March 2021 marked one year since the market turmoil induced by the global COVID-19 economic shutdowns and accompanying uncertainty of the pandemic. While from an economic and social perspective it’s been a difficult and uncertain path to recovery, from an investment perspective it’s been a much more positive story. Financial assets (particularly equities and credit), commodities and Australian residential property have performed much better than most would have predicted a year ago. To put this into context, US equities (i.e. the S&P 500) ended March 2021 78% higher than the low point in March 2020.
However, the real market story of the past 12 months has been about stimulus and liquidity. Not only has this helped facilitate the economic recovery, it has propelled asset prices significantly higher. While the liquidity taps seem unlikely to be turned off anytime soon, it seems unlikely that markets will repeat their remarkable Lazarus-like performance of the past year – despite a much more positive economic prognosis.
There are several reasons for this.
First, in the case of credit, spreads are already significantly compressed and the risk of higher interest rates is rising. In other words, not much more can be squeezed out of credit. A good outcome is relatively stable and moderate returns (i.e. ‘carry’).
Second, while equities still offer upside potential, the strong run in most markets has left them relatively fully valued – even allowing for a relatively constructive earnings outlook. Furthermore, the more bullish arguments for equities that had been based around the large gap between earnings yields and bond yields has also weakened, as mid- to long-dated bond yields have risen.
Finally, while central banks remain firmly committed to low policy rates and ongoing aggressive support (including by the RBA), markets will firmly test their resolve if economic data continues to be strong and concern about inflation builds. Any material upside surprise to upcoming inflation numbers could provide some real headwinds.
None of this is to say that markets are about to turn ugly. Rather, it is to recognise that returns from here on will likely be tougher to come by, particularly with interest rates as low as they are. The positive is that economic recovery is still unfolding well, and policy settings are likely to continue to underpin growth with most policy makers reluctant to put the brakes on too early (China being the exception, given they have started to limit credit growth). However, we also need to recognise that economies and markets are not the same thing. Markets have already moved to price in a significant economic recovery and it will take ongoing growth without persistent inflation to propel equity markets materially higher.
In writing this equivalent report one year ago I suggested that there were three critical things to understand: the profile of the economy and in particular the profile of the recovery (whether it was V, W, U or L-shaped); the collateral damage to corporate health; and the progression of the virus (flattening curves and vaccination development and efficacy). While we’re not out of the woods yet, we can say that the recovery has been more V than W, the collateral impact on corporate health has been mitigated globally by stimulus (in Australia JobKeeper did some of the heavy lifting until it ended on 28 March) and vaccines have proven relatively effective. But we are still some way from knowing how vaccine rollouts will feed through to broader economic reopening and a return to ‘normal’ for the global economy.
Amid these questions, we’ve steered what we think is a sensible middle course – surviving the crisis and profiting from the recovery. We are also confident that had the recovery profile been more problematic, corporate health more severely impacted and the virus progression even more debilitating, we would have been well positioned for our clients.
March 2021 itself was another solid month. Sentiment was buoyed by the passage of US President Biden’s fiscal package and the US Federal Reserve Bank’s re-commitment to extended low rates and ongoing quantitative support – despite rising market angst around inflation. Progress with vaccinations in key economies also helped support market sentiment as confidence in global re-opening grew.
The main negative has been the back-up in longer dated bond yields (and steeper yield curves). This reflects the tension between central bank policy rates (largely driving the front end of yield curves) against investor concern that too much stimulus and supply constraints will lead to inflation and ultimately challenge the sustainability of the current monetary policy regime.
We made a number of changes to positioning in March. On the equity side we added an additional 2% to our overall exposure on the back of additional US fiscal stimulus and, importantly, we rotated 3% out of emerging market equities and into US equities. On the interest rate side, with longer dated bond yields moving higher, we added back 0.25 years of duration taking duration back to 1 year in aggregate.
Consistent with these moves, we also reduced our USD position by around 2%, although our FX positioning remains a key defensive position which is expected to perform well during periods of equity market weakness.