Sub Heading

Author: Provision Wealth

Five reasons why the Australian dollar is likely to resume its upswing over the next 12 months

Date: Sep 15th, 2021

Dr Shane Oliver Head of Investment Strategy and Chief Economist, AMP Capital

Key points

  • Since its February high of around $US0.80 the $A the $A has fallen on the back of global growth concerns, a slowdown in China and the Delta outbreak in Australia.

  • However, there is good reason to expect the $A to resume its rising trend: sentiment towards the $A is negative; global growth is likely to remain strong; commodities look to have entered a new super cycle; Australia has a large current account surplus; and Australia is likely to see strong growth next year.

  • There is a case for Australian based investors to tilt a bit to hedged global investments but while maintaining a still decent exposure to foreign currency given the diversification benefits it provides.

Introduction

Movements in the value of the Australian dollar are important for Australian-based investors in that they directly impact the value of (and hence returns from) international investments and indirectly effect the performance of domestic assets like shares via the impact on Australia’s competitiveness. But currency movements are also one of the hardest things to get right. This year has been no exception with the $A initially surging to $US0.80 in February only to then fall to a recent low of $US0.71. This note takes a look at the outlook for the $A.

The $A is around long-term fair value

From a long-term perspective the $A is around fair value. The best guide to this is what is called purchasing power parity (PPP) according to which exchange rates should equilibrate the price of a basket of goods and services across countries – see the next chart that shows annual data for the $A back to 1900.

The $A is “around” fair value based on relative prices

Source: RBA, ABS, AMP Capital

If over time Australian inflation and costs rise relative to the US, then the value of the $A should fall to maintain its real purchasing power. And vice versa if Australian inflation falls relative to the US. Consistent with this the $A tends to move in line with relative price differentials – or its purchasing power parity implied level – over the long-term. And right now, it’s around fair value. So, nothing to get excited about, right?

But as can be seen in the chart, it rarely spends much time at the purchasing power parity level. Cyclical swings in the $A are largely driven by swings in the prices of Australia’s key commodity exports and relative interest rates, such that a fall in Australian rates relative to US rates makes it more attractive to park money in the US and hence pushes the $A down. “Investor” sentiment and positioning also impacts – such that if the $A is over-loved with investors overweight in it then it becomes vulnerable to a fall and vice versa if it’s under-loved.

Why has the $A fallen since February?

  • First, there has been concern that global growth may have peaked not helped by the latest global coronavirus wave driven by the more contagious Delta variant, supply chain constraints and central banks moving to reduce stimulus. This weighs on the Australian dollar because it’s a “growth asset” which, because of Australia’s high commodity exposure, is harmed by fears of weaker global growth.

  • Second, there is likely no quick exit from the coronavirus pandemic, and this is also adding to uncertainty to the global growth outlook. The vaccines provide very good protection against serious illness, but only 60% to 80% protection against infection and their efficacy appears to decline over time requiring boost shots. All of which combined with the higher transmissibility of the Delta variant is making coronavirus hard to eradicate. To this must be added the low level of vaccination in less developed countries which risks the mutation of new more problematic variants. All of which risks ongoing waves of coronavirus outbreaks until global immunity is built up by exposure to it and vaccination – and this will take time.

  • Third, these concerns for Australia have been accentuated by the slowdown in Chinese economic growth, in particular Chinese moves to slow steel production (to limit carbon emissions) and the property sector which has seen the iron ore price fall more than 40% since July.

  • Fourth, and related to this, tensions between China and Australia that have resulted in restrictions on various Australian imports into China have arguably been keeping the Australian dollar lower than it otherwise would be.

  • Finally, the Delta coronavirus outbreak has interrupted the Australian economic recovery, seen the RBA extend bond buying albeit at the reduced rate of $4bn a week and has pushed back expectations for the first rate hike. This is at a time when Fed tapering is getting closer and there is debate about whether the first Fed rate hike might come next year.

But there are five positives likely to push the $A up

Against this there are a bunch of forces suggesting that what we have seen since February is most likely part of a correction.

  • Firstly, global sentiment towards the $A is now negative again and this is reflected in short or underweight positions being back near extreme levels. In other words, many of those who want to sell the $A have already done so and this leaves it vulnerable to a rally if there is any good news.

$A positioning is back to being very short

Source: Bloomberg, AMP Capital

  • Second, the global recovery is likely to remain strong even if we have seen the peak in growth. While it’s not a smooth ride, vaccines are helping keep hospitalisations and deaths down relative to past waves allowing heavily vaccinated countries in Europe, the UK and parts of the US to continue reopening and avoid a return to lockdowns. And policy easing in China is likely to see Chinese growth pick up next year. This is ultimately positive for the growth sensitive $A.

  • Third, commodity prices look to be embarking on a new super cycle. After bottoming in last year’s global lockdown metal prices and wider commodity indexes that include energy have surged to around the last mining boom highs of around 2011. The key drivers are a surge in goods demand, onshoring requiring new capex to avert a rerun of pandemic supply chain disruptions, the demand for clean energy and vehicles all compounded by global underinvestment in new commodity supply. For example, a battery electric vehicle contains 4 to 10 times as much copper as a conventional car. This has all seen Australia’s terms of trade rise to levels that last saw the $A above parity in 2011. Of course, the 40% and still falling collapse in the iron ore price will put a dent in this, but it’s partly offset by a surge in coal prices.

Long term bull and bear markets in commodity prices

Source: Bloomberg, AMP Capital

  • Fourth, Australia is seeing its biggest current account surpluses since the 1950s. A big part of this has been the surge into a trade surplus in the last four years – this will likely fall back somewhat due to the declining iron ore price but strength in other commodity prices will partly offset this. However, in recent years there has been a significant decline in Australia’s net income deficit as a result of super funds investing in international assets providing higher income yields than Australia pays on its foreign debt. The swing into a current account surplus means Australia is a capital exporter and that there is more natural transactional demand for the $A than supply.

Biggest Aust current account surpluses since 1950s

Source: ABS, AMP Capital

  • Finally, rapid vaccination is likely providing a path out lockdowns with Australia likely to see a return to growth next quarter and strong growth in 2022, which could neutralise the interest rate outlook between Australia and the US.

So where to from here?

Ultimately, we expect the positives notably in the form of strong global growth and high commodity prices to triumph over the negatives and push the Australian dollar higher, and over the next 12 months see it rising to around $US0.80-0.85.

What does it mean for investors?

A rise in the value of the Australian dollar will reduce the value of an international asset (and hence its return) by one for one, and vice versa for a fall in the $A. So last year global shares returned 13.8% in local currency terms but only 5.7% in Australian dollar terms as the $A rose in value. So, when investing in international assets an Australian investor has the choice of being hedged (which removes this currency impact) or unhedged (which leaves the investor exposed to $A changes). Given our expectation for the $A to rise over the next 12 months there is a case for investors to tilt towards a hedged exposure of their international investments.

However, this should not be taken to an extreme for two key reasons. First, currency forecasting is hard to get right. Second, having foreign currency in an investor’s portfolio via unhedged foreign investments is a good diversifier if the economic and commodity outlook turns sour. As can be seen in the next chart there is a rough positive correlation between changes in global shares in their local currency terms and the $A. Major falls in global shares which are circled in the next chart saw sharp falls in the $A which offset the fall in global shares for Australian investors. So being short the $A and long foreign exchange provides good protection against threats to the global outlook.

Global share prices versus $A

Source: Bloomberg, AMP Capital

Finally, the last commodity super cycle in the 2000s saw Australian shares outperform global shares, so one way to play a new commodity super cycle would be via a higher exposure to Australian shares.

Source: AMP Capital September 2021

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

Australian GDP slowed in the June quarter & will be hit hard by the lockdowns

Date: Sep 01st, 2021

– but here’s 7 reasons to look beyond the gloom

Dr Shane Oliver Head of Investment Strategy and Chief Economist, AMP Capital

Key points

  • Australian GDP growth slowed in the June quarter but to a stronger than expected 0.7%qoq. This avoids a technical recession, but the current quarter is likely to see a 4% slump due to the lockdowns.

  • While there is lots of gloom around there remains strong reason for optimism regarding economic growth in 2022: the vaccines are effective in helping prevent serious illness; Australia’s vaccination rate has increased dramatically; pent up demand will help drive recovery; and global growth is likely to be strong.

Introduction

Three months ago there was much optimism about the Australian economic outlook. GDP regained its pre pandemic level, confidence was strong, the jobs market was roaring, there was minimal community coronavirus & vaccines were providing optimism of a more sustained reopening. Since then renewed coronavirus outbreaks of the Delta variant have seen the near-term outlook turn pear shaped – notably in NSW & Victoria. However, much as the near term is depressing in lockdown states there are good reasons for optimism about 2022.

June quarter GDP slowed less than expected

The June quarter saw GDP up 9.6% from the lockdown depressed June quarter last year, but quarterly growth slowed to 0.7%qoq. Thanks to smaller detractions from stocks & trade and very strong growth in public demand (which contributed 0.5 percentage points to growth) this was above our final estimate for a 0.3% gain and well above our initial estimate of a -0.1% decline and avoids the label of a double dip technical recession as September quarter GDP is almost certain to be negative – providing of course we see some recovery into year end.

Australian real GDP growth

Source: ABS, AMP Capital

While domestic final demand rose a strong 1.7% – with consumer spending 1.1%, business investment 2.3%, dwelling investment 1.7% & public demand 1.9% – stocks detracted -0.2% points from growth and net exports -1% points.

Consistent with the growth rebound since first half last year, the June half earnings reporting season saw listed company profits rise nearly 50% last financial year driven mainly by resources & banks, with 75% of companies seeing profits up. But the big positive was a huge return of capital to shareholders – with 89% of companies raising or maintaining dividends driving a record dividend payout of nearly $40bn and over $20bn in buybacks.

Proportion of Australian companies seeing profits up and raising or maintaining dividends

Source: AMP Capital

First the bad news

The news flow since late June has been bleak:

  • Locally acquired coronavirus cases have surged – driven mainly by NSW but with problems in Victoria & the ACT too.

Australia: New Daily Coronavirus Cases by State

Source: covid19data.com.au

  • This has led to various hard lockdowns notably in Sydney and Melbourne with both likely to be extended into October.

  • Our rough estimate is that the lockdowns since late May are costing the economy around $25bn in lost output and will result in a 4% fall in September quarter GDP. And of course, there is the psychological costs of lockdowns too.

  • This is occurring when other developed countries are reopening thanks to being more advanced in vaccinations – leading to a sense that Australia is being left behind.

  • Even when reopening comes as vaccination targets are met it will be very different to last year’s reopening. That occurred when coronavirus cases had fallen to around zero, but this time coronavirus cases are likely to be running much higher. While people in Europe, the UK & the US may be used to this (eg, the same number of per capita cases as the UK is now seeing would mean 13,000 cases a day in Australia), it may take a bit of getting used to in Australia which may act as a constraint on confidence, and hence the pace of economic recovery, initially, compared to last year.

  • The degree of reopening that can safely occur without problems in hospital systems when the national 70% & 80% of adults’ vaccination targets are met (which mean that 44% and 36% of the whole population will still be unvaccinated) may initially be limited if daily case numbers remain high in some states, and the zero case states (like WA & Queensland) may delay the opening of their borders until higher vaccination rates are achieved.

…but there is good news too

While it would be wrong to get too confident – as coronavirus has had a few occasions over the last 18 months where it looked under control only to flare up again – there is reason for optimism and this, along with the strong return of capital to shareholders, partly explains why the Australian share market remains relatively resilient.

  • First, while the lockdowns are very painful, Australia’s policy of suppression has saved lives. If we had taken a laxer approach and had the same per capita number of deaths as the UK and US, we would have lost an extra 48,000 people.

  • Second, while the vaccines are less effective in preventing infection from the Delta variant (at 60-80% effective), look to require top ups and may have to be tweaked against new variants, they remain highly effective in preventing serious illness (at 85-95%). This is evident in the UK (where deaths are running around one fifth the level predicted on the basis of the last wave), Europe, Canada and in highly vaccinated US states. It can also be seen in Australia where deaths in this wave are running around one quarter the level predicted on the basis of Victoria’s second wave last year likely thanks to high levels of vaccination amongst older/at risk people.

Australia COVID-19 New cases & deaths

Source: ourworldindata.org, covid19data.com.au, AMP Capital

  • Third, the pace of vaccination in Australia has doubled from 1 million vaccines a week to nearly 2 million a week over the last six weeks. At the current rate we will reach the first national reopening target of 70% of the adult population in October, 80% of the adult population in November and 80% of the whole population (which may be needed for a safe reopening) in December and 90% of the whole population (which would be ideal) in January. Of course, incentives may be needed to reach the higher vaccination rates – vaccine passports (no jab, no entry) are being implemented and will help in this. NSW is about 3 weeks ahead of the national average.

Coronavirus Vaccinations: Daily vaccinations per 100 people

Source: ourworldindata.org, AMP Capital

  • Fourth, while the process of “learning to live” with covid may mean that the initial part of the recovery will be slower than seen last year, pent up demand (thanks to government support payments and constraints on spending in the lockdowns) and a reasonable degree of job security (with state business support payments contingent on businesses maintaining their workforce) along with bank payment holidays will still see significant spending unleashed once reopening occurs which will spur recovery through 2022.

  • Fifth, despite the lockdowns the ABS’s business investment survey of July/August still points to significant growth in investment this financial year.

  • Sixth, monetary policy will likely be easier as the hit from the lockdowns and a slower initial recovery results in a higher unemployment profile through next year than the RBA has been assuming. We expect the RBA to delay the tapering of its bond buying and to continue buying bonds at the rate of $5bn a week into early next year and the first RBA rate hike is now likely pushed back into 2024. 

  • Finally, Australia will benefit from the cyclical recovery globally. While peak global growth will probably be seen this year with global GDP growth of 6% it’s still likely to be strong next year at 5%, increasing vaccination globally allows a continuing reopening. This assumes that China moves to boost its growth rate which has slowed lately.

The Australian economy – rough now, better in 2022

The Australian recovery will see a big setback this quarter (of around -4% for GDP), but the start of a gradual reopening from October gathering pace later this year and through next year as higher vaccination rates are reached should see the recovery start to get back on track in 2022. While growth though this year is likely to be just 1% (compared to our expectation for 4.8% 3 months ago), it’s likely to be around 6.5% through next year.

Australian real GDP level

Source: ABS, AMP Capital

Source: AMP Capital September 2021

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

China’s growth slowdown and regulatory crackdown

Date: Aug 25th, 2021

– but is it sustainable?

Dr Shane Oliver Head of Investment Strategy and Chief Economist, AMP Capital

Key points

  • China is seeing a regulatory crackdown on tech companies, the property sector and inequality aimed at supporting its middle class.

  • The shift to “bigger government” likely has further to run.

  • Chinese economic growth is likely to be soft this half but policy easing and maybe a pause in some regulatory moves should allow a rebound next year.

  • This will be positive for commodity prices and Australia.

Introduction

After surging 65% from its coronavirus low in March 2020 to its high in February this year, the Chinese share market saw an 18% decline into July. This reflected concerns about policy tightening, the economic outlook and a regulatory crackdown on a range of industries, notably tech stocks and steel production, with the latter contributing to a plunge in the iron ore price. So, what’s going on? How serious is the regulatory crackdown? What does it mean for China’s economic outlook and shares?

Regulatory crackdown

China’s regulatory crackdown has impacted multiple industries including internet stocks (like Alibaba & the Ant Group, Tencent and Didi with various anti-monopoly, financial regulation and cyber security investigations or scrutiny), private tutoring companies, property and online insurance. It has also recently restricted steel exports and announced a plan for “common prosperity.” The latter is focussed on growing the middle class, redistributing income, maintaining a large role for public ownership, and guiding public opinion on common prosperity.

What’s driving the regulatory crackdown?

China’s policy moves reflect a variety of drivers, in particular:

  • Rising levels of income and wealth inequality. Similar to the US, China has high income inequality and low-income mobility between generations. There’s also an element of resentment towards billionaire moguls. If uncontrolled, these may threaten social stability as we’ve seen in the US.

  • The three-child policy. China wants to boost population growth to support economic growth and reduce the burden of aging. A barrier to this is the high cost of education, particularly via private online tutoring which the government is seeking to regulate. Housing and healthcare costs may also be a target on these grounds.

  • Concerns about social media and gaming. The recent US experience that saw social media exacerbate social unrest, social polarisation, and populism was no doubt observed by the Chinese Government. At the same time, social media and gaming are not seen as adding to productivity with semi-conductors and artificial intelligence (AI) a key priority. Hence the desire to regulate it more strongly.

  • Concerns about big tech restricting small competitors.

  • Poor housing affordability and rising household debt. This is the main factor behind regulatory moves in relation to property, eg, banks in Shanghai being instructed to raise mortgage rates. Curbs on the property sector may have a bigger impact this time around and are key to watch.

  • A desire to boost the middle class. While the industrialisation unleased by Deng’s opening and reform from the late 1970s saw rapid growth and some get rich fast, the increasing focus over the last decade has been on quality growth and benefitting all with more social welfare. The focus on “common prosperity” is a continuation of that.

  • Geopolitical tensions. Slowing social media may help free up resources needed for greater self-reliance in high priority areas like semi-conductors and AI (given US restrictions). Some of the recent action may also be aimed at reducing the reliance of Chinese companies on American capital and to protect Chinese data and technologies.

  • Government control and financial risks. The growth of largely unregulated tech giants in China and relative decline of state-owned enterprises may undermine Communist Party control. The current leadership has been seeking to reverse this. Fintech companies offering payment platforms, lending and wealth management products threatened to further diminish that power and add to financial risks, and, as a result are now starting to be regulated like banks.

  • Climate action. The move to restrict steel exports is part of this. The Chinese Government has long used directives like this to meet economic and social policies.

China’s policy moves towards greater government involvement in the economy are not inconsistent with trends in western countries since the GFC and the observation that the political pendulum is swinging back to the left after swinging strongly to the right with economic rationalist policies in the 1980s-2000s. Under President Biden the US will end up with a bigger government sector, while the last Australian Budget projected Federal spending stabilising at a level of GDP well above pre-pandemic norms. Western countries are also considering regulatory action against big tech. But of course, China is a communist country and a one-party state so its swing to the left seems more noticeable, particularly at time of geopolitical tensions with western countries.

What are the risks?

China’s reforms over the last decade have had mixed success – including the focus on de-leveraging and the introduction of a national property tax. However, Chinese policy campaigns often go on for several years so it’s too early to say that it’s over. The shift towards free market capitalism under Deng ran for 30 years or so, meaning the current shift towards big government (and more Communist Party control) could run for decades (as it could in western countries). The reforms face four main risks:

  • Reduced ability to attract western capital – although they may be aimed at cutting reliance on foreign capital anyway.

  • Reduced ability for Chinese tech companies to expand globally – eg Didi put plans to expand into Europe on hold.

  • Reduced entrepreneurial spirit in China threatening longer-term growth, particularly after the crackdown on tech companies. Bigger government is not necessarily the best way to drive higher productivity growth in the long term – and that may also be an issue in western countries. A counter view though may be that the tech crackdown is not aimed at smothering big tech companies but rather at controlling them, that it will make it easier for smaller tech companies and boost competition and that reducing inequality, boosting population growth and the middle class will actually support long-term growth.

  • Slower growth in the short-term. Reforms and the uncertainty they engender often come at the expense of short-term growth. While the Chinese government wants to focus on balanced growth and common prosperity, it also knows it must avoid significant economic weakness which could also lead to social unrest. As we have seen in recent years with the policies to reduce leverage, reforms are often paused if there is a short-term threat to growth.

China’s growth outlook

Which brings us to concerns about slowing growth in the near-term. After rebounding sharply from the lockdown last year Chinese economic data has slowed. Business conditions indicators (or PMIs) have been trending down.

Chinese manufacturing and services PMIs have slowed

Source: Bloomberg, AMP Capital

And industrial production, retail sales, investment, exports, imports & credit growth all slowed more than expected in July.

Chinese activity indicators

Source: Thomson Reuters, AMP Capital

The slowing in annual growth measures partly reflects the drop off of the base effect boost as the 2020 lockdown slump drops out, but it has gone a bit beyond that as a result of floods, policy tightening after last year’s easing, increased covid restrictions due to a new Delta outbreak and carbon pollution reduction measures. As a result, September quarter growth is likely to be weak. A slowing in covid cases in the last two weeks may allow some easing of restrictions but they are likely to remain to some degree ahead of the Winter Olympics in February 2022.

China: Coronavirus daily change (new cases)

Source: ourworldindata.org, AMP Capital

More fundamentally though the July Politburo meeting suggested some monetary and fiscal easing ahead and that the regulatory crackdown may go through a brief pause given the growth slowdown. In terms of the latter there has also been some indication of a slowing in anti-carbon pollution measures. As a result, growth is likely to accelerate again in 2022. After slowing to 4% year on year in the December quarter this year (from 7.9%yoy in the June quarter), growth is expected to accelerate to 6.5%yoy through 2022. Longer-term the trend is likely to be down in China’s growth rate as its period of rapid industrialisation and productivity growth is behind it.

The Chinese share market

The chart below relates to monthly data and so misses the extremes, but Chinese shares saw an 18% decline from their February high to their recent low. Valuations are not particularly onerous and will likely benefit from anticipation of stronger growth next year. However, regulatory uncertainty and geopolitical risks may constrain it on a medium-term view.

Chinese shares are off their highs

Source: Thomson Reuters, AMP Capital

Implications for Australia

A slowdown in China’s long-term growth rate and trade tensions impacting multiple Australian exports to China mean that the big boost to Australian exports from trade with China may be behind us. Over the last year it was offset by the surge in the iron price to over $US220 a tonne, but from its May high it fell by over 40% to its low last week, albeit to a still very high level.

However, commodity prices don’t go in a straight line and some slowing in Chinese anti-carbon policies may see some stabilisation/short-term improvement in the iron ore price and it has had a bit of a bounce this week. Commodity prices generally should benefit from an upswing in Chinese growth next year, which should benefit Australian export earnings.

Source: AMP Capital August 2021

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

Six reasons why shares are at or near record levels

Date: Aug 17th, 2021

– but is it sustainable?

Dr Shane Oliver Head of Investment Strategy and Chief Economist, AMP Capital

Key points

  • Bonds and shares often diverge – we saw this a year ago with shares rallying but bond yields staying low.

  • Shares have been boosted by strong earnings news, improved valuations, investor awareness of last years’ experience of a post lockdown bounce back, vaccines providing optimism in a more sustained reopening, some pressure for more stimulus & M&A activity.

  • While shares remain vulnerable to a correction, the trend is likely to remain up.

Introduction

Despite lots of worries – around the resurgence of coronavirus driven by the Delta variant, peak growth, peak monetary and fiscal stimulus and high inflation – global and Australian shares are around record levels. So how can this be? Particularly with bond yields down sharply from their highs earlier this year. And how sustainable is it? And what are the risks?

Bond yields down

On the face of it, shares and bonds seem to be telling us a different story. Since their highs earlier this year, ten-year bond yields have fallen 0.5% in the US to 1.26%, 0.4% in Germany to -0.47% and 0.7% in Australia to 1.16%. The decline in bond yields appears to reflect several factors:

  • Increased confidence that the spike in inflation is mainly being driven by pandemic and reopening related distortions and so will be transitory. July US core CPI slowed more than expected and while producer price inflation is high, the flow through to consumer price inflation is weak with core inflation around 1% or less in Europe, China and Japan. And in Australia, June quarter inflation was relatively benign. 

  • Fears that the rise in Delta coronavirus cases globally might badly derail the economic recovery – with China seeing its toughest restrictions since early last year, rising US cases driving sharply lower consumer confidence and Australia seeing extended and new lockdowns as cases rise.

  • Concern we have seen the best in terms of economic growth, regardless of coronavirus outbreaks.

  • Ongoing central bank bond buying (or QE).

  • A slowing in the supply of bonds in the US as the US Treasury has been issuing less bonds due to a lower budget deficit and as the debt ceiling has been reached.

  • A short covering rally – as those who have been short or underweight have been forced by the bond rally to buy back into them which in turn pushes bond yields even lower.

But shares have been trending up

But while it may seem perplexing, and I must admit that I have been seeing shares as vulnerable to a correction, there are good reasons behind the strength in shares:

  • First, earnings news has been strong. The June quarter earnings reporting season in the US is now largely complete with 85% of companies beating on earnings (compared to a norm of around 76%), 83% beating on revenue and earnings up by around 87% on the June quarter last year compared to market expectations for a 62% rise. In other words, US earnings have come in around 15% higher than expected. And it’s been basically the same story globally.

US earnings growth and beats

Source: Bloomberg, AMP Capital

Similarly, in Australia. While it’s still early in the June half earnings reporting season, results so far have been stronger than expected with 79% of companies reporting earnings up on a year ago and a large return of capital to shareholders via increased or reinstated dividends and buybacks.

Proportion of Australian companies seeing profits up and raising or maintaining dividends

Source: AMP Capital

  • Second, the rebound in company earnings has seen price to earnings multiples decline from recent highs despite the strength in share markets this year, resulting in higher earnings yields. At the same time, the decline in bond yields has increased the risk premium shares offer over bonds – as proxied by the earnings yield less the bond yield. In other words, shares have become more attractive.

Shares have become a bit cheaper versus bonds

Source: Thomson Reuters, AMP Capital

  • Third, last years’ experience in Australia and in other countries more recently (eg Europe after a double dip recession earlier this year) – showed that once lockdowns end, the economy bounces back strongly. This is partly because fiscal support protects businesses, jobs and incomes and combines with ultra-easy monetary policy to see pent up demand unleashed far more quickly than would occur coming out of a normal downturn. So having learned the lesson from last year where many investors got wrong footed (selling shares driving a roughly 35% decline only to then have to quickly buy them back or miss out) investors are keen not to make the same mistake again.

  • Fourth, in contrast to the first lockdowns early last year, vaccines are now providing confidence that more heavily vaccinated countries will continue to recover and that Australia will see a more sustained recovery from later this year. The experience with vaccines in more heavily vaccinated countries is that they are working. They are less effective in preventing infection from new variants like Delta (at 60% plus) and onward transmission which is challenging whether “herd immunity” can ever be achieved. But they are highly effective in preventing the need for hospitalisation (85% plus) and death (90% plus). So if a sufficient proportion of the population is vaccinated hospitalisations and deaths won’t surge with new cases and we can learn to live with coronavirus without overwhelming the healthcare system. The UK is a good test case in relation to this and so far, so good with hospitalisation and deaths remaining far more subdued than seen in previous outbreaks.

UK: New Coronavirus Cases, Hospitalisation and Deaths

Source: ourworldindata.org; AMP Capital

The US faces greater risks with some states seeing their hospital systems getting stretched to the limit but this appears to reflect their low vaccination rates. The lowest 25% of US states by vaccination are seeing 3 times the number of new cases per capita, 4 times the number of hospitalisations and 7 times the number of deaths compared to the top quartile of states by vaccination. But apart from some restrictions there appears to be little inclination to return to lockdowns so long as vaccines continue to work.

Australia’s vaccination rate has surged to 1.6 million doses a week with 39% of the whole population having had one dose and 21% two doses. If sustained, this means that the target for 70% of the adult population to be vaccinated should be met by mid-October, 80% of the adult population by early November and 80% of the whole population – which will likely be needed – in December. If this is correct then Australia should be able to more sustainably start relaxing and then exiting lockdowns from later this year. Of course, this will likely mean even higher daily coronavirus numbers but as long as they don’t overwhelm the hospital system we should be able to live with it. (Of course, the unvaccinated will remain at high risk.)

  • Fifth, while we may have seen peak stimulus – the Delta outbreak is reinforcing pressure for more fiscal stimulus in the US & while it has not seen the RBA reverse its decision to start tapering its bond buying next month it has pushed out our expectation for the first rate hike to late 2023.

  • Finally, some may be expecting more M&A activity given the low cost of borrowing.

Key risks

The key risks are that:

  • The Delta variant or similar necessitates much higher levels of vaccination than most governments are assuming. This in fact appears quite likely but would just delay reopening a bit – as noted above Australia should be able to reach 80% of the whole population vaccinated by year end at the current rate, although this may require some carrot and stick.

  • A new coronavirus variant mutates and is able to get around the defences provided by current vaccines in terms of serious illness. Lambda which originated in Peru last year is of some concern but does not seem to have spread much.

  • The inflation spike proves not to be transient. More supply side disruptions are likely (eg from the restrictions in China) and this could keep inflation elevated for longer. This would ultimately mean faster central bank monetary tightening and higher bond yields which would weigh on equity valuations.

  • A US fiscal scare – in the near term this is a risk in relation to the need to increase the debt ceiling by around October (with a showdown now looking likely) and tax hikes on high income earners, profits, capital gains and dividends. The former could mean a short-lived scare but with both sides ultimately cooperating as they don’t want to get the blame for having a US default, but the tax hikes are a bigger risk.

  • Political tensions with China or tighter than necessary policy resulting a sharply Chinese slowdown in the near term.

Outlook

While shares remain at high risk of a short-term correction – potentially triggered by the above-mentioned risks – we ultimately see the rising trend continuing and bond yields trending up again once it’s clear that economic recovery will continue despite the disruption from Delta. Peak GDP and earnings are far more important than peak growth in either and both look to be a long way off given that the excesses that normally lead to peaks in both – a lack of spare capacity, a sustained rise in inflation and central banks jamming the brakes on – are still mostly absent.

A divergence between shares and bonds is not that unusual – in fact, much consternation was expressed about the same a year ago. Ultimately shares prevailed as investors looked beyond prevailing uncertainties and bond yields eventually rose. As long as the market can look beyond current uncertainties to something better, then it will.

Source: AMP Capital August 2021

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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