Quarterly economic update

By Jon Fernie, chief investment officer

January 2021

Global equity markets finished 2021 strongly, but have pulled back at the start of this year due to higher inflation, expectations central banks will bring forward interest rate hikes and ongoing pandemic uncertainty. We retain a defensive bias in the current environment despite the recent pull back improving equity market valuations.

Equities

  • The MSCI World Ex Australia Index (in AUD) delivered a total return of 7.2 per cent over the December quarter and 29.6 per cent over 2021. Robust economic growth and corporate earnings offset concerns over higher inflation and central banks tightening monetary policy. Australian equity markets lagged in comparison, although the ASX 300 Accumulation Index still provided a total return of 17.5 per cent for the year after a volatile December quarter which saw a Covid-19 driven market correction in November followed by a Christmas relief rally.
  • In the International Equities Trust - Wholesale, we added ServiceNow and Pandora and increased exposure to Apple, Daimler, Bank of New York Mellon, Union Pacific and Edward Lifesciences. We also reduced exposure to Vestas, Inditex, Danone, Kimberly Clark, Unilever and Home Depot. We exited Koninklijke Philips following ongoing concerns around its product recall and the associated earnings uncertainty.
  • In the Australian Equities Trust, we added APM Human Services and real estate investment trust GPT Group. We also increased exposure to Macquarie Group, copper producer Sandfire Resources and iron ore producer Fortescue Metals. We exited Seek as we considered it fully valued and the acquisition of Spark Infrastructure was completed. We reduced exposure to the financial sector including the major banks and Suncorp, as well as consumer discretionary companies Webjet and Super Retail Group.

Fixed-income

  • Over the December quarter, the Australian sovereign yield curve has risen across the whole curve with the 3 year yield widened to more than double the 10 year yield. The move was negative for fixed rate bond performance. Within the Enhanced Income Trust-Wholesale, fixed-rate positioning (~7 per cent of portfolio) contributed negatively to returns. The Australian investment grade credit market also underperformed for the quarter with spreads widening 10 basis points as investors tend to be risk averse into year end.
  • Over the same period, there was continued firm demand for hybrids given the relatively attractive yield and the ongoing market appetite for bank credit. Tier 2 bonds now appear less attractive on a risk adjusted basis compared to senior debt issues given the latter has seen spreads widening after the end of the Committed Liquidity Facility (CLF).
  • During the quarter, the Bank Bill curve saw a notable steepening most prominent in the 3-6 month period, indicative of shifts in wholesale funding demand from banks. Whilst liquidity conditions in the financial system remain highly accommodative, term deposit curves have begun to steepen. However, short term deposit rates including 11am remain ‘pinned’ with the overnight cash rate at historical lows.

Economic update and markets’ outlook

During the year we have seen global GDP growth above trend as economies rebound, but this is expected to moderate moving forward. US and Chinese GDP growth for the December quarter both exceeded expectations and delivered 2021 growth of 5.7 and 8.1 per cent respectively. While risks remain from the failure of Chinese property developer Evergrande, so far these appear to be relatively contained. US labour markets continue to show strength with the unemployment rate improving to 3.9 per cent and we have seen a similar trend domestically. Global Purchasing Manager Indices (PMIs) also remain in expansionary territory despite easing at the end of the year with the rise of Omicron variant Covid-19 cases.

While we expect supply chain disruption to gradually ease in 2022 there continues to be pressure on certain raw commodities, components, labour and logistics. Further improvement will also depend on Covid-19 cases and government policy responses. These issues contributed to headline inflation in the US rising to an annualised rate of 7.0 per cent in December. Core inflation (stripping out the more volatile food and energy factors) also increased to 5.5 per cent adding to concerns that higher inflation is more than transitory.

US inflation has continued to rise

Source: US Bureau of Labor Statistics as at 25/01/22

On the back of this, US 10 year government bond yields have continued to rise to above 1.8 per cent at the end of January, which is up significantly from the prior year. The Federal Reserve has signalled that it expects to end bond purchases in early March and “it will soon be appropriate” to raise interest rates given a strong labour market and higher inflation. Market expectations are for several interest rate rises in both 2022 and 2023. The Reserve Bank of Australia has also brought forward its expectations of interest rate rises to 2023, but the market currently expects this to occur sooner. This view has been strengthened with domestic headline inflation in December higher than expected at 3.5 per cent. Australian 10 year government bond yields have also risen substantially to around 2.0 per cent.

US 10 year government bond yields have also climbed

Source: Factset as at 25/01/22

Concerns over higher inflation, central banks tightening monetary policy and relatively high valuations have led to global equity markets selling off at the start of this year. The S&P 500 and ASX 300 Accumulation indices both retreated around 10 per cent at the start of this year as sentiment turned more negative, but have since recovered some ground. Higher growth stocks in particular have been heavily sold off as valuations have come more into focus. While expectations are for solid corporate earnings growth in 2022 for Australian and international equities, risks to these forecasts include supply chain disruptions, Covid-19 restrictions and higher interest rates impacting economic activity. The upcoming domestic reporting season provides a good opportunity to reassess the outlook for equities as companies provide trading updates and earnings guidance.

The pull back in equity markets has led to improved valuations with the ASX 300 Accumulation Index currently trading on a forward price-to-earnings ratio of 16.5 times compared to more than 20 times at the end of 2020. However, this still remains above longer-term historical levels. We retain a defensive bias as markets navigate a normalisation in global interest rates and the outlook remains uncertain due to the ongoing pandemic.

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Article by

Jon Fernie

Published

09 February 2022

Jon is responsible for the formulation of investment strategy and overall management of U Ethical portfolios. This includes overseeing securities selection, sector/country allocation, risk management, and implementation of our Ethical Investment Policy.

Categories

Responsible investing

Article by

Jon Fernie

Published

09 February 2022

Jon is responsible for the formulation of investment strategy and overall management of U Ethical portfolios. This includes overseeing securities selection, sector/country allocation, risk management, and implementation of our Ethical Investment Policy.