Markets have recovered the losses of the previous week
The Week That Was
Despite some notably weak economic data markets had their best week for several months and recovered the losses of the previous week, ending up by 3-4% around the world and a little higher for some emerging markets. One notable exception was the UK where Brexit and COVID have both conspired to disrupt supply chains and the economy to an even greater degree. Having been flat for the week that leaves the FTSE also flat for the year while the rest of the world is up 4-8% so far in 2021.
Along with apparent relief that attempts by retail investors to corner the market in certain stocks had died down the market was buoyed by more strong results, especially from the digital economy and this meant that the Nasdaq and growth indices performed the best while the rise of more industrial stocks was more muted. In fact the last few weeks has seen a more familiar pre-COVID pattern of risk vs return emerge with tech stocks leading the market up but also exhibiting considerably higher levels of risk (also falling by more when sentiment deteriorates). It was also notable that the extent of 2020 profits being reported outweighed any concerns the market might have had about signs of inflation emerging in the producer prices in the US and even some consumer measures in Europe (these stocks have in the past been seen to be increasingly sensitive to interest rates).
As a result long-term interest rates continued to grind slowly upwards, something which probably helped banks provide the next best sector performance, up by 6% here and abroad. A steeper yield curve should make banks, whose business is to borrow short-term deposits and make long-term loans, more profitable. Given the size of the sector that accounted for almost half of the 3.5% rise for the local market while almost all other sectors were positive, with the exception of utilities.
Government bonds also sold off another 0.5% and corporate bond spreads tightened slightly leading to modest gains while high yield (junk bonds) did better. The RBA announced another round of bond buying to try and keep long-term rates in line with those of the US. Local bond yields dropped immediately only to bounce up again a few hours later. These were quite small movements in the scheme of things but it remains to be seen how effective the RBA's actions will be if the divergence grows.
Metals were down slightly, soft commodities up again and oil prices were up another 10% (although oil stocks lagged amidst some woeful profitability being reported for 2020).
If analysing a week in markets is sometimes useful to get a sense of what one particular longer-term scenario might look like last week was representative of a recovery typified by benign levels of rising inflation and even more benign market reaction to potentially higher rates. Long may it last……..
The Week Ahead
We will be watching:
Inflation. We are seeing more tangible signs of inflation in supply chains and production prices around the world and it is perhaps only a matter of time before that makes its way into consumer prices, at which point the market might react more strongly.
Bond rates. In not unrelated development last week the RBA announced a further round of quantitative easing was was surprisingly frank about the fact that it was competitive in nature. That is to say that while we probably don’t really need cheaper long-term rates what we definitely don’t need is a much stronger currency and with local 10 year bond rates starting to already edge higher than US rates they obviously see a significant risk an unintended tightening of monetary conditions relative to the rest of the world. The epicentre of this dynamic is the US Federal Reserve who are almost forced to backstop, or to be seen to be backstopping, a market that may or may not hit another road bump. Another situation where ‘we have apparently nothing to fear but fear itself’. But if the economy does come bolting out of the blocks in the next few months the Fed will be forced to surprise markets. In hindsight that will be seen as an unintended policy mistake but right now they remain stuck between a rock and a, so far, indefinable hard place. This suggests considerable bond volatility in 2021.
The portfolio implications of the inflation and rates outlook. A good but confusing example is property and infrastructure investments which in theory should be a good hedge for inflation - rents rise in line with inflation and many infrastructure investment cashflows are indexed to inflation. However, they are both seen as bond proxies to some extent and the long duration nature of their cash flows also make their current value very sensitive to discount rates (which in turn are driven to a large extent by long-term interest rates expectations). Similar arguments apply to value vs growth and pretty much everything we invest in in an era when cheap money has become the defining factor of market direction and outlook. Which brings us to the other side of that coin - what if low interest rates are here to stay and inflation does not materialise? Andrew Hunt of Hunt Economics has discussed with us a few times in the past few years markets of the past that he has experienced where notions of value are fairly meaningless for extended periods of time. At the time it is fair to say, fascinating as the anecdotes were, this was primarily of historical interest. These concepts now seem to have much more immediate relevance and we will aim to dust off that discussion this week and maybe we will have a podcast to show for it too.