Updated: Feb 4, 2021
The first week in November, always notable due to the running of the Melbourne Cup, can also be more significant than most for financial markets. It is the week of the monthly Reserve Bank Board (RBA) meeting, which provides the central bank with the last realistic opportunity to influence the broader economy prior to the holiday season. Once every four years it also the week of the US election. In 2020, the week was particularly noteworthy, with the following outcomes:
The RBA announced a lowering in the cash interest rate target to a new record low of 0.10%. The target yield for the 3-year government bond was also lowered to 0.10%. In addition, a “quantitative easing” program was introduced, that will result in the RBA purchasing $100 billion of government bonds of maturities of around 5 to 10 years over the next six months, in an attempt to further lower interest rates across the yield curve.
The Democrat victory in the U.S. election. With this victory likely to be associated with the maintenance of Republican control of the Senate, financial markets were delivered their “preferred” scenario of political stability without the prospect of the new President having unencumbered power to dramatically alter policy settings.
Highlighting the seriousness of the second wave of COVID-19 infections, the United Kingdom, France and other European countries have introduced another round of lockdowns, expected to be in place until at least the end of November.
Following a period of weakening in equity markets and rising global bond yields over October, the above events appeared to have re-set markets with equities rallying again and bond yields shifting lower. The continuation of the COVID crisis combined with the expectation that the new U.S. administration will be constrained in its ability to add substantial fiscal stimulus (due to not having control of the Senate) has reinforced expectations that interest rates will have to remain low for an extended period. Central banks will be primarily focused on restoring employment and economic growth. Domestically, this expectation was underwritten by the RBA’s latest policy announcement.
Within equity markets, the extension of the period of low-interest rates and COVID-related
restrictions have a somewhat disparate effect. Companies with higher than average earnings growth prospects tend to benefit the most from low-interest rates as there is less “penalty” for the time delay applied in the valuation of future earnings that are heavily weighted to future years.
In addition, although some businesses are clearly negatively impacted by lockdowns and the broader economic growth implications of COVID, others have had positive experiences with COVID acting to either change business models or accelerate changes that were already in train. As a high growth sector, Information Technology (I.T.) sits at the intersection of the positive influence from low-interest rates as well as the business model changes being brought about by COVID. The I.T. sector has led most major markets higher over recent years. This is particularly the case in the U.S., where it is the largest sector and has appreciated by 23% per annum over the past 3 years – dwarfing the overall U.S. share market increase of 10% per annum.
Potential risks to the “more of the same” scenario.
Hence the events of the past week potentially return us to the familiar pattern that has prevailed over recent years. Low interest rates, constrained economic growth and disparate share market appreciation heavily weighted to specific sectors such as I.T. and healthcare. There are, however, some risks to the continuation of this scenario, which are discussed on the below.
Valuations - given the dominance of the same prevailing trend over recent years, bond yields and share prices in high growth sectors such as I.T. appear priced for perfection. In the case of the Australian and U.S. central banks, there appears little appetite to take interest rates below zero, creating a lower bound, which should ultimately cap bond prices and interest rate sensitive equities.
Inflation – the ongoing maintenance of low bond yields is dependent upon the continuation of low inflation. The financial market and central bank confidence that inflation will remain low appears strong. This expectation is largely dependent upon spare capacity in the labour market (i.e. unemployment) keeping wages growth subdued. However, whilst spare capacity is one important influence on inflation, it is by no means the only influence. The experience of the 1970s and 1980s demonstrated that high inflation can coexist with higher unemployment. Further, the unprecedented nature of the recent government spending combined with heavy purchasing of government bonds by central banks has rapidly pushed up money supply growth and household savings. This ultimately could create demand conditions that are inflation inducing at a time when supply in certain industries is being artificially constrained by COVID related measures.
Vaccine Development – an earlier than expected COVID vaccine release should be unambiguously positive for equity markets. However, the associated stimulatory impact on spending could rapidly build on the inflationary pressures discussed above. The resulting upward shift in bond yields may then trigger a significant change in the pattern of price movement on equity markets, with those higher growth sectors that have dominated price growth in recent years being the least supported.
An Unexpected US Senate Result – financial markets appear to be operating on the assumption that the new U.S. administration will be constrained somewhat by a Republican-controlled Senate. However, there is a possibility that Senate control will be determined by a run-off election in the State of Georgia in early January. Given that Georgia appears to have favoured Joe Biden in the Presidential election, a Democrat victory in the Senate can’t be ruled out at this stage. Such an outcome would be likely to change inflation and interest rate expectations, with policies such as a doubling of the minimum wage and a larger government spending program more likely to be introduced.
A Worsening COVID crisis – after the initial sell-down in March, share markets have been prepared to “look through” the downturn in company earnings associated with COVID and push prices to record high levels in some markets. Implicit in the market’s response is the expectation that COVID will have only a temporary impact on the earnings. However, should a vaccine take longer than expected to be developed and distributed and infection rates continue to require lockdowns, then the impact on company earnings may have to have a more significant effect on share prices. This could be particularly the case for those companies that have experienced the greatest recent price appreciation – with these companies ultimately requiring a healthy economy to meet the earnings growth rate assumed in current valuations.
Hence, whilst financial markets have shown immediate confidence and direction in response to the events of the past week, there remains various uncertainties and risks to the central scenario assumed by markets. With local cash rates now effectively zero, investors may be tempted to follow the momentum of markets and re-orientate portfolios to those investment categories and styles that have performed better over recent years. However, given the heightened valuation on some of these investments and the potential for the broader economic scenario to change rapidly, investors should consider diversifying well beyond “yesterday’s winners” to build a robust strategy for the years ahead.