Weekly Market Update - 15/06/2021
The week that was
Once again nothing much happened in the early part of the week and then on Thursday the US Labour Department released the core Consumer Price Index (which includes volatile items like energy and food) and things got a little more interesting, though with an outcome that few would have expected. This is of course exactly one year on from the nadir of the COVID crisis (as far as markets are concerned) and from that low base it was not surprising that it was the largest year on year increase in 13 years. What was surprising was that it was a little above expectation and still bond yields fell. This seems to be because 1) the composition of the rise in May seemed to support the ‘transitory effects only’ inflation thesis and 2) it coincided with some relatively weak US industrial data (although wage rates appear to be on the up as well). The fact that markets took this as a net positive underscores the importance of rates to markets at the moment. That meant that the fall in expected bond rates of the last few weeks is now quite appreciable, and it also meant that tech stocks were in the ascendant for the second week in a row.
Lending weight to the view that markets are looking through the bump in inflation and even seeing a moderation in economic activity, global sectors like industrials, materials and financials all sold off 1-2%.?The standout performer during the week was healthcare stocks (up 3%) buoyed by the somewhat controversial FDA approval of Eisai and Biogens Aduhelm drug for treating Alzheimers. Both stocks were up 40% but a raft of other approvals and encouraging data or rumours thereof (including another Alzheimer drug from Roche) also buoyed the sector. Closer to home Australian IT stocks like Afterpay, Altium and Appen also continued their recovery with 20-30% returns for the week while IRESS, a normally more staid financial software company, was also up 20% on takeover rumours. While most Australian sectors ended the week in positive territory, the size of the banking sector (down 2%) meant that the local index ended up only slightly. Although global materials stocks fell, local iron ore producers bucked the trend as iron ore prices rose another 5%. Most other commodities were up slightly.
In bond markets lower long-term rates has led to capital gains of 0.5%-1% in the last two weeks and corporate spreads remained resilient.
What we'll be watching this week
Bond yields have fallen more or less across the board in the US, Australia and Europe?by .2%. While we have become used to commenting on what were once tiny moves of a few basis points, the falls we have seen in the last few weeks are significant in this low rate environment and perhaps suggests that bond markets are sniffing out trouble ahead that equity markets remain oblivious too. Very short-term moves support this view but the trend downwards may also be due to technical factors in the plumbing of the banking system, namely shortages of treasuries that need to be used as collateral for banks to lend in the post-GFC regulatory structure. This matters as, if inflation does prove to be persistent and rates are actually lower than they might be for technical reasons, that could cause a precipitous rate shock later in the year.
The effects of bond rates on implied values for other asset classes has become something we need to understand intimately. For instance, growth managers will argue until the cows come home that future cash flows will trump rate effects but in the short-term the market has been sending a clear message that counters this view. This debate also applies to other supposed inflation hedges such as REITs and infrastructure - the market tends to worry about the immediate effect of higher rates before getting around to consider how higher inflation will, eventually, affect relative rates of nominal growth in cash flows. One angle that is particular fascinating in the current environment relates to a company like Amazon, whose share price has proven to be very interest rate sensitive. However, they might equally be in a much better position than most to pass on price increases, something which is as yet unproven and untested.?So far we have come across many interesting and opposing views and we have a few more conversations with fund managers on this topic lined up.
Last year a fund manager also raised the spectre of the potential ability of the US to weaponise the financial system, and the capital account in particular, against China. Even in the dying days of the Trump administration this was touted but not acted upon. However, it maybe that the most recent declarations from the G7 Summit heralds a move in that direction. So far markets haven’t reacted but if Biden’s bite turns out to be worse than Trump’s bark in this regard it may be worth watching out for. This is potentially not great for markets.