Sovereign Wealth Partners and InvestSense Pty Ltd
August was a generally positive month for equity markets despite gently rising interest rates. We say ‘gently’ as many investors we talk to are:
- Of the view that very low interest rates are here to stay, but;
- Are increasingly preoccupied by the potential impact on markets if that were not to be the case.
At such low rates of interest, an increase of, say, 1% in long term rate expectations could have a potentially dramatic effect on stock and bond valuations (they would fall for the same reasons that an increase in mortgage rates would lower the affordability and hence prices of houses). It was therefore especially notable that when Jerome Powell, Chairman of the US Federal Reserve, announced the intent of the Fed to target an average inflation rate of 2% pa. This means that if inflation were zero, they would need to target 4% to raise the average. This had been largely discounted by markets so bond yields drifted up only slightly but this kind of language and the stimulatory actions of the US Government and Fed has served to undermine the value of the US Dollar which continued to depreciate against most currencies by around 1-3% during the month. Clearly higher inflation with low bond yields is a fine line to tread and one that does not bode well for bond investors if it were to eventuate.
Such an environment would be an excellent backdrop for stocks, especially tech stocks with cash flows that are seen to be long in duration and growing, thus US tech stocks continued to lead the rally throughout the month. A rise in inflation and much higher rate expectations would probably have the opposite effect. That said industrials were not far behind, buoyed by successive potential vaccine announcements during the month and hopes of a sustained recovery that would come with it. At the other end of the ledger were Energy (despite a bounce in oil prices), Health Care, Real Estate and Utility stocks. Most other regions also rose by 3-6% although much of this was due to currency movements. In Australia, the overall market was up by 3% but smaller and mid-sized companies rose by over twice that much. Again, Technology companies performed the best while the Banks lagged, and Utilities fell back on lower (Australian) interest rate expectations and mixed earnings. In general earnings in Australia followed a similar pattern to the US last month whereby weak results surpassed dismal expectations, thereby giving a boost to many areas of the market. The most positive results came from big miners which helped keep the large-cap index in positive territory, also boosted by higher Iron Ore prices during the month.
Australian Government bonds fell back by 0.5% compared to a negative 1% for overseas equivalents while investment-grade credit was flat for the month. Lastly, gold gave back 0.5% during the month after strong gains earlier in the year.
This all adds to a sense amongst many market commentators that markets across the board are now quite expensive. The more divisive question is whether that leaves them more vulnerable to a set-back or whether the Fed, in saying that it will ‘do what it takes’, has underwritten the market for the foreseeable future. So far markets themselves are suggesting the latter but the biggest question mark concerns the strength of gold and the weakness of the US Dollar. Should this persist, if and when markets do capitulate, then it would be a sign that we are seeing a regime change that might involve some rewriting of the rules we have got used to over the last 30 or so years. For our part we remain cautiously long, seeking growth opportunities with relatively robust valuation support while being alert to a potential shift in the investing environment. That shift would probably lead to a more dynamic asset allocation strategy between defensive and growth assets. Already the strategy within defensive bond portfolios is becoming more proactive as an environment of very low rates and negative real rates implies that the era of set and forget bond investing ended with COVID.