22 September 2021
As we navigate through 2021, the world continues to emerge from the significant economic obstacle that is COVID-19. Whilst there are still multiple economies initiating further lockdowns as they face the fast-spreading Delta variant, we continue to see rapid economic growth and record valuations across many asset classes.
This has been off the back of a declining mortality rate and improved vaccination rates globally.
The COVID-19 Delta variant has become the dominant strain globally over the last quarter. Vaccines remain key. In the U.S., 99.2% of COVID-19 related deaths over the past six months were within the unvaccinated population. Overall, hospitalisation rates have generally been lower for countries with higher vaccination rates.
Domestically, the spread of the Delta variant is continuing to enforce extended lockdowns in most states. State Governments have indicated this will continue until the vaccination rate improves substantially (80% approximate indication) which will take time.
Despite improvements in vaccine production, access remains poor across parts of the developed and emerging markets. We expect the mobility restrictions to delay some aspect of the economic recovery but not impede the outcome over the long-term.
With the uncertain landscape that is COVID-19, central banks continue to maintain interest rates at historically low levels and target an “average” inflation rate over the longer term allowing shorter term numbers to look excessive.
Notably, the US Fed changed its language on inflation in response to COVID-19, replacing its two percent inflation target commitment, and instead said it will “seek to achieve inflation that averages two percent over time.” In Australia, the RBA has an inflation target that seeks to keep consumer price inflation (CPI) in the economy within two to three per cent, on average, over time.
Record economic growth continues off the back of the expansionary fiscal and monetary policy implemented across the globe. It is important to remember that this record growth is coming off a significant low base fuelled by the forementioned fiscal and monetary support.
The record economic growth rate is causing a significant surge in inflation numbers and both investors and policy makers are continuing to make this a major focus. Whilst numerous indicators are pointing to “transitory” or short-term inflation due to bottlenecks in supply chains, we continue to focus on the data coming to hand. There are some data points suggesting inflationary pressures are extending beyond those most affected by the reopening (airfares, travel, used cars, etc.).
Some indicators of this are rising house prices and the increased cost of personal services like take-away food, which could point to higher wages being passed onto consumers.
Whilst markets have revised down their inflation expectations since the beginning of the year, as reflected in the falling ten-year bond yields, we remain wary that these indicators can move quickly.
Global asset prices continue to rise
Conditions have continued to be accommodative to share markets. On top of the monetary and fiscal stimulus mentioned, elevated savings rates have driven massive flows into markets
With the US positioned generally as the leader in terms of global economies, the enormity of the recovery has been staggering in terms of GDP growth and market returns.
Investors have reaped the rewards from high-risk assets as illustrated below with returns through the first six months of 2021.
It is important to note some asset classes were significantly depleted by the onset of COVID-19. Oil for example was US$67 a barrel in January 2020 and was trading around US$72 a barrel 30 June 2021 after plunging to US$38 in April 2020 during the onset of COVID-19 and the Saudi/Russian Oil price war. In context, that’s a seven percent increase from pre COVID-19 prices.
Earnings growth expected to moderate
Q2 2021 earnings so far have continued to beat market estimates. For example, for Q2 2021, the S&P 500 companies reported their highest year-over-year growth in earnings since Q4 2009. As per FactSet data the YoY earnings growth was 109.1 percent as of mid-August with 91 percent of S&P 500 companies having reported. The high earnings growth rate is predominately due to higher earnings coming off a low base from a year ago. We expect this positive earnings growth to moderate in the coming quarters as the economy normalises.
Early signs indicate that profit margins are peaking. The multi-speed global recovery is likely to continue to drive revenue growth at a slower rate than the record numbers we have been witnessing. Whilst the recovery is not complete, economies globally do appear much improved. Signs continue to point to further growth through the second half of 2021 with the macroeconomic backdrop being positive. Inflation remains a major concern with severe bottlenecks and pent-up demand driving prices higher. Whilst the COVID-19 Delta variant still poses a significant threat, we are seeing vaccine rates trending higher globally. Vaccine rollouts have significantly improved throughout Europe and Japan, which should unleash further pent-up demand.
Government’s continue to roll out further stimulus packages. The US is currently rolling out a child tax benefit to an estimated 39 million families that will further encourage consumer spending. Locally, the extension of small business tax write offs and business grants continue to encourage significant purchases. JP Morgan are estimating global consumption to be still three percent below pre COVID-19 levels which indicates further spending if things remain on track.
We are focusing on two key considerations which are cash rates and asset tapering. On cash rates, we expect central banks to continue their “cautious” approach in raising rates given the high levels of debt and preference to allow inflation to run higher than target over the medium term (targeting a range). They have also been quite vocal in terms of specifying their intention to give sufficient signals to the market before raising rates. As touched on earlier, central banks believe the high levels of inflation will dissipate, based on the transitory nature of the re-opening, however we remain cautious and continue to monitor relevant data sources.
Asset Tapering is the reduction in the rate at which Central Banks accumulate new assets on their balance sheets under a Quantitative Easing (QE) program. Using the US as an example, tapering will involve the Federal Reserve reducing “gradually” the amount of Treasuries (Government Bonds) and Agency Mortgage-Backed Securities (MBS) it acquires. Tapering does not imply the sale of these assets, rather a reduction in purchasing further assets over time until purchases reach zero. Whilst there is no defined timeframe, tapering is usually gradual as the Fed attempts to avoid unsettling markets or causing a sharp rate rise within the bond market. The last time the Fed went through an asset tapering exercise was in 2014 and this took approximately ten months.
Asset class valuations – Long-Term
On a relative basis, analysis remains supportive of Growth Assets.
Equity markets continued their positive momentum in Q2 2021. The majority of indices are trading above their long-term price to book and price to earnings ratios (P/B and P/E). Historical earning yields are lower and this reflects the impact of the pandemic on corporate earnings over the period, however strong improvements in forward earnings have resulted in falling forward P/Es. This is consistent with Q2 corporate earnings reports, which have continued to beat sell-side estimates.
Relative valuations have been driven by improving earnings vs. Bond yields which have fallen over the last three months as markets revise down their inflation expectations. The outlook across real assets is broadly positive despite mobility restrictions. Over the recent quarter, we have seen a rise in Mergers & Acquisitions activity as patient capital (pension funds) have looked to secure quality assets at attractive long-term valuations. Cash rates globally are close to zero percent and central bank commentary indicates that this is unlikely to change in the short-term. Taper discussions are likely to impact valuations and result in market volatility.
Over the medium-term, we see catalysts for volatility in the form of tapering discussions and evolving spread of the delta variant. Over the longer-term we believe the global recovery is well supported, and it will be a matter of time before vaccination rates globally bring the virus under control.
Findex Portfolio Positioning
Findex Investment Committee’s decision for this quarterly update is to maintain the current asset allocation stance. Relative to Strategic Asset Allocation (SAA), portfolios have an overweight to Growth Assets, with an overweight to International Equities, Hedge Funds, AREITs and Domestic Floating Rate, while being underweight in Property, Domestic and International Fixed Income.