Welcome to our Autumn edition of On the Marc. In this edition, we will review markets for the first quarter and consider the outlook into the foreseeable future.

Market update

The global “V” shaped recovery continued to accelerate, fuelled by low-interest rates, further fiscal stimulus and optimism around COVID vaccine rollouts. Domestically the February reporting season was generally a positive one. The majority of companies beat market earnings forecasts, with better than expected margins the key driver of the earnings beat. A theme the equity market continues to focus on is the “re-opening” stocks – those stocks exposed to international borders re-opening and economies and people functioning as normal again.

The US, in particular, is accelerating and recent data releases have been particularly strong. For example, the US services Purchasing Manufacturers Index (PMI) jumped to 60.4 in April, the highest reading since 2014. The inventory cycle is intense so companies with strong supply chains are winning market share. New orders were at record levels, especially for consumer goods. Price increases, reflecting higher costs, were the highest in the series history.

For the past 40 years, politics and economics have been dominated by the Friedman monetary economic policy agenda. Since the 1970s, major governments and central banks have been focused on monetary policies (interest rates) to fight inflation. We appear to be at the end of this approach.

Fiscal (government) spending is on the increase. It is no longer political poison to increase debt. US President Biden has unveiled a large multi-trillion-dollar infrastructure plan called the “Build Back Better” infrastructure investment plan, focusing on transport infrastructure projects, manufacturing, renewable energy, high-speed broadband networks and affordable housing. The plan is subject to US Congress and Senate approval and if it is passed without change, we could see nearly US$300b of incremental investment per annum (or ~1.5% US GDP) over a period of 10 years, with potential upside from multiplier effects. US transport infrastructure investments amount to ~US$150b per annum, while the total gross fixed asset investment by the government amounts to ~US$400b per annum. The plan also appears to favour “green development” of infrastructure assets, like building 30GW of offshore wind energy by 2030.

To fund this there will be some tax increases but ultimately the world will have more debt and central banks appear to be favouring allowing the economy to run hot. The Federal Reserve is changing its policy footings including no longer aiming to pre-emptively tighten policy to control inflation, which may unsettle markets. Another change is that central banks will care less about markets and will favour Main St over Wall St. From the early 1990s, central bank best practice included several features: a focus on an explicit inflation target; forward-looking policy adjustments; and a respect for markets. Central banks have tended to overreact in the past three decades, resulting in inflation being below trend most of the time. Poor forecasting means they are giving up on predicting inflation, preferring to wait to see the evidence, which means allowing the economy to overheat a little.

There is also a greater focus on the labour market with full employment plus low inflation increasingly seen as the goal. The Reserve Bank of Australia is hinting that it will ignore any rise in inflation as transitory unless it is due to sustained strong wage increases. Central banks will be more likely to dismiss increases in inflation (including increases in core inflation) as temporary if wage growth is not suitably robust.

Since the GFC, tighter fiscal policies saw governments resort to quantitative easing (QE) to lower interest rates. This approach was intended to lower long term interest rates, lower the currency to improve the competitive position, and to create a wealth affect where higher asset prices encouraged investment.

However, QE wasn’t particularly effective because as everyone was undergoing QE there was no currency benefit, there wasn’t much credit creation and while asset prices went up, so did savings rather than investment. We now find ourselves in a different world where fiscal policy is now the prime tool of cycle management.

Market returns for major indices

Below is a table showing the percentage returns of the major market indices to 31st March 2021.

The outlook for the year ahead

Over the past decade, bonds have been negatively correlated to equities. Investors in bonds have enjoyed strong returns plus a hedge against a negative equity market. However, volatility in bonds is increasing. The US long-term bond index has seen more double-digit drawdowns than the S&P 500 over the past decade.

In a low-inflation environment, equities will be negatively correlated to bonds but this flips as inflation rises above 2.5%. When the correlation was negative, bonds would rise substantially in an equity-led bear market, but this is unlikely in an inflation-led bear market (note that bonds would still outperform a large equity drawdown, but perhaps not be up).

An economy is driven by fiscal stimulus with stronger inflation is likely to see a change in market leadership. Those companies with stronger exposure to the economic cycle would tend to do better, while longer duration growth stocks would struggle. We have seen this play out over the past six months. The question is how far has this left to run. The following chart suggests there could be substantially more to run. It shows prior growth outperformance rallies relative to value. It would appear we are in the early stages of a value rally.

For the year ahead we don't expect the same high level of returns as experienced in the past year. Nonetheless, the expectation is for positive returns from growth assets (shares property) as the markets overcome the Covid-19 pandemic with strong tailwinds. Performance across sectors will vary greatly due to pricing in future interest rate increases.

May companies including private equity firms are cashed up so we expect a lot of activity in the mergers and acquisitions space.

Did you know?

Sydney’s median house price has risen $100,000 since the new year began as property values defy a global pandemic, leaving investors and first-home buyers battling it out at auctions.

According to Corelogic, Sydney dwelling prices were up 3.7 per cent overall for March, with apartments rising 2.1 per cent pushing the median house price to $1,112,67 and units $755,360.

Sydney prices have now lifted by 6.7 per cent during the first quarter of the year—the strongest quarterly growth since mid-2015.

Final reMarc

We are seeing a broader range of companies offering growth than we have seen in recent years. Digital disruption will continue to be a source of growth, but we note these other opportunities for growth:

- Infrastructure spending and the move towards renewables.

- The above driving demand for commodities boosting resources.

- The war on waste creating growth opportunities for individual companies.

- Cyclical recovery in earnings for financials.

- Companies benefiting from the reopening of the economy and the strong increase in consumer savings, which will likely be spent.

Active Australian and global share fund managers remain very upbeat in the likely returns into the foreseeable future. This is due to the large dislocation in prices across various sectors in financial markets and the unprecedented level of government spending injecting billions of dollars into the world economy.

“You should be far more concerned with your current trajectory than with your current results.”

James Clear

Key Facts & Figures

Australian Cash Rate remains at the record low of 0.10%.
The RBA Cash Rate is poised to remain at present levels until 2024.
Our annualised inflation rate is 0.9%. This remains well below the RBA’s target band of 2 - 3%.
Australia’s unemployment rate sits at 5.6%.
In the US, the Federal Reserve keeps rates at the record low range between 0% and 0.25%.