Bond market takes charge

Momentum in global equity markets increased after a slow start to the month as some indices made new highs. However, the big themes around inflation and growth persisted, adding to volatility in bond markets as investors speculated around an accelerated path of interest rate hikes and some central banks become more hawkish in their views.

The combination of rising energy prices as well as persisting bottlenecks in the global supply chain have investors on edge when it comes to the inflation outlook. Short-dated bonds, which are more sensitive to interest rates, started to rise as expectations for rate hikes were brought forward. Some central banks also became more hawkish in their views, which added to the upward pressure on global bond yields. The Bank of Canada ended its bond purchase program earlier than expected, the Bank of England prepared the market for a November rate hike, and the Reserve Bank of Australia abandoned its yield curve control policy.

Inflation pressures in many economies are surprising to the upside and bottlenecks may last longer than anticipated, but we expect inflation pressures to ease in the coming months. The near-term risk is that higher inflation curbs the growth outlook, particularly if it limits consumer spending, or leads to a policy error from central banks in moving too quickly or perhaps too slowly. However, the current shift from central banks is away from emergency policy settings, and monetary policy remains very accommodative.

While the bond market may be focusing on the negatives, global equity markets continued to grind higher on the growth and earnings outlook. In the U.S. in particular, the stock markets were supported by the better-than-expected third quarter earnings season. At the time of writing, three-quarters of S&P 500 companies had reported their earnings with year-over-year (y/y) operating earnings tracking a 36% rise, lower than in the second quarter but still strong by historical standards. More than 80% of companies have beaten earnings estimates and 67% have beaten revenue estimates. However, somewhat surprising is that even as input prices have been rising, profit margins for U.S. stocks have not fallen far from last quarter’s record highs.

Equity markets could still run further in this mid-cycle environment and rising yields, if combined with steeper yield curves, supports the rotation to cyclical reopening sectors and value stocks. Flatter yield curves has seen the value ration put on hold and growth regain favour. Fixed income markets will remain challenged by the prospects for higher yields, but keep in mind high inflation in the near term means real yields are still negative.  

Economy:

• Third quarter inflation in Australia rose by 0.8% quarter-over-quarter (q/q), slowing to 3.0% y/y. This was largely in line with expectations. However, the much sharper rise in the trimmed mean rate of inflation to a much higher-than-expected 2.1% created a stir in bond markets. This was the first time since 2015 that this “core” measure of inflation had been back in the Reserve Bank of Australia’s target 2 to 3% band.
  (GTM AUS page 7)
• At the headline level, fuel and homebuilding costs contributed most of the quarterly increase and it will be difficult for this to be maintained.
• Employment fell by 138,000 in September after falling by 146,000 in August. Mobility restrictions across more than half of Australia explain the drop, but employment remains 0.9% below the peak in early 2020. Despite this, the unemployment rate of 4.6% is below the pre-lockdown rate and reflects falling participation in the labour market. A clear direction of the labour market and wages will take some time to appear given the impact of lockdowns.
  (GTM AUS page 8)
• Business and consumers remain broadly positive. Business confidence has risen sharply as economic reopening plans were outlined. Consumer confidence took a bit of a dip in October but is robust by both historical standards and the conditions that many people are operating in.
  (GTM AUS page 5)
• The outlook for the Chinese economy remains clouded by the property sector and the continuation of zero-COVID-19 policies. The economy expanded by 4.9% y/y in the third quarter. Fixed asset investment in the property sector fell 2.6% y/y as the sector was the focus of increasing regulatory pressure and at risk from potential defaults of large developers.

Equities:

• For the second month, the ASX 200 posted a small decline, falling by 0.1% in October. The Australian market lagged last month given the sharp repricing of higher-than-expected inflation and tighter monetary policy compared to other developed economies. The MSCI World Index rose 5.5% and the U.S. market was up 7.0% thanks to the stronger than expected earnings season (local currency returns).
  (GTM AUS page 33)
• Even as yields rose, the IT sector was the strongest performer gaining 2.1%, while healthcare (1.0%) and financials (0.8%) did well. Industrials (-3.2%), energy (-2.7%) and consumer staples (-2.3%) were the laggards (price returns only).  
• Developed markets outperformed emerging ones in October as the MSCI Emerging Market Index only gained 0.9%. Sentiment towards China could be impinging on sentiment to the rest of emerging Asia and emerging markets more broadly. However, rising vaccination rates and plans to reopen economies could lead to a change in emerging market equity performance. 

Fixed income:

• Short-dated bond yields climbed as markets repriced for rate hikes commencing in 2022 around the world. After stronger-than-expected inflation figures for 3Q 2021 in Australia, the policy-sensitive 3-year government bond yield jumped 89bps. The move higher for the month of October was the fourth largest in the last 30 years and second largest in the last decade.
• Longer-dated government bond yields have also risen, but not by as much, leading to a flattening of the yield curve. 10-year bond yields in Australia rose by 59bps, which means that the spread between 10- and 3-year yields narrowed. Flatter yield curves are typically a bad sign for the outlook as it implies less growth in the future and an inversion of the yield is often a precursor to recession.
  (GTM AUS page 51, 54, 55) 

Currencies and commodities:

• Gold prices held off inflationary concerns, possible higher interest rates and a rising U.S. dollar, as real yields remain near all-time lows, providing support for the yellow metal. Gold rose USD 26 to USD 1,769/oz.
• Rising demand and still disrupted supply saw the oil price rise to USD 84 per barrel, its highest since 2018.
  (GTM AUS page 64)
• Iron ore dipped again, down USD 3 to USD 108/Mt as fallout from the property sector weighs on the outlook for steel and production was moderated due to power shortages.
  (GTM AUS page 65)
• The U.S. dollar gained closed to 4% on a trade-weighted basis as markets factored in the possibility of interest rate hikes and tighter monetary policy. The Australian dollar held its own for similar reasons, rising 4.0%. However, the currency was rather stable when compared to the actions of the Australian bond market and likely reflects the “China effect” on Australia and the decline in iron ore prices.
  (GTM AUS page 67)