Quarterly economic update: transitory inflation good news for equities – but what about the impact of persistently low rates?
By James Cook, chief investment officer
Looking over the September quarter, global equity markets continued to rally; both the MSCI World Ex Aust (in AUD) and ASX 300 Indices were up 4.0% and 1.8% respectively, driven predominately by a strong recovery in corporate earnings. However, we expect these equity returns to moderate moving forward on indications that economic growth is slowing, earnings revisions have turned negative and valuations are still full. The ongoing spread of Delta has seen a rise in global COVID-19 lockdowns domestically and supply chain bottlenecks. All contributing to increased levels of uncertainty. This quarter, the Federal Reserve also signalled that interest rates in the US won’t be substantially increased in the near term and recent data has presented conflicting signals surrounding the outlook for higher inflation. The emerging uncertainty is likely to raise the level of volatility across equity and fixed income markets.
For the three months from 30-June to 30-September, the Australian sovereign yield curve saw longer end yields begin to rise from their lows in mid-August which was negative for long-dated fixed rate bond performance. Within the Enhanced Income Trust- Wholesale (EIT-W), fixed-rate positioning (~5% of portfolio) contributed negatively to returns given the longer-dated exposure.
Over the same period, there was continued firm demand for hybrids given the relatively attractive yield and the ongoing market appetite for bank backed credit. These forces were confirmed with a new hybrid issuance from Westpac which was well received by the market.
Term deposit curves have flattened with term premium (the increase in yield for longer dated deposits) reducing. This is in light of increased deposits held at banks by retail investors due to continuing lockdowns in both NSW and VIC. As deposits grow, banks require less funding from wholesale markets, which asset managers such as U Ethical typically deal in. This oversupply has contributed to reductions in 11am (at-call) account rates and deposits.
Australian company reporting in August was generally positive with strong earnings and dividend growth as companies benefitted from a recovery in economic activity and as higher commodity prices flowed through. The ratio of company earning expectation beats to misses was relative to consensus estimates and above historical levels. However, many companies did not provide guidance or were conservative in outlook statements given uncertainty around the global rise in COVID-19 and ongoing lockdowns in NSW and VIC.
In the International Equities Trust - Wholesale, we added medical device company Edward Lifesciences, Daimler and Alstom. We also reduced exposure to GlaxoSmithKline, Royal Phillips and Vestas Wind Systems.
In the Australian Equities Trust, we added miner Sandfire Resources to the portfolio and increased exposure to a number of stocks including GUD Holdings, QBE, Reliance Worldwide and the major banks (ex Commonwealth Bank). We exited A2 Milk following another earnings downgrade and expectations that trading will remain challenging in the near-term.
Economic update and markets’ outlook
Recent economic data has been mixed. While global Purchasing Manager Indices (PMIs) which cover the manufacturing and service sectors have generally remained in solid expansionary territory, recent Chinese industrial production along with US retail sales and employment data has disappointed the market. Given the rise in COVID-19 cases stemming from proliferation of the delta variant, we have seen consensus downgrades to GDP growth forecasts for the world’s two largest economies. Earnings forecasts for global equity markets (including the ASX 300 Index shown below) have risen strongly since mid-2020, contributing to the market’s recovery. However, this trend has started to flatten and reverse over the last month and negative earnings revisions may prove a headwind moving forward.
Inflation concerns eased and interest rates likely to remain low
In the US, core inflation data for August came in below expectations with the annualised rate dropping to 4%. Contributing to this has been the decline in used car prices and discretionary spending on services as a resurgence in COVID-19 cases dampened demand. This may ease concerns about runaway inflation leading to higher interest rates. Following the Fed’s Economic Policy Symposium meeting at Jackson Hole, Chair Jerome Powell signalled the central bank won’t be in a rush to raise interest rates after it begins tapering bond purchases later this year. Domestically, the RBA has already started reducing its bond purchases, although the Governor has dismissed market expectations for a cash rate increase in 2022 or early 2023 given different conditions to overseas.
The market focus remains fixated on whether any inflation pressures likely to emerge from the COVID-19 disruption of supply chains is likely to be transitory or more structural. Either outcome will have a major bearing on future market direction. Most major central banks have signalled a greater tolerance for higher than usual inflation in expectation that it will prove temporary. Moving forward, the major risk is a tightening of monetary policy which may choke off any real underlying growth momentum. Much of the growth achieved to date has come from latent demand from a very weak 2020 that was recoiling from the initial pandemic outbreak.
Should supply disruptions prove more structural in nature, noting there has not been much capital expenditure and investment in capacity from global corporates despite the low cost of capital, the massive expansion in liquidity conditions would fuel an inflation outbreak.
(Source: Reserve Bank of Australia).
Absolute valuations still full
Equity valuations look reasonable on a relative basis, when you consider the low rates on offer for cash and fixed income. The chart below compares the earnings yield of the ASX 300 Index (green) and 10 year Australian government bond yields (blue) - the largest it has been over the last 10 years. While the process will likely be slow, we expect a normalisation in interest rates over the next few years and equity markets are likely to correspondingly move well in advance of central bank implementation. Looking at absolute valuations, the ASX 300 Index currently trades on a forward price-to-earnings ratio of 18.5x; this is more than one standard deviation above the 20 year average. Therefore it is not difficult to forecast a de-rating from current levels which would result in a fall in the market level.
Not out of the woods yet: a cautious approach still justified
The low interest rate environment may be supportive of equities in the near-term, although we believe that some caution is still warranted given earnings revisions have turned negative, valuations remain stretched and the ongoing uncertainty over rising global COVID-19 cases and supply chain bottlenecks. While inflation appears to be under control, this remains a key risk for equity markets. As a result, we maintain a defensive bias across the portfolios.
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