Elsewhere around the world, European markets were 4.2% stronger, China improved 3%, while the local market was much more subdued, finishing basically flat for the month. Bond markets sold off during the month, flattening the Australian yield curve with the 3-year bond rising 89bp as the RBA abandoned its 0.1% target for the April 2024 bond, while 10-year bond yields increased by 59 basis points to close at 2.08%. In the US, the 10-year treasury note increased by only 2 basis points to finish at 1.55%.
The highlight for the month in commodity markets was the 11.4% rise in the oil price due to severe supply shortages in Europe and the United States, a stark reminder that despite the virtuous trend to clean energy, the global economy remains deeply dependant on fossil fuels for now. Base metals were also very strong led by copper up 9.7% and zinc up 15.8%, while the widening 10-year bond spread with the US pushed the Australian dollar higher to finish just over 75 US cents.
Strong Earnings Momentum Outweighs Inflation Concerns
As mentioned last month, the key risk to the financial market outlook is that the short-term spike in inflation becomes more persistent due to a re-setting of inflation expectations. In Australia, the RBA’s preferred measure of underlying inflation rose to an annual rate of 2.1% to now sit within the 2-3% target band for the first time in five years. Higher inflation leads to higher bond yields which has a negative impact on the valuation of company earnings and therefore share prices.
The counterbalance to this is the evidence of strong profit growth emerging, as the global economy progressively re-opens with the removal of COVID restrictions due to increasing vaccine proliferation around the world, together with the development of several very promising anti-viral COVID treatments. It is becoming clear that the pandemic can be resolved by the combination of a front-line defence afforded by vaccines together with the backstop provided by new therapeutics. Going forward it will likely be regarded as an endemic disease that can be managed without the need for the economic disruption witnessed over the past 18 months. This is very positive for the global economy and the profit outlook which remains the key driver of share market returns.
A consequence of the post pandemic economic recovery is that central banks around the world will begin to progressively reduce the level of emergency support to financial markets. Both the US Federal Reserve and the Reserve Bank of Australia have announced they will begin to reduce their monthly asset purchases from November. While this is sometimes defined as a “tightening” of monetary conditions, it is really a reduction in the degree of monetary stimulus consistent with a recovering economy. It’s now likely that rate rises may occur sooner than previously anticipated with the first cash rate increase in the US and Australia likely to be towards the end of 2022. While the easing of liquidity support for asset markets is reducing the strength of the tailwind they have experienced since the beginning of last year, monetary conditions remain supportive and still provide an environment in which profit growth will translate to high share prices.
Strategy and Outlook
Positive revisions to company earnings are likely to be the dominant theme driving equity markets for the balance of 2021 and into 2022. While bond rates have crept up, they are not sufficiently high at this stage to pose any great risk to equity valuations. We continue to believe that better opportunities in share markets exist overseas and hence we have a strategic bias towards international equities compared to Australian shares. This has been vindicated over the past 12 months as evidenced by the US market’s return of 43% compared to our market’s 28%. We are carefully watching developments in inflation as a structural shift higher will have a significant implication to our allocation of risk in multi-asset portfolios. Once supply and demand imbalances are resolved as COVID restrictions are fully removed, we’ll get a clearer picture of the long-term state of inflation. Rising inflation is negative for conventional fixed coupon government bonds which we are avoiding in favour of inflation-linked government securities and floating rate corporate debt which provide greater capital protection.