Markets continue to push higher despite mixed progress on the COVID-19 front as we roll through the global earnings season, with the majority of international reporting season done though Australian financial year results are just starting to come through.
At the time of writing, the S&P/ASX 200 rose 1.9% over the past four weeks, with gains driven by consumer and resource sectors whilst the tech sector stalled. Meanwhile, the U.S. was the big outperformer over the same period with a 7.1% rally and is now less than 1% away from record highs achieved in February as this earnings season is shaping up to be one of the best ever in terms of beating consensus expectations, primarily due to low expectations.
The Euro STOXX 50 was a relative laggard for developed markets, rising just 0.4%, whilst Chinese equities fell on rising tensions with the U.S. and a retracement from a steep rally in prior weeks. Despite the 4.5% pullback in the CSI 300 index, it remains the second best performing equity index next to the NASDAQ 100 over the past year.
Commodities continue higher, driven by gold and silver, along with a continued recovery in oil prices as mobility recovers.
U.S. 10-year bond yields rose to 0.65% whilst Australia’s 10-year bond yield remained largely flat at 0.9% whilst credit continued to gain with yields falling below pre-COVID-19 levels.
The Australian Dollar rose to 71.5 U.S. cents as the U.S. Dollar continued to slide.
As economic data rolls in, preliminary GDP figures for the second quarter show the incredible magnitude of the economic contraction resulting from mass lockdowns with many expected to record their worst ever quarters in history when the figures are finalised. The U.S. economy is expected to shrink more than 30% whilst the Eurozone will likely shrink around 15%. On the positive side, economic data indicate that the second quarter is also likely to mark the end of this recession though the road back may be longer than expected.
Domestically, the Reserve Bank of Australia has resumed bond purchases in the effort to maintain government bond yields maturing up to 2023 around 0.25% but refrained from any further action. The rebound in employment of over 114,000 jobs added in July is a positive start that smashed through estimate figures, but remains a long way from pre-COVID-19 levels at 7.5%, and sentiment of both consumers and businesses remain weak.
Globally, Purchasing Manager Indices (PMIs), which are a measure of expected economic activity, all pointed to a rebound in both manufacturing and services for most of the world. Retail spending also rebounded in June but consumer sentiment readings continue to weaken, suggesting that the re-opening bounce may not last.
Notably, inflation has been mildly surprising to the upside. Given the levels of stimulus, markets had already been expecting a rebound in inflation which has led to real yields (yield minus inflation) to turn negative, driving up prices of precious metals and alternative currencies like Bitcoin. This is worth keeping an eye on as traditional bond and equity markets continue to price for yields to stay low but this may change if there are signs that inflation does finally start to rise after over a decade of low inflation.
Apart from looking for an economic recovery and with earnings season nearly wrapped up, global markets will be looking towards the U.S. presidential election. Locally, the near term focus will be on earnings as it kicks into full swing over the rest of August, and of course, the COVID-19 situation in Victoria.
The search for real yields
With global central banks driving government bond yields lower and pumping money through the system, investors have been forced into ever riskier assets in the hunt for reasonable returns. As a result, everything from corporate credit to equities to infrastructure have been bid up resulting in lower yields across the board.
Source: JPMorgan and TME
As the chart above shows, the majority of the traditional investment universe yields less than 5% as marked by the horizontal red line. The percentile indicates how often the asset has had a lower yield in the last 10 to 30 years (depending on availability of data). If an asset is located on the left side of the vertical red line, it means that 95% of the time, the asset has had a higher yield than what it trades at now. As you can see, for most, it is pegged closer to the 0 percentile meaning that these assets are trading at the lowest yields in history. The only assets that are outside of the 5th percentile and higher than 5% yields are highly stressed assets at higher risk of defaults, or highly specialised and niche assets.
The U.S. Federal Reserve has indicated that it will be in no rush to raise rates in the medium term and will allow inflation to overshoot its 2% target for some time before acting in order to beat the low inflation mindset that has plagued the world since the 2008 financial crisis. With inflation expectations recovering since then, the real yields has continued to fall since April meaning that the sub-1% yields from most developed market government bonds cannot protect your capital from the expected erosion of inflation. As shown in the chart below, the 10-year inflation (or breakeven) rate has climbed steadily back to 1.6% whilst yields remain around 0.6%, which means that the U.S. real yield is now around -1%. Japanese and German real yields have been negative for years but Australia has also followed suit with breakeven rates over 1% and Australian 10-year government bonds below it.
Since investing is a relative game, this helps to explain the huge rally in everything since the end of March, despite the hugely uncertain backdrop of COVID-19, U.S.-China tensions and the U.S. elections.
Source: Commerzbank AG
Investors are being forced to seek higher yields in more risky assets to earn a return above inflation, leading to huge inflows into both investment grade and high yield corporate bonds. Whilst equities haven’t enjoyed such inflows, prices have also been bid up across the board as prospective sellers demand ever higher prices. It is also no surprise the valuations look extended given that many common methods of valuations require yields as an input. The common Price/Earnings measure is usually flipped to show earnings yield where investors tend to use the long-term government yield and an equity risk premium to determine the appropriate valuation. With low yields below 1% and a historical average of 3% to 5%, the fair value range of P/Es stand between 17x and 28x, far higher than the 14x to 20x range when yields stood at 2%. For discounted cash flow models, another popular method to measure the price of an asset, lower yields mean higher value for cash flows further in the future, hence the outperformance of higher growth assets which have driven equity returns over the past decade.
Even negative yielding assets like gold have received boosts as part of many investors’ reluctance to purchase such assets were that positive real yields could be found elsewhere. With this dynamic changed, even those who have historically derided gold now see a reason to own it – Warren Buffet just bought gold exposure via a mining company, reversing his long-standing stance against the asset.
Given this backdrop, where inflation goes from here will be critical to investors. If it continues to push higher thanks to the massive monetary and fiscal stimulus, it could push yields upward, leading to capital losses (and higher yields) for fixed income assets. High yields could also lead to lower equity valuations and a rotation in equities where value and cyclicals close the gap with growth assets. The other side of it is that inflation remains range bound which, perversely, could keep investment prices high and widen the wealth gap given that asset owners are usually the wealthy.
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