FAIT Accompli 

August proved to be a strong month for risk assets as earnings seasons around the world wrapped up and economic data continued to improve off of the economic nadir from earlier in the year.

Surprisingly, central banks found more room to ease already exceptionally loose monetary policy. In Australia, the Reserve Bank of Australia (RBA) managed to surprise at both its August and September meetings by conducting more bond purchases and then extending its term funding facility to increase the amount of cheap loans to banks and support credit growth in the economy. However, it was the Federal Reserve (Fed), which gained all the attention as it announced the conclusion of its monetary policy review. While there are many details still to come, the Fed will shift its focus to target an average inflation level of 2% over time (Flexible Average Inflation Targeting - FAIT). This means that after years of failing to reach its inflation mandate, the Fed is prepared to tolerate higher rates of inflation before raising interest rates so that inflation, on average, is 2%. This pushes any expectation for a rate hike well beyond the 2023 date priced by the market. The shift was widely expected and the market reaction was short lived.

Such a move means that other central banks are unlikely to be able to raise their rates if the Fed doesn’t, given the impact it could cause currencies to further appreciate against the U.S. dollar. It also means that real rates and real yields will remain negative for some time, further limiting the appeal of core government bonds. This could push more investors towards equities, gold and alternative assets as they seek income and diversification benefits not available in government bonds.

However, the surprising, better than expected economic data and corporate earnings propelled markets higher. The low bar for earnings in the U.S. and Australia was easily passed. It was not all good news, as there was a clear distinction in sector performance in terms of those impacted by restriction of movement of people and those that benefited from the shift to an online world. The narrowness of the rally, fueled by tech and internet related stocks, as well as the rising number of retail traders have some concerns that a correction is imminent.

It is also clear that the COVID-19 virus will be with us for some time as case numbers have increased in European countries as restrictions were removed. News on a potential vaccine and treatment will support markets, but may not be enough to offset volatility and potential profit taking heading into the U.S. Presidential election in November. It is also likely that economic momentum will start to wane as the bounce off of the economic bottom passes. 

Economy:

• Australia’s not-as-bad-as-feared recession is largely playing out. The economy contracted by 7.0% quarter-over-quarter (q/q) in the second quarter of the year. The decline was almost entirely the result of a 12.1% q/q plunge in household spending. While the economic trough was lower than in many other developed countries, the drag could be worse given the restrictions that have been in place since the end of June. The RBA’s own forecasts in its Statement of Monetary Policy were for a slight upgrade to growth this year, but the outlook for the labour market remains the same and the path out of recession will perhaps be flatter than other developed markets.
  (GTM AUS P. 8)
• A divergence has emerged between consumers and businesses. While confidence across both groups plunged at the early onset of the pandemic, business confidence has since recovered even as consumers’ view of Australia plummet once again. This reflects the impact of second lockdown in Victoria on consumers and the improved outlook globally which may be lifting corporate sentiment.
  (GTM AUS P. 5)
• The U.S. economy continues to steadily improve even as the political environment deteriorates. Manufacturing surveys, car sales and housing data have improved, suggesting that consumers are taking advantage of low rates to finance purchases. However, much of this will have also been financed by additional fiscal support which has now ended. A fourth fiscal package to support those unemployed looks unlikely until after the U.S. election as negotiations between the two main political parties repeatedly fail.
• China is benefiting from its position as first to exit the pandemic as economic data continues to beat expectations. Notably, trade data was strong and inflation has started to lift on economic activity. Chinese officials appear unfazed by an increasing list of U.S. sanctions and the review of the Phase One trade deal between the U.S. and China was rather amicable in the scheme of things, so this should ease the threat of another round of tit-for-tat tariff increases.
  (GTM AUS P. 17)

Equities:

• The low weight of the tech sector in Australia meant the ASX 200 lagged the rest of the world again last month. The ASX 200 rose 2.8%, well below the developed world’s 6.3% for the month. IT, consumer discretionary and REITs were the strongest performers, while utilities, consumer staples and communication services lagged.
• With the earnings season in Australia now complete, there was positive news in more companies offering up better-than-expected results, but the margin was not as high as in other markets. The greater worry for many investors is the outlook and dividends. There was little corporate guidance on what to expect from here, leaving investors guessing as to what earnings and dividend payments, and by who, will look like in the future. Valuations remain elevated as the ASX 200 trades of a forward price-to-earnings multiple of 20.2x.
  (GTM AUS P. 41)
• The August rally pushed the MSCI World index into positive territory for year, driven by the performance of the U.S. The S&P 500 rose 7.2% in August, topping all other global markets. Meanwhile, the MSCI Emerging Markets index moved higher, thanks mainly to performance of Asian markets. The MSCI Emerging Markets index was up 2.2% for the month, while Asia ex-Japan gained 3.2%.
• The bifurcation of the market rally continues to irk some investors, particularly those that have missed the remarkable rally in the IT sector and online-focused consumer companies. The weight of IT in country level indices is a defining feature of why some markets are outperforming others, as ‘growth’ orientated markets, e.g. the U.S., beat out ‘value’ ones, e.g. Europe.
  (GTM AUS P. 34)

Fixed income:

• Global bond yields spiked higher in August and the 10-year U.S. bond yield rose 17 basis points to 0.70%. In Australia, the equivalent bond yield rose by the same amount to 0.98%. The improving economic outlook and rising fiscal stimulus has markets pricing in more inflation and breakevens started to rise.
• Spreads in the credit market continued to narrow. Global investment grade bonds have gained 6.7% this year in local currency terms, meanwhile global high yield is not in positive territory for the year at 0.8%.
  (GTM AUS P. 52)

Currencies and commodities:

• A sustained period of depreciation in the U.S. dollar helped to lift the currencies of major markets. The Aussie dollar was up 3.1% over the month and the euro by 1.1%. However, it is worth nothing that on a trade-weighted basis, the Australian dollar was essentially flat over the month at -0.2%.
  (GTM AUS P. 67)
• Global commodity prices continued their recovery in August. Brent oil rose USD 1.98 per barrel to USD 45.7. Meanwhile, the price of oil ore rose by USD 15 to USD 125 per tonne as demand from China remains strong and supply weak. Gold lost some shine, and while still hovering around the USD 2,000 per ounce mark, the better economic prospects may have led to some re-risking in investor portfolios. 

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