Inflation and infections

The final month of the quarter was marked by new waves of COVID-19 infections across Europe and fears of inflation in the U.S. The spike in case counts in major European economies along with the plagued vaccine roll-out would have normally weighed on markets and risk sentiment, but bond yields continued to move higher as growth and inflation expectations rose. The positive outlook is not without risks, but the focus on the medium-term economic improvement is translating into upward revisions to the earnings outlook.

Progress on a vaccine roll-out was always going to be a defining feature of the economic re-opening in 2021. The divergent paths between the U.S. and the rest of the world have become clearer, notably against Europe. The slow progress in Europe has allowed a reinvigorated viral spread and further economic shutdowns. Meanwhile, the U.S. is vaccinating their population at a faster-than-expected rate and should reach herd immunity in the next few months.

U.S. economic optimism and inflation expectations were further bolstered by the passing of a USD 1.9trillion stimulus package which should lift consumer spending at a time when the U.S. economy is already gaining momentum. The blockbuster March employment report which saw 916,000 jobs added in the month points towards near-term economic improvement. This also lifts the inflation risk, and U.S. 10-year Treasury yields reached a 14-month high during the month.

Central banks, by and large, pushed back against higher bond yields and rising inflation expectations. It is actual inflation rather than expected inflation that concerns central banks and their policy outlook. Inflation will be higher in the coming months as the base effects from the global shutdown a year ago come into effect. But the expectation is that this will be temporary and central bankers want evidence of inflation that is persistently above target before raising rates. The same cannot be said for emerging market (EM) central banks, where rates have started to rise in response to inflation or to defend currencies.

Higher yields and higher growth is adding to the rotation to value stocks and cyclical sectors. The economic data continues to point towards a stronger economy, and the yield curve moves on its steepening path supports the outlook for financials. The oil price has found some stability as demand returns, helping to lift the ailing energy sector.

The one rotation that is not playing out as expected is the U.S. dollar, which has strengthened over the first quarter against consensus expectations for a decline. The stronger U.S. dollar does cause some headwinds to EM assets.

Economy:

• Australian sentiment improved over the month as both consumer and business sentiment moved higher. The outlook is positive as most areas of the country move back to something close to normal. Key indices in the business survey were at multi-year highs. An outbreak of COVID-19 in Brisbane and the subsequent lockdown is a reminder of how long the effects of this virus will linger.
• Concerns about the ending of government stimulus measures in Australia, particularly the JobKeeper scheme, were reduced by the strong labour market report for February. The unemployment rate dropped to 5.8% and participation remained at an all-time high. Broader measures of the health of the labour market, such as the underemployment rate, are back at pre-COVID levels. However, the fading of fiscal support should mean a slowing in employment gains and the Reserve Bank of Australia (RBA) is looking for wage growth “sustainably above 3%” to drive inflation higher.
  (GTM AUS P. 8)
• The housing market was in focus again given the pace of house price rises. House prices rose 2.8% month-over-month (m/m) across the eight capital cities of Australia in March. Building approvals were up a dramatic 21.6% m/m in February supported by the HomeBuilder scheme.
  (GTM AUS P. 10)
• Looking back, the Australian economy snapped back faster than expected as the fourth quarter GDP figures showed the economy expanded by 3.1% quarter-over-quarter in the final three months of the year. This was largely driven by household consumption which contributed more than 2 percentage points to the headline figure. The transfer of wealth from the government to households is now making its way into the economy, and the household savings rate fell sharply in the last quarter. This trend should continue to add to strong domestic demand in the coming quarters.
  (GTM AUS P. 4)
• Internationally, the economic picture is improving. The latest round of Purchasing Managers’ Indices for manufacturing and services showed strong gains. Notably, the numbers out of Europe were at record highs, while the U.S. figures have steadily illustrated an economic expansion.
  (GTM AUS P. 16) 

Equities:

• The ASX 200 rose 2.4% in March, underperforming the 4.3% rise in global developed equities. Consumer discretionary (6.9%), utilities (6.8%) and Telecoms (5.8%) were the strongest-performing sectors over the month. Meanwhile, materials (-5.0%), information technology (-3.0%) and energy (-0.5%) were at the bottom of the list (price returns only).
• The markets that had greater cyclical exposure did the best over the month. The MSCI Europe was up 6.2% and the Japanese TOPIX 5.7%. Meanwhile, EM equities recorded a -0.8% decline. The strong performance in Japan and Europe perhaps contrasts the economic outlook for those regions, but it is evidence of the stronger relative valuation position compared to the U.S.
• Equity valuations have come down this year, but are still at elevated levels. The S&P 500 is trading at a multiple of 21.9x, and Europe and Japan at 16.9x and 17.6x respectively, which may be more appealing to investors. The ASX 200 ended the month at 18.3x, after being over 20x in recent months.
  (GTM AUS P. 34)

Fixed income:

• The yield on Australian 10-year government bonds fell 9bps to 1.79% but with large swings throughout the month. The U.S. 10-year Treasury yield rose by 28bps to 1.74%. U.S. yields continue to rise with inflation expectations. The inflation outlook is stronger in the U.S. compared to other nations given the strength in both the labour market and the added stimulus measures. The return on U.S. Treasuries was -1.5% over the month.
  (GTM AUS P. 59)
• The divergence in U.S. and Australian bond markets was also due to the more dovish response by the RBA in recent policy meetings as well as engaging in further bond buying. The RBA now owns 13% of the local government bond market and has plenty of capacity to use up in the second AUD 100billion tranche of Quantitative Easing. Still, the RBA has pushed the flexible nature of its bond purchases and the message that it will do more if required.
  (GTM AUS P. 58)
• Credit markets had a weak month and the return on global investment grade bonds was -1.9% for the month, while U.S. dollar-denominated EM debt fell by the same amount. Rising U.S. Treasury yields and a stronger U.S. dollar are headwinds to the outlook for EM debt, but the still relatively high yields should attract flows, while emerging markets are beneficiaries of the wider global economic improvement.
• High yield debt continues to eke out small gains given the higher yields on offer. The U.S. high yield bond market was up 0.2% over the month. 

Currencies and commodities:

• The Australian dollar fell 1.6% against the U.S. dollar. The U.S. dollar was stronger against both the euro (3.3%) and yen (3.7%) over the month. The potential for the U.S. Federal Reserve to hike rates sooner than expected, the relatively stronger U.S. economy and some flight to safety has supported the greenback.
  (GTM AUS P. 71)

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