1 July 2021.

Market highlights
• Financial markets are currently challenged by the possibility of a critical inflection point in inflation expectations and the possibility of interest rates rising
• Equity markets have continued an incredibly strong rally through CY21 to date, buoyed by a combination of stronger economic data, low interest rates and supportive liquidity flows
• Warning signals of excessive behaviour are evident across asset bubbles in crypto currencies, residential housing and commodity trading along with continued highs in equity market valuations
• We remain cautious of the longer term implications of the excesses evident across financial systems despite the positive economic news flow

Market commentary
There has been plenty of activity across economies and financial markets in recent times amidst a surfeit of conflicting messages. An ongoing sharp recovery across major economies, led by the United States, has shifted the market focus from how great the pandemic inspired economic impost will be to the prospect of inflation finally breaking out. This was heightened by recent releases from the US Federal Reserves that signalled the days of easy monetary conditions, so critical to the heightened state of financial markets, may be ending.

With so much of the state of today’s economic and financial markets position predicated on the continued run of low interest rates and containable inflation, the shift in tone was marked. This had not been anticipated by the markets at large, resulting in equities selling off and justifying the slow but steady rise in the longer-term yields of benchmark government bonds. More noticeably, one of the more pronounced effects of easy money, namely the heady rise of Bitcoin and other crypto currency plays, came to a shuddering halt with prices falling almost 50% from CY21 highs.

Risks from excessive inflation
Any breakout of core inflation would likely lead to a rise in interest rates and a sell-off in bonds and ultimately, threaten the heady bull market we have seen in equities since the lows of the GFC in March 2009. Higher interest rates would finally offer an alternative return profile to investing in equities whilst also threatening a slowdown in corporate earnings as the monetary tightening cooled economic growth. It is at such a juncture that we often see equity markets correct. The big risk at present is that the record low interest rate regime has forced many investors into higher risk assets such as equities and property which present a risk profile above one typically tolerated. Benign complacency, which we are arguably in the midst of, can easily be overturned. Rising interest rates may prove such a catalyst as the resulting volatility generates a reassessment of risk exposures and an exit of riskier assets – see Bitcoin.

While interest rates have been very low and typical savings accounts are offering next to zero for most Australian deposits, the explosion in money supply, most commonly referred to as M2 (which includes cash, cheque deposits and easily convertible ‘near’ money) has also fuelled risk taking. As central banks have facilitated the printing of money to finance expansionary economic policy, the volume of money has exploded. Up until very recently, despite the large increase in M2 and the very low interest rate regime, private new capital expenditure had not taken advantage of easier financial conditions, with capex declining over the last two years. It had instead found its way into less productive and more speculative activity, such as equities and residential property.

The one alternative indicator of loose financial conditions leading to excessive risk taking is most evident in the rise of crypto currencies. While there are polarised views on the subject, we remain extremely cautious of the rise of crypto currencies as a potential ‘free-world’ alternative to traditional sovereign fiat currencies. As a store of value and a reliable medium of exchange, the current bout of volatility in cryptos remains hazardous. In the last two weeks we saw the value of Bitcoin fall from USD 63,480 to a recent low of USD 32,910, a fall of 48% – hardly an effective exchange mechanism but more of an indicator of excessive risk taking.

Chart 1: Bitcoin daily prices
*Source Factset

At most points through the investment cycle, valuations and fundamentals will not provide much of an indication of future market direction. However, at times of extremes, valuations can prove one of the more reliable measures. Again, with the USA leading global risk appetite, it is worth monitoring the US equity market valuations which look expensive with the median price to earnings ratio for the S&P 500 at its highest point in close to 20 years. The strong rise in US corporate earnings just posted provides some explanation as does the low interest rate environment which seemingly positions equities as the unnegotiable default option.

Chart 2: S&P 500 Median Price to Earnings Ratio

At this juncture, it is worth exploring sentiment indicators as well, which essentially capture the element of fear and greed in the markets. Here we find the cause for caution even more compelling. Whether it be bull/bear ratios, asset allocation optimism or trading sentiment optimism, most measures signal uncomfortable extremes.

While such measures do not ‘ring the bell’, they do lend themselves to developing some conviction around the need to maintain a cautious stance as extreme optimism on the part of the public and even professionals almost always coincides with market tops.

Inflationary pressures on the rise

Inflationary fears do appear to be playing on investors’ minds once again as commodity prices rise along with cost-of-living measures (outside misleading CPI indicators) and labour market demands finally become more telling. This was evident in shifts in the US 10-year Treasury yield which shifted to a high of 1.61%, before ending the March quarter in the 1.5% range from recent lows of just 0.9%. However, the real risks lie more deeply embedded in our financial system. With our banking system in much better health than it was entering the Global Financial Crisis, banks are now primed to expand their lending activities. When coupled with the powerful cocktail of expansionary spending policies and the continued stance of central banks to err on the side of excess, economic growth may well accelerate harder than what we have witnessed for quite some time.

Once preoccupied solely with price stability, we now see central banks taking into account a broader range of social measures, such as housing affordability and even climate change, which has dulled the responsiveness of their traditional weapon - shifts in interest rates, and their pointed focus – price stability.

The lower interest rate regime has allowed central banks to acquire government bonds at very cheap rates to release liquidity into the economy and to keep money market rates and the cost of borrowing very low. The upshot is that we are now left with a very short supply of government bonds in the private market and ‘artificially’ low interest rates. That means a rash of future debt issuance beckons at a time when both public and private borrowers are holding very high levels of debt obligations, all highly susceptible to interest rate shifts. If inflationary pressures do emerge, the economy will prove highly sensitive to rate rises and the public and private borrowers will be forced to come to the market to refinance their obligations while facing increasingly more expensive debt obligations.

Caution still warranted

Volatility and heightened speculation is still evident across many asset classes whilst economic stimulus is in abundance. Timing is always difficult to anticipate and any unravelling of the good news story that has been a product of the heavy central bank intervention witnessed over the last twelve months will threaten the amazing economic recovery which has defied all expectations since the advent of COVID-19.

But what are the indications for the future? Given the rise in geopolitical risk and the prospect of further trade sanctions from China, the domestic outlook had good reason to be subdued, however this was challenged by a hot residential property market. Home prices, nationally, regionally and in capital cities posted their biggest gains in 17 years. Rising home equity has traditionally buoyed the wealth effect and no doubt accounted for why Australian retailers dominated the list of strongest performers in March. However, with equity markets now spinning their wheels in the sand, despite the recent flurry of strong economic and earnings news, we may well be at the juncture whereby all the good news now unfolding has already been well discounted by equity markets. It appears the prudent investor is now looking ahead and can see an uncomfortable level of inflation on the horizon.