Updated: Feb 4, 2021
Despite the ongoing resurgence of the COVID pandemic, the prospect of effective vaccines, continuing low interest rates and a clear result in the US presidential election, allowed share markets to rally strongly, with record gains posted for the December quarter. The A$/US$ exchange rate rose a further 8.4% to US$0.7702 over the quarter. For investors with unhedged currency exposure on overseas equities, this currency appreciation offset some of the gains on global share markets. Fixed interest remained a low returning asset class, with higher bond yields in Australia creating a small negative return.
In an extraordinary quarter, most major share markets delivered double digit returns, with the Japanese market surging 18%. Several smaller “Emerging” equity markets were more than 20% higher. Whereas much of the rally on share markets earlier in the year had been focused on companies that were positioned to perform well in the COVID lockdown environment (most notably the IT sector), the rise in the December quarter was broad based. In particular, the spike in valuations that took place in the month of November was notably greater in stocks which are more exposed to traditional economic growth. This change marked a rotation by investors away from “Growth” exposures to “Value” exposures. This rotation is in its early days but may mark a significant change in the drivers of market returns in the months ahead.
China’s share market finished the quarter on a high, with ongoing evidence of renewed strength in the Chinese economy. More broadly, the impact of a surge in COVID cases in the Northern Hemisphere winter has been offset by the improvement in investor confidence generated by the announcement of a range of COVID vaccines, the completion of the US election and the introduction of further economic stimulus programs.
Also adding to investor confidence towards the end of the quarter was the post-Brexit trade agreement reached by Great Britain and the European Union, just ahead of the end of Britain’s transition period. The deal allowed for trade in goods to continue unencumbered by tariffs or quotas. Agreement was also reached in the U.S. in relation to a $900 billion stimulus bill. This bill will provide individuals in the U.S. a one off payment of $600 and also increase unemployment benefits by $300 per week until mid-March. Additional funding for healthcare, vaccine distribution and rental assistance was also included in the economic stimulus measure.
There was a high level of disparity in returns across sectors on the Australian market last quarter. Rising commodity and oil prices saw Resources and Energy rally strongly, reversing some of the underperformance from earlier in the year. Similarly, Financials, primarily Banks, rose strongly too. Investors viewed bank forecast earnings with more certainty, considering the expected impact of COVID vaccines in the new year and ongoing evidence of housing price growth. The Property sector was also notably stronger, with investors gaining confidence as COVID restrictions were eased.
Shopping centre property was particularly strong, as signs of buoyant retail spending continue to build. The long-term impact of increased working from home on office property is not yet clear, however rental outlooks and landlords’ collections have improved. The more defensive sectors were weaker over the quarter, with Healthcare and Utilities posting negative returns. The Australian equity market finished the year 1.4% higher despite the extraordinary series of events in 2020. This was, however, well below the 10.5% gain enjoyed by global equity investors (currency hedged). The relatively small size of the local Information Technology sector (which advanced 57.8% over 2020) accounts for at least some of the underperformance from the Australian market.
Fixed Interest & Currencies
The A$/US$ continued its trend upward to US$0.77. Prices for commodities, and iron ore in particular, have been strong and have supported the A$. The strength of the local currency has occurred at a time when the $US has weakened against the Euro and Yen, thereby magnifying the gain in the $A / $US exchange rate. This currency strength has also occurred despite Australia’s trade tensions with China continuing to escalate. Restrictions on Chinese imports from Australia are now widespread, with significant cuts to coal and agricultural items. To date, however, Australia’s largest export to China, being iron ore, remains unaffected.
In early November, the Reserve Bank (RBA) made possibly the last cut in the cash rate target, reducing the rate from 0.25% to 0.10%. Also falling from 0.25% to 0.10% was the target yield on 3 year government bonds. The RBA also lowered the rate on bank settlement balances to zero and implemented a program of government bond purchases with $100bn targeted over the next six months. Importantly, the RBA Governor also indicated his belief that cash interest rates were likely to remain at current levels for at least 3 years. Despite the easing in monetary policy, optimism over the outlook for global economic growth has resulted in an upward shift in bond yields, with the Australian 10-year Government bond yield rising from 0.84% to 0.97% last quarter. Similarly, the U.S. counterpart was 0.24% higher at 0.93%.
Outlook and Portfolio Positioning
Given the magnitude of the rise in share market valuations over November, the fact that prices continued to move higher over December indicates the current degree of investor support for the equities asset class. The prospect of a vaccine supported economic recovery, improved company earnings and the maintenance of low interest rates continues to present a convincing rationale to hold equities as the asset class most likely to produce longer term wealth accumulation. Whilst this rationale may remain convincing for some time ahead, investors should remain alert to factors that may disturb the underlying investment case for equities. Most notably, the following should be monitored as potential destabilisers to the existing investment outlook:
Although central banks appear committed to maintaining exceedingly low interest rates, much of the emergency fiscal support provided by governments around the globe will be withdrawn over the months ahead. Due to the size of these support programs, their withdrawal could destabilise spending and broader economic activity.
The combination of near zero interest rates, policy induced rising money supply & spending and potential supply disruption could create inflationary pressures, which have been absent from the global economy for some time. Ultimately, this could threaten the outlook for low longer term bond yields, which underpin much of the rationale for current equity valuations.
The new administration in the United States is somewhat of an unknown quantity. There is some risk that aspects of new policies to be introduced won’t be as “pro-business” as those introduced by the previous administration.
Whilst indications of the effectiveness of the COVID vaccinations appear extremely positive, the task of vaccinating a substantial proportion of the world’s population without side effect remains monumental and may not prove as smooth as is currently embedded into market expectations.
Domestically, the escalating trade tensions with our largest trading partner threaten to unwind some of the positive contribution to economic growth from external trade that has been a key characteristic of our economic performance over the past 2 decades.