Weekly Market Update - 20/07/2021

The week that was

‘Unprecedented’ was the watchword for markets at the onset of the COVID crisis and then during the monetary/fiscal stimulus that swiftly followed. Then this year the new watchword became ‘transitory’ as the market tried to decide what inflation, economic growth and interest rates would look like when supply chains were cleared, and we stumbled into some kind of post-COVID new normal. ‘Confusing’ is a word that has become increasingly prominent in the last few weeks as the crosscurrents swirling around economies and markets have befuddled the most strident market commentators. The poster child of ‘confusing’ this week was the bond market's reaction to the highest inflation number the US has seen since 2008 and arguably 1982.

Inflation was always going to be high for year-on-year comparisons (due to so-called base effects from a year ago) but the monthly number of 0.9% was also the highest since 2008 (just before the GFC) and if you include so called volatile items you would have to go back to 1982. Most confusing though was the fact that this was above already high estimates and also that bond yields, which have spiked ever so slightly, fell sharply to levels last seen in February.

Most Western markets were down 1-2% but energy stocks were down the most while defensive utilities and consumer staples were up. The weakness of oil prices and energy stocks could also be down to imminent OPEC supply increases (announced over the weekend) but the defensive mood of markets overall points to worries over the delta variant and another global COVID wave. While the highly vaccinated UK tentatively celebrates ‘Freedom Day’ today amid rising cases but low deaths, the latter metric is unfortunately on the rise again in many Asian countries. In the US, the prognosis for reopening may be OK for many coastal states where vaccination rates are high but there are increasing worries for states in the mid-West where this is not the case as COVID cases are also on the rise again. Ironically US consumer sentiment dipped last week, because of inflation concerns.?Closer to home, last week saw strengthening iron ore prices and the big miners kept the local market in the black despite increasingly stringent lockdowns. At the other end of the ledger the local 'buy now pay later’ stocks were hit hard when PayPal launched a competing service last week, as well as news of further competition from Apple and CBA.

Despite the worsening COVID situation in Asia, emerging markets produced the best returns last week buoyed by strong rebounds from large Chinese tech stocks like Alibaba, Meituan and JD. com, seemingly a classic case of sell the rumour buy the news. These stocks have been under pressure all year, culminating in a particularly pointed regulatory offensive on Chinese ride-hailing company Didi, moments after it raised capital on the US stock market. Perhaps the firming prospect of these stocks raising capital via Hong Kong rather than in the US is settling in the minds of global investors.

With most sovereign bond markets following the US lead (in typically slavish fashion in Australia) fixed income portfolios were up by around 1% while gold was up 2%. Rounding out the defensive flavour of markets last week, high yield bond spreads edged out ever so slightly, although certainly not enough to presage a credit crisis at this stage.

Markets being confused is not unprecedented and this too will no doubt prove transitory as market participants work out a serviceable narrative. But for now, what lies on the other hand remains enigmatic and not as much to do with company earnings as one might have expected at the onset of a highly anticipated US earnings season.

What we are watching and working on.

Last week, and even more so over the weekend there has been a torrent of interesting explanations for the divergent moves between inflation, inflation expectations and bond rates. Here is a quick summary:

1.??????The Fed will be forced to tighten too much, and then we get a recession that we may or may not have ‘needed to have’. This is a well-worn path and, arguably, the cause of most recessions. The problem this time around is that with so much debt issuance, the margin for error is very low. A related, longer-term, theory holds that we are already in a debt trap and economies simply can’t function with anything other than very low nominal rates and possibly negative real, after inflation, rates. The market is therefore just reminding us of this inconvenient truth before anyone gets any bright ideas about raising rates too early.

2.??????The other side of that coin is that short-term inflation pressures are still rising and many of them are starting to look less and less transitory. The longer the Fed leaves it, and the more obvious it becomes that the US economy might be overheating, the more the Fed will have to do. It may be the Fed is just a stick between a rock and an even harder place.

3.??????Continuing the ‘rolling-over’ of growth theme is the recent easing by the People’s Bank of China is another plausible candidate. The theory goes that the Chinese authorities know more about the second most important economy in the world, and they are presumably worried about what they see. Increasing geopolitical tensions between the US and China obviously exacerbates these worries.

4.??????Liquidity and technical factors (colloquially known as ‘the plumbing’) are notoriously difficult to pin down but there is mounting evidence that the Fed, the ECB and China have already been implicitly tightening monetary policy for a few weeks. One potentially significant way this is playing out is with the Fed being forced to mop-up excess short-term cash deposits through ‘reverse-repo’ operations.?

5.??????Or maybe it is because bond rates are no longer derived by markets and yield curve control is already a reality. We don’t think we are quite there yet, especially for short-term moves, but there are some credible voices that see this in our future, especially given point 1 above.??

For now these are all just theories, some or all of which are likely to be true to a certain extent, so we will continue to digest and monitor. More tangibly there is no shortage of evidence that at least some of the inflation we are seeing is going to be around for a while longer.

We also had a brief conversation with Andrew Hunt last week about digital currencies. Just as bitcoin was languishing after a volatile year so far, the European Central Bank launched their own digital currency and we think Andrew does a good job of delineating between the speculative attributes of popular crypto currencies and the longer term implications of central bank sponsored digital currencies. The latter area is especially thought-provoking. We can provide a recording of the conversation to readers upon request.

Chinese tech stocks have been very much out of favour this year, and in the last week or so market commentators have been drawing an increasingly explicit link between strained Sino-US relations and the investment credentials of these stocks. Last week we outlined the valuation-based case as to why this might be an opportunity and since have been researching the bear case. With a few more conversations happening this week this may be something we can comment on more but in the meantime, this was actually one of the bright spots in markets last week, so maybe the bad news is already priced in.??????

Otherwise COVID data, US earnings (the first of the US tech companies are up next week) and more inflation data are all likely to keep us and markets occupied next week.

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Integro Holdings (WA) Pty Ltd

ABN 61 612 297 739 AFS Licensee No. 489444

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