Markets wobbled at the start of the week

The Week that Was

?Markets wobbled at the start of the week before rising again a few percent but then falling back to where they started the week in the final session. Again this was really down to the tension between worsening near-term COVID and economic data around the world and a much improved out look for 2021. This is pretty much the holding pattern we have found ourselves in since the November vaccine rally. At a sector level this translated into gains by tech stocks while energy stocks gave back some gains from earlier in the month. The underlying spot prices for Oil and Gas were up another 5% or so during the week, implying continued economic optimism. In fact pretty much all other commodities continued upwards unabated and iron ore was the best performer (up another 10%). This leaves the broader commodity market (as measured by the widely used GCSI Index) where it started at the beginning of the year. However, iron ore prices are now up 60% this year while oil (a larger part of the Index) remains down 25% for the year. China consumes around 15% of global oil production but some 70% of Iron Ore production. Australia now supplies 80% of China’s iron ore imports due to South American supply issues. These figures perhaps tell a different story of Australia’s current predicament than many of the headlines about coal, wine and wheat. This is reflected in the performance of the local market which is up by over 2% for the month so far, but almost all of that is accounted for by the performance of the three largest iron ore producers. So, last week it was IT stocks, led by Afterpay, that were best local performers (up by 6%) but that only contributed 0.25% to an overall market return of 0.5%.

Bond yields here and abroad drifted up again by around 0.05% as expectations of inflation in 2021 also solidified, although 10 year rates remain at 1% in Australia and just below that in the US. Meanwhile 5-year break-even rates (the amount of inflation forecast by bond markets) continued to rise to a greater degree. Here and in the US they are up by 0.5% so far this quarter and are now above where they were at the beginning of the year at 1.5% and 2% respectively. Based on currently depressed inflation levels local bonds offer a negligible real (after inflation) return but based on projected inflation they now imply a loss of purchasing power of around 1-2% per annum over the next 5-10 years. There is a growing sense in markets that if the reflation trade eventuates in 2021, or actual inflation rises for other reasons (like impaired supply chains), then the ability of central banks to maintain rates at these levels will be tested.

The Week Ahead

We will be watching: 

• Long-term forecast returns for different types of equity portfolio  – Having finally been able to update our forward-looking risk/return Dashboard to include value and growth indices it has strengthened our view that, actually, the really useful work in projecting future potential outcomes will happen at a portfolio level. Put simply, potential growth rates and valuation discrepancies are not only very polarised at an overall index level but the forward looking implications differ greatly across different growth or value portfolios. For instance, some ‘value’ portfolios are concentrated in beaten down cyclicals or European banks while others have crept up the quality curve and perhaps capitalised R&D expense (which for some makes Amazon a value stock). Then there is the concept of a ‘zombie’ companies kept afloat by low rates and increasing debt that might well re-rate upwards if rates stay low but would find themselves severely challenged if rates were to rise. On the other hand we hear anecdotally that institutional investors have started rotating towards value in a way that they didn’t during the short-lived value rotations seen in the last few years. So maybe value managers of all stripes will enjoy more of a tail-wind next year.
• Infrastructure and property – we have spoken to a few managers in these areas in recent week and have a few more meetings lined up next week. We were originally of the view that the degree of polarisation between sectors might have left some opportunities on the table but our tentative view is that actually the valuations across different sectors probably reflect the evolving risks facing each sector and the degree to which cash flows remain potentially impaired, or not.
• Year end liquidity - This one actually appears to be a receding risk as Andrew Hunt of Hunt Economics discusses in a podcast which will be published tomorrow. Here he suggests that this year central banks are providing more than enough liquidity to underwrite credit and equity markets so maybe that’s one thing we don’t have to worry about so much this Christmas and New Year. Andrew also gives us a decent road map for investing 2021 even though it wasn't meant to be a one of those end of year forecast discussions. 
• COVID – While a Christmas shutdown might not have quite the impact that it would at other times of the year it is clearly dampening spirits in the US and Europe as are the worsening numbers. Closer to home the latest Australian outbreak is obviously distressing for those on the Northern Beaches of Sydney and worrying for the rest of the country. That said the numbers are a still a fraction of those that were experienced when Melbourne was forced to lock-down with at least 4 times the amount of testing so there are perhaps grounds for some optimism, if not complacency. Let’s hope so