Sovereign Wealth Partners and InvestSense Pty Ltd
Broadly speaking July was a ‘risk-on’ month, that is to say that asset prices rose and the riskier the asset the more it rose. However, there were some striking nuances. Equities here and abroad (unhedged) were both up by a modest 0.6% but smaller companies and emerging markets were up by more. Government bonds were also up for the month, but corporate bonds were up by more (and in fact more than equities). Lastly, amidst the calm in markets, gold, the ‘crisis hedge’ was up by some 10% over the month.
At one level these moderate moves reflect the tension between the worsening COVID-19 and economic data and the market’s increasing conviction that the Fed, in particular, will do ‘whatever it takes’. It also masks the continuing polarisation between certain stocks and the concentration within markets. Tech stocks both here and in the US continued their ascendency with high single-digit returns while industrials and financials were flat overseas and fell in Australia. This fits the lower for a longer narrative where economies muddle through and rates stay very low without outright depression or an inflationary surge that forces rates higher.
Interestingly though the most negative returns (down several percent) were energy stocks, reflecting weakening longer-term economic expectations in the Western world as well as perhaps a COVID-19 accelerated shift towards greener energy and/or less household energy consumption. On the other hand, materials stocks were amongst the best performers, reflecting the recent start-up of economies around the world and especially in China. Overall, therefore, equity markets in July exemplified the global crosscurrents that COVID-19 has wrought upon different industries while still being buoyed by central bank liquidity and the expectation of further government stimulus.
Bond markets, by comparison, witnessed a steady grind downwards in yields across the risk spectrum, to the point where the bonds of most Western governments are very low in absolute terms and negative taking into account expected inflation. In fact, inflation expectations have been drifting upwards due to the degree to which so-called ‘quantitative easing’ has morphed into outright printing of money in the US. With an increasing sense, rightly or wrongly, that the local banks are likely to be backstopped in some manner by the Australian Government and RBA, senior bank debt now trades at yields of 0.6-0.8%. Note that, while Australia just printed a negative inflation number there is also a good chance that this proves to be very temporary and the ‘Trimmed Mean’ measure used by the RBA remains above 1%. Credit spreads from investment grade to high yield are also back to the levels they were at the beginning of the year before COVID-19, when arguably expected default rates were lower.
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.