian reporting season was described as the best reporting season in decades. Around 46% of Australian large-caps reported better-than-consensus earnings due to stronger-than-expected reductions in margins. As a result, 44% of companies saw upgrades in consensus earnings per share. In fact, consensus earnings forecasts for the ASX 200 in financial year 2022 is now only 4% lower than before the pandemic. The US also had a strong season, with around 96% of large-caps reporting better-than-consensus earnings for the December 2020 quarter. Sell-side analysts are now expecting yoy earnings growth for the March quarter of 28.2%.

Looking ahead – a tug of war

Many have been bullish on shares since the second half of 2020, so it is natural to ask, given the rise in bond yields, whether it’s time to go defensive and rotate away from shares. One short answer is that it’s probably too early. There is a bias, albeit a weakening one, towards shares and other reflationary assets over the short term. However, the upside in shares is considerably less than it was six months ago as the risk-return trade-off of these investments has deteriorated due to higher valuations and the significant risks posed by higher inflation and bond yields. For now, however, some considerations on the factors still favouring shares at this point in the cycle:

  1. The driver for higher bond yields is expected higher inflation, which is the result of stronger economic growth as the pandemic fades. Though the real US bond yield has risen, it’s still low by historical standards and financial conditions remain accommodative. In this regard, it is encouraging to note that the spread on corporate bonds has remained steady.
  2. Secondly, stronger economic growth is leading to earnings growth which should accelerate as economies re-open and normalise. In this regard, the US is leading developed share markets

On a longer-term basis, rising global bond yields do pose a significant threat to share prices and could have a negative impact on economic growth.
The question is, how far away is this tipping point?

In this context, the current tug of war between financial markets and central banks on the timing of the interest rate hiking cycle is fascinating. Currently, markets have priced in a policy rate increase in both the US and Australia by the 2022 September quarter. But both the Fed and the Reserve Bank of Australia (RBA) have repeatedly stated that they don’t expect an increase in rates for some time. For instance, the RBA’s Governor Lowe has said that the “cash rate is very likely to remain at its current level until at least 2024”, while the policy rate forecasts of the Fed’s Federal Open Market Committee members suggest the policy rate will not increase until 2023.

So, which is correct: financial markets or central banks? Paradoxically, both sides may be correct. Markets may be correct in the sense that economic conditions will return to pre-pandemic levels faster than expected with somewhat higher inflation. However, this does not necessarily mean central banks will have to capitulate and increase policy rates before the end of 2022. If the RBA or the Fed are willing to tolerate somewhat higher inflation – say, close to 3.0% – to achieve their policy aims, they are able to as long as they’re willing to tolerate lower exchange rates. Under such a scenario, short-term interest rates (say, maturity of under three years) will remain low and well anchored, while rates at the long end of the curve will rise in volatile trading.

What does this mean for shares? The easiest answer is greater volatility. As market expectations adjust to new economic data and central banks’ messaging, prices tend to jump around. The March quarter is a prime example of this. It’s possible that the Fed’s narrative on the US economy will likely be challenged over the next six months given the possibility of significantly stronger economic data, higher inflation due to the base effect and the prospect of another major spending bill from the Biden administration which focused on infrastructure. The more difficult answer, however, is the timing of a re-allocation from shares. As long as higher nominal bond yields are driven by the expectation of higher inflation caused by stronger economic growth, share prices can be supported by higher expected earnings. Valuation matters and companies with lofty valuations, whether it’s Tesla in the US or AfterPay in Australia, will likely come under more pressure.

The main risk over the next six months is not higher policy rates but the main central banks, in particular the Fed, reducing (tapering) its purchase of bonds faster and earlier than markets expect. While this risk is real, such “tapering” is still some way off for two reasons. Firstly, while US inflation is expected to increase over the coming quarters due to the base effect and early signs of upstream price pressure, inflation is likely to remain well contained due to the large output gap in the US economy. Secondly, the Fed will be extremely careful in the unwinding of quantitative easing. Post-GFC history suggests that this will be a long and gradual process, starting with the suspension of the re-investment of coupons from its holding of bonds. In doing so, the Fed will try not to spook investors.

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