Three months into the new year, it is fair to say that the global economic outlook certainly seems more stable than it was last March amid the COVID-19 pandemic. Vaccines are gradually being made available around the world, central banks have brought stability and liquidity to global markets, and governments worldwide have introduced some of the largest fiscal stimulus packages in modern history.
Massive central bank balance sheet expansion and the surge in government debt/deficit will likely encourage investors to venture further into alternative asset classes. While it’s likely that investors will increasingly focus on traditional alternative assets such as private assets, emerging markets, and infrastructure and agriculture funds, we believe there’ll also be a growing demand for assets whose value cannot be distorted by central bank purchases, specifically those that may be subject to less regulation and taxation, since governments may be seeking additional revenue to fund expected future deficits.
The strength of the global economic recovery depends on the speed at which COVID-19 vaccines can be distributed, the scope for further fiscal spending depends on the outcome of delicate political negotiations in each country, while the resilience that we’re seeing in the financial markets may be limited by when investors believe central banks might start to roll back quantitative easing (QE). Inflation may be stubbornly low for now, but a big enough blast of demand could push it higher, leading the Fed to raise rates somewhat sooner than it currently plans. The ripple effects of such a move on asset markets would separate the strong from the weak and hit emerging markets particularly hard.
Economic analysis (Australian Update)
Australia is enjoying a recovery in the wake of the COVID-19 pandemic with jobs, iron ore prices and retail recovery all filling the nation’s coffers. And because of the surprise strength of the economic recovery, the amount of deficit spending required by government to support economic activity will be much less than forecast. It estimates an underlying cash deficit of $167 billion in 2020-21, which is $31 billion smaller than Treasury was forecasting in December.
The Australian economy’s growth has been forecast to increase more than was first predicted for 2021. The International Monetary Fund (IMF) updated its 2021 global economic growth forecast and it has increased Australia’s expected GDP growth to 4.5%. This means Australia could recover from the pandemic-spurred economic downturn this year, after GDP shrunk by 2.4% in 2020.
The RBA kept official rates at 0.1% and reaffirmed its belief that bank credit standards were sound even as it admitted it was keeping a close eye on the booming property market. In releasing its semi-annual Financial Stability Review, the RBA said the major risk to financial stability was an incomplete or uneven economic recovery but found that financial systems in Australia and globally have coped well with substantial shocks.
Australia’s CPI rose 0.6 per cent for the March quarter, the latest figures from the Australian Bureau of Statistics have revealed. Annual inflation to the March quarter increased 1.1 per cent.
The Australian earnings season was strong in aggregate but could not offset the rise in yields and broader investors’ worries. The rise in yields weighed on the long duration technology sector. However, the earnings outlook for Australian equities remains robust and the return of corporate guidance has bolstered earnings expectations. Meanwhile, dividends payouts surprised to the upside giving investors a much-needed jolt of income.
Since its pandemic-trough on March 23, the Australian market has rebounded sharply by 49 per cent (from its low point of 4,546 points). Despite the recent volatility, there are some decent opportunities for investors. Things have been difficult for retail, but there are positive signs, utilities had underperformed the market by around 30 per cent and consumer staples are the cheapest pricing they have been in a decade and are good value. There are two main risks that the market has either discounted or is paying no attention to. The first is the risk of the coronavirus mutating, which could make existing vaccines not as effective. Second there a chance that economies might “overheat”, triggering faster rate hikes and a stock market correction.
Commodity prices have surged worldwide over the last few months on the back of governments’ pandemic-related stimulus policies and supply constraints. Prices for industrial metals, such as iron ore and copper, have reached multiyear highs, owing to strong demand from China and supply bottlenecks.
Already this year, several commodity markets have witnessed considerable bullish sentiment, prompting many analysts to project a brighter future for commodities as the world strives to put the impact of COVID-19 behind it once and for all. Of particular interest with this rally has been the weakness of the US dollar, which is the de facto currency used to price virtually every global commodities market. A weak dollar means commodities are cheaper for global buyers when converted back into their domestic currencies and, as such, will induce greater demand, all else being equal.
Since peaking in August 2020, gold has lost momentum and has shown no willingness of retesting its highs. The weakness goes against what many investors had expected to happen. Gold entered the new year with a major catalyst for growth. The higher gold price prediction was based on President Joe Biden’s massive $1.9 trillion stimulus package that by default bodes well for the metal.
So, what can we expect in the coming weeks and months? Will gold prices go up or will the sluggish trading activity continue? There is no mistaking the fact that gold prices historically perform well during periods of inflation. Gold and other metals like silver ended 2020 with their strongest gains in a decade – and for good reason. Some of the more notable factors that supported a higher gold price forecast include the weakening US dollar, continued uncertainty created by the Covid-19 pandemic, and expectations for rising rates.
None of these catalysts have abated since the start of 2021. Quite the contrary is true as all the factors that supported a higher gold price change remained in place. It would be reasonable to conclude that the trading action seen in 2020 has not come to an end and 2021 could see new highs. The reasons to hold gold – if inflation is coming (and it probably is) you want to hold a real asset that can hedge against it – one that can’t be inflated away by relentless money creation and currency debasement. That’s particularly the case in an era of very low interest rates.
Oil prices have also staged an impressive comeback, with the price for Brent crude returning to pre-pandemic levels. The rally in crude looks far from over, with the underlying fundamentals supporting more gains this year. Oil balances continue to tighten with a seasonal summer demand boost, higher refinery runs, and an improving outlook for the COVID situation amidst ongoing vaccinations.
Australian real estate investment trusts (AREITs), as represented by the S&P/ASX 200 AREIT Index, returned +6.6% in the month ending 31 March 2021. The AREIT index outperformed the S&P/ASX 200 return of +2.4% over the month. Over the 12 months to March 2021, AREITs posted a total return of +44.7%. This is 7.2% higher than the S&P/ASX 200 return of +37.5%.
Sector returns in March were led by Industrial AREITs with +9.5%, followed by Office AREITs with +8.4%, Diversified AREITs with +7.8% and Retail AREITs with +1.0%. Returns were strong across all sectors on the back of easing covid restrictions. The positive performance of AREITs for March can be partially attributed to recent comments by the RBA detailing how interest rates are unlikely to increase until 2024.
AREITs are likely to perform strongly in 2021 – especially those that are trading at attractive discounts, but own quality income-earning assets. The outlook is undoubtedly brightening, though, as vaccination programs get under way, and a gradual return to economic normality. Inevitably, though, it will take some time for vaccines to roll out and take effect and —crucially for sentiment — for their positive outcomes to become clear. With market interest rates now at an effective lower bound, capital values in coming years are set to be determined not by yield movements as they were in the past two cycles but by fundamentals — namely, in maintaining and growing income receipts.
It will take most of 2021 and into 2022 for the full benefits of vaccination to be felt, and maybe even longer in poorer countries. The OECD recently reported, “prospects have improved over recent months with signs of a rebound in goods trade and industrial production… Global GDP growth is now projected to be 5.6% this year… world output is expected to reach pre-pandemic levels by mid-2021.” The greatest vaccination relative to population has occurred in the U.K. and the U.S. China has a low vaccination rate that is not as worrisome as it may seem because their count of new cases is very low. Although Chinese data is not totally trustworthy, even with substantial misreporting the country is in good shape.
While short-term rates are anchored at ultra-low levels, long-term bond yields are more sensitive to changes in the macroeconomic backdrop, and they have been moving higher. Rising inflation expectations and the prospect of better economic growth pushed yields gradually higher since their early 2020 lows and that trend accelerated in early 2021.
The U.S. and most other major economies are progressing toward the mid cycle phase of expansion, with levels of activity based on vaccine rollouts and reopening progress. While China’s expansion is maturing in its post pandemic period, U.S. activity is poised to accelerate amid economic reopening and fiscal stimulus. Many other large economies, particularly developing countries, have slower vaccination and recovery trends.
Just as the pandemic’s initial hit was very uneven across Europe, so will be the member states’ recovery paths. More than half of the member states are forecast to close the distance to their pre-crisis output levels by the end of 2021. Others, however, are expected to take longer. Many factors contribute to such an outcome. The economic structure, the share of the tourism sector, and the size of policy responses are among them. Yet, the road out of the crisis still critically depends on the pandemic’s evolution as well as the stringency and duration of measures needed to contain it. The longer the crisis protracts, the greater the risk of large cross-country divergences becoming entrenched, especially if policy responses do not address them adequately.
The Eurozone economy contracted in the first quarter of 2021 as countries implemented new lockdowns and restrictions amid a third wave of coronavirus infections. Gross domestic product in the region fell by 0.6% quarter on quarter. It marks the second consecutive quarter of contractions, meaning the region is in a technical recession. Most of the region’s largest economies — Germany, Italy and Spain — saw a decline in activity during the first three months of the year. The sharpest fall in activity occurred in Portugal, which has faced a wave of new Covid cases and led to the country’s second lockdown.
France was an exception, with the Eurozone’s second-largest economy posting better-than-expected growth of 0.4% in the first quarter. Though the French economy remains below its pre-Covid levels, the growth numbers will bring some reassurance going into the second quarter. However, in Germany, the economy contracted 1.7% over the same period. The nation has been severely hit by a third wave of Covid infections, and different approaches among its various regions have further complicated its fight against the pandemic. In Italy, the latest GDP numbers showed a contraction of 0.4% for the quarter, slightly better than expectations. The Spanish economy also shrank over the same period, by 0.5%, while Portugal’s economic activity contracted by 3.3%.
Countries in the region are due to start receiving EU-wide Covid support funds in the second half of the year. The 27 European nations agreed in July 2020 to implement a 750 billion euro ($895 billion) joint stimulus, but those funds have not yet been distributed. The economic performance of the EU will depend on the evolution of the pandemic, including new variants; as well as the vaccination rollout, which has been difficult for the EU so far. In this context, whether at the national or European level, it has been suggested that member states might soon be discussing how to provide more help for their populations.
China’s economy managed an impressive recovery in the past year following its COVID 19 lockdown, with housing market and industrial activity having largely surpassed pre virus levels. Credit growth has decelerated as monetary policymakers shifted away from easing and toward addressing medium term financial risks, implying the rate of economic improvement may moderate as the expansion matures.
Compared to other major economies, the Chinese government was relatively restrained in adopting large fiscal and monetary stimulus policies to help boost the economy. Nonetheless, Beijing is still expected to pull back some of the stimulus measures to control rising debt levels and prevent asset price inflation.
We expect China’s overall economy to continue to recover and grow by 8.8% in 2021. Stability of the labour market has been a top priority for the Chinese government in recent years. To support the labour market amid the pandemic, the government has taken various measures including expanding higher education enrolment and reducing social security contributions by companies.
Economic activity boomed to start 2021, as widespread vaccinations and more fuel from government spending helped get the U.S. closer to where it was before the Covid-19 pandemic struck. Gross domestic product, the sum of all goods and services produced in the economy, jumped 6.4% for the first three months of the year on an annualised basis. Outside of the reopening-fueled third-quarter surge last year, it was the best period for GDP since the third quarter of 2003.The boost in GDP came across a spectrum of areas, including increased personal consumption, fixed residential and nonresidential investment and government spending. Declines in inventories and exports as well as an increase in imports subtracted from the gain.
Joe Biden also announced a $1.9tn Biden stimulus package — which will add 9 per cent of national income to US spending power — is designed to boost the US recovery. The Biden package is massive. It puts up to $1,400 into the pockets of low-paid workers and members of their families. It extends a wide range of welfare payments into the autumn, boosts parental tax credits, and maintains special unemployment reliefs and health care subsidies. Much of the support is unconditional. America is set to be the only one of its members states whose economy will be larger at the end of 2022 than the OECD was predicting before the pandemic. The US is expected to grow faster even than China, which has not happened for years.
While the numbers indicated that many used the free money to spend, they also tucked a good portion of it away, as the savings rate soared to 21%, from 13% in Q4.
Rising growth, massive amounts of stimulus, from governments and central banks and inflation expectations boosted riskier asset prices to additional gains during Q1, marking a remarkable one-year performance rebound since the bottom of the pandemic sell off in March 2020. Rising bond yields caused fixed income returns to struggle, with more economically sensitive high yield corporate bonds holding up best.
The potential for higher inflation represents a risk factor for a multi asset portfolio. Inflation resistant assets, including commodities and commodity producer equities, can help hedge against surprise increases in inflation while providing potential for capital appreciation in a higher nominal growth environment. In fixed income, inflation hedging assets such as TIPS have provided better diversification than Treasury bonds.
Markets have seen a rotation that has been underway for months, with investors favouring cyclical and value stocks and we expect this trend to continue. Sectors like financials, energy, industrials, and materials could outperform the broader market.
With an unprecedented amount of cash in the system, equities and high yielding bonds are attracting a lot of interest from investors in the absence of acceptable yields from money markets and longer-term government bonds. That may continue to push risk assets higher, although valuations are approaching extreme levels. To keep this rally alive, we need more intervention from fiscal and monetary policymakers and for investors to believe that policies will be generous enough to provide further liquidity.
With interest rates at record lows and continuing low inflation, investors can continue to rebalance the property component of their portfolio to their full Australian Retail Investment Trust (AREIT) weighting as per the current Merlea Models. While many REITs have recovered there are still opportunities within the sector. The greatest risk to the sector is a rising in bond yields, which would negatively impact pricing.
Investors should focus their attention on ensuring that their overall portfolio is suitable for their risk tolerance, their lifestyle needs and their long-term return requirements. Market performance is difficult to predict, particularly over the short term but putting together an appropriate mix of Australian and international equities, fixed interest, property, cash and alternative investments is more likely to achieve an investor’s long-term goals compared to reacting to market events without the benefit of a plan.
Diversified portfolios with a mix of asset classes have managed to post acceptable returns over longer time frames of 5 or 10 years despite market volatility. This reflects the short-term nature of many of the equity market declines, together with the other asset classes being influenced by different drivers, and therefore providing an offset when equities perform poorly.
Merlea Investments recommended portfolios are generally designed to diversify assets across a range of asset classes to obtain low volatility given a stated return goal. The actual goal, or targeted return, from a portfolio is perhaps the most important influence in a portfolio as once a goal is stated the ability to assign asset allocations becomes a matter of maths. We will always prefer to gain as much return as possible from cash and defensive type assets and then augment this return with the higher risk/higher return possibilities from growth assets.
Opportunities exist to accumulate specific sectors that are showing market weakness, however, as we believe markets are currently trading above fair value, investors may again need to look outside the top ASX200 stocks to find value.