A VIEW FROM THE TOP END

Markets:

The market experienced its first pullback of the calendar year, triggered by a sell off in the bond market as inflation speculation hit a tipping point. We will unpack what happened and contrast it to similar periods in market history later in the piece, but generally markets do not like the thought of higher interest rates, and we are seeing the temper tantrum play out. With the market feeling threatened by the possibility of a rise in interest rates we saw the ASX down -1.33%, SP500 -0.87% and Nasdaq 100 -3.68%. Over the last two weeks mining, energy, financials, and real estate were positive for the ASX. Sectors that dragged the country’s index down were info tech (-12%), telecom (-6%) and consumer discretionary (-4.5%).

Bond Market Meltdown Pulls Markets Down:

We will start with some definitions. The bond market refers to debt or fixed income. Essentially loans to governments or companies that can be traded. Next when we refer to bonds, they are bought originally at a price of “par”, which can be imagined as $100. Borrow $1,000,000 by offering bonds and you will offer 10,000 units at $100 each. Interest on the borrowings is paid in the form of periodic coupons, with the final coupon returning the original $100 borrowed. As interest rates move up and down with time the value to an investor of the fixed coupons and final payment changes. To simplify conversations about bonds we refer to this value as the “yield”. The yield is an estimate of the value of the bond going forward and lets us rank the bond against other similar bonds. Now because the coupons on most bonds are fixed, if prices people pay for bonds go up, you are now paying more for the same coupons, so the yield goes down and vice versa. Think if you get $10 a year on a $100 bond, you earn 10% yield, but if interest rates were now 5%, and the price of that bond rose to $150 and you bought the bond, your yield would be 6.7%. In another case if rates were to rise to 15% and the bond sunk in price to $75, your yield would be 13.3%. There are a few added complexities, but this example emphasizes that yields move inversely to bond price.

Now that we have set the scene for bonds, we can talk about what is going on in the bond market and how it effects the stock market. We mentioned earlier that stock markets dislike rising rates, and the reason for this is twofold. Higher rates make companies that depend on debt have higher lending costs and ultimately less borrowing capacity. It is tougher for companies to access capital to grow when rates are high. The other effect is that it hurts stock valuations by making earnings in the future worth less than if rates were low. We have talked a lot about multiple expansion in the valuation section of these notes, if rates begin to rise or quantitative easing ended then we would see multiple contraction.

Share markets are forward looking, they do not wait around for something to happen, they shoot first and ask questions later. We saw this with Covid and we have seen the same behaviour with the Covid recovery. It always feels a little too soon.

Right now, the issue in the market’s sights is inflation. Inflation is horrendous for bond investors, especially if you are holding long term bonds, so they are selling, and this selling causes long term yields to rise. As you can see in the following chart long term bond rates are highly correlated with the mortgage rates that we pay, and they also translate to other lending.

Looking at the heavily effected sectors during the latest pullback (think Tech), they are sensitive to long term bond rates. When doing a valuation on a company, the long term (typically the 10yr bond) plays a factor. For a company that does not make money today but has the expectation of having significant growth will see its valuation fall more than a company that has profit today and lower growth expectations purely from mathematics associated with higher rates. Currently the share market believes the bond market is signalling that higher rates are coming from the Central Banks. This is not the first time this has happened. The same thing happened in the wake of the global financial crisis (GFC). During that time Central Banks held the line and did not rase rates from 2008 until 2015. The market had expectations of rate rises that entire time as seen below (actual Federal Reserve Interest Rate is in Red, interest rates on the y-axis, all other lines are estimates of interest rates at the time of the Federal Reserve Monthly meetings)

WCentral Banks are serious about the recovery, and at the end of the day their policies are dictated by employment. It is unlikely that that rates will rise in the near to medium term until unemployment rates are below where they were before the pandemic struck. This does not alleviate inflation fears, nor does it make the market trust central bankers.

To protect against inflation the play is to enter sectors that benefit from the phenomenon. Commodities, commodity-based currencies (yes, the AUD is one of these), cyclic sectors, real estate, gold and user pay infrastructure will benefit.

Updating our checklist:

• Valuation: The pullback in the market took valuations down a hair, but they are still high with earnings depressed from the pandemic and still in recovery. The ASX200 P/Efwd is 19.8x and the S&P P/Efwd is 22.5x. The market continues to look expensive on earnings. We expect a recovery in profit and profit margins this year to bring the ratios back towards the average instead of asset prices collapsing, despite the recent fall in shares.


• Global PMIs: It is a new month, so we get a raft of new data. Manufacturing PMIs globally are in expansion (above 50) as the recovery continues. Of note the Caxin China Manufacturing index missed analyst estimates, and we have seen US manufacturing PMI accelerate to over 60, which is a 10yr high for the survey. On the services side the US output PMI continues to rise and is now at 58.7 led by positive outlooks in construction, real estate, and financial services. Easy to see how many people get back to work once a nation’s housing market kicks into high gear.


• Downgrades on guidance: The current earnings season is wrapping up and it started strong but has ended up a bit messy in the tech sphere. Leading tech companies failed to grow at lofty expectations, Afterpay, Appen and Nuix all disappointed markets as growth came in lower than expectations. Most interesting have been the heightened expectations from the banks, as they see the economy recovering faster than anticipated 6months ago. A hot real estate market helps, as the big four rely heavily on mortgage lending for their bottom lines.


• Infection rates to slow globally: With Prime Minister Scott Morrison grinning ear to ear as he received his Covid shot Australia’s vaccination program has begun. The Prime Minister was amongst the first Australians to be vaccinated. It is early days, but Australia is far below the vaccination rate required to get herd immunity by the end of calendar year 2021. Do not worry yet though, as the UK, and US found themselves in similar situations and are now within the rate window that Australia requires. If you would like to follow Australia’s vaccination journey, please check out our vaccine tracker below:
  
  TFM Vaccine Tracker




• Monetary and Fiscal stimulus announcements globally: US stimulus seems a certainty now, and next up will be an infrastructure bill. We are watching China’s credit impulse, as a high-ranking Chinese official made comments about debt levels this past week that turned the Chinese share market downward. If China pulls back on their monetary expansion it will send ripples throughout the world. In Australia we are focused on JobKeeper. We expect the program to end at the end of the month, but any extension will be positive surprise for markets.

A pullback in share markets was overdue and it will not be the last one we see over the year. We still see a lot of opportunity in the market despite the fall in prices. In Australia we have a wealth of choices in the commodity and cyclic space to play inflation and tech is not dead. We think it is a good year for active management, and we would like to point out that the recent fall in asset prices has provided an excellent entry point for anyone with extra capital to invest. If you do find yourself looking to enter the market, we suggest you speak to one of our advisors as they are trained to assess your financial goals and provide a plan for you to meet them. Till next time take care and we will be in touch in two weeks.

Regards,