The Big Picture
Last month we reported the 11th consecutive monthly gain on the ASX 200 and the 7th on the S&P 500. Both of those runs ended in September!
All market rallies eventually end, as valuations get stretched new buyers fail to materialise to drive prices higher giving the appearance of and ‘exhausted market’ other times there is a catalytic event that results in a mass change in the risk appetite and the rally ends. September witnessed a number of quite different factors coming into play. We will try to simplify our analysis by unpacking these factors into three broad groups – in addition to the normal fundamentals that drive markets: China uncertainties; the US Federal Reserve (the “Fed”) and its return to ‘normal’ policy conditions; and the response to the pandemic.
China has been an engine of growth for years – forcing the price of iron ore up to as much as $US233 / tonne in April of this year. It is often difficult to see what is going on inside the Chinese economy and their government but the slide of the iron ore price to $104 / tonne near the end of September was clear.
Some commentators speculated over growth concerns – possibly caused by the pandemic. Towards the end of September, it emerged that one of China’s major property developers, Evergrande, had big debt servicing problems. Evergrande owed about $US 300 bn to both domestic and overseas bond-holders. Interest payments were due on the 23rd and 29th September and people wondered whether or not Evergrande would default. The problem was exacerbated by some saying that a default could spark a Lehman Brothers type crisis with an ensuing contagion that would again freeze global credit markets.
As the tension rapidly built before the first payment was due, it transpired that the property developer was also engaged in retail financial products; internet and media; food; and even electric cars. It looked like the company had lost its way. It was also reported that China was trying to control the whole property sector and some of the China economic slow-down was deliberately engineered by authorities to avert a property collapse.
On the morning of the first due payment, it was reported that the company had found a solution to paying the domestic (Chinese) bond-holders – without giving details. The price of iron ore rose 14.4% within hours and stock markets rallied. Little was said about how the $US 83.5 million foreign-owned interest payment, also due that day, would be met – or not. Evergrande has 30 days in each case to make the payments before a default is called.
The Chinese government made some favourable noises about financial stability but then, out of the blue, Evergrande ‘found’ $US1.5bn dollars by selling some of its shares in a Hong Kong company with the help of a Chinese bank – and there’s reportedly still quite a bit left over to plunder!
Given the usual lack of transparency in Chinese activities, and the complexity of the situation, we cannot reasonably suggest that we can make a firm prediction about all of the consequences arising from the Evergrande situation. We do, however, believe that the Chinese government will do its best not to allow any financial crisis to ensue.
Lehman Brothers was quite different. In that case, vast sums of money were owed to various groups in a web of complex, cross-funded synthetic financial products. No one really knew who owed what to whom which was the catalyst for a reason why credit markets collapsed in the GFC. Despite that, the Fed – through its TARP programme – was able to stabilise the global economy. The Evergrande situation would be easy to manage by comparison. It is a straightforward debt holding and small by comparison. Evergrande has a debt of $300bn while the Fed is currently buying $120bn of bonds per month in its Quantitative Easing (QE) programme!
While it is quite possible, even likely, that further market volatility might flow from the Evergrande situation, at this point we do not see it impacting too much on long-term growth in China or our share markets.
The Australia nuclear submarine deal with the US and UK further exacerbated volatility in late September by upsetting China. We have not as yet seen any fall out from that deal into long-term market gains but it is early days.
The second problem group that we have identified is associated with the Fed’s probable start to its tapering programme (i.e. reducing the bond buy-back scheme that is QE to zero).
The Fed had signalled a couple of months ago that tapering was imminent in 2021. Indeed, an announcement to that effect at the September meeting was ‘almost certain’ in the minds of most commentators a month or so ago. It just so happened that the Evergrande situation blew up on the eve of the September Fed meeting.
As a result, we suggest, the Fed did not announce November as the start of tapering as most expected. Instead, it announced that tapering would start ‘soon’. Nevertheless, it fully expected tapering to end by mid-2022. That is, the Fed must decrease the $120bn per month buy-backs to zero in just over six months. We think the chair, Jay Powell, just didn’t want to scare the horses and give a hard date in the midst of the Evergrande affair.
Powell went to great lengths to emphasise the disconnect between tapering and subsequent rate hikes. But the ‘dot plot’ that gives a graphical representation of the constituent Fed committee members’ forecasts for the cash interest rate over the next few years showed some changes.
By a slim majority, the first rate increase is now forecast for some time in 2022. Not all of the ‘dots’ vote in any given meeting so we can’t say for sure how the relevant committee would have voted. On top of that, two regional Fed Presidents announced imminent retirements – one through health and one from the fall-out of the uncovering of substantial financial trading activity by some regional presidents and Chair Powell, himself!
We think there is only a real chance of a hike in rates during 2022 if it turns out that the current blip in inflation is not transitory after all. The latest US CPI inflation read came in at 5.3% over the year against an expected 5.4%. The month-on-month read was only 0.3%. Furthermore, the CORE monthly read – that strips out volatile items such as food and fuel inflation – was only 0.1%!
We are still in the ‘transitory camp’ and, therefore expect a gentle start to tapering at the end of 2021 and the first rate-hike will be pushed back to 2023. That is, any market volatility due to the Fed in September was only transitory. Fed chair Powell, more recently expressed ‘frustration’ at the stubbornness of the inflation blip to dissipate – he now feels it might spill over into 2022 – but he did not change his call on inflation to return to target levels in 2022 and 2023.
Whether for the inflation blip situation, or other reasons, the US 10-year Treasuries yield climbed to over 1.50% after having been as low as 1.3% a few months ago and well under 1% last year. These swings in rates appear to have caused some volatility in currency markets.
Of course, our third plank in our market volatility story is due to the pandemic and its spill-over into lockdown and, hence, economic growth.
Australia’s slow response to vaccinations and other responses to the pandemic have meant that we are well behind many countries when it comes to the openness of business and social outlets.
No country seems to be doing particularly well. Singapore boasted an 80% fully-vaccinated population but it just had to start placing some restrictions on dining and drinking venues to contain a fresh breakout.
The US has had very mixed results in terms of vaccination rates by state but a lot of social and business activity in that country seems relatively normal compared to pre-covid days.
The UK has a high vaccination rate and it has full stadia for its football (soccer) matches. Up to 60,000 bodies in a venue with singing and chanting with little in the way of mask-wearing. Social distancing when singing ‘You’ll never walk alone’, shoulder to shoulder on the Kop redefines how many people per square metre you can fit in a space without creating a health crisis. The daily UK new inflections have been falling steadily to around 35,000 from a third-wave peak of close to 50,000.
At home, some states have been enduring pretty stiff lockdown conditions. Sydney has just completed three months of ‘essential reasons’ being necessary to leave home even for a very short time. NSW has declared that when 70% of the population over the age of 16 is fully-vaccinated, they can have some freedoms – probably by October 11th. It seems that rules and dates change on a daily basis so this note is not the place to understand current public health policy but it is clear that we have a very different view from many similar nations on how to live with covid.
At last governments are allowing the over 60s to receive a Pfizer shot instead of AstraZeneca (AZ). There are so few over-60s unvaccinated left that it’s all a bit moot. That supports the view that it was never that AZ was preferred for the over 60s – it was a rationing of the Pfizer vaccine to better vaccinate younger folk.
Everyone now seems to realise that covid will never go away completely. The talk of herd immunity, and the like, 18 months ago is a fading dream. The possible needs for a booster shot, vaccinating small children and wearing masks ‘forever’ are now common topics of conversation.
Our new daily infection rates are running at about 1,700 a day for a population of about 25 million. The US reports about 110,000 new cases per day for a population of around 320 million while the UK has about 35,000 new cases for a population of around 60 million. There are probable differences in the way these numbers are calculated but it is clear we have been far more restrictive than the US and UK in social distancing and the like. We have more than half of the population fully vaccinated and over 75% with one or more shots.
What the published statistics available to the common person lack is a classification of number infected by severity including how many of those infected just had a couple of days feeling off-colour? It is almost impossible to judge whether or not we agree with the people who legislate on our behalf. It is little surprise, therefore, that there has been social unrest in various parts of the country and serious flouting of the rules by many in parks and at beaches.
It is fairly clear that Australia’s Gross Domestic Product (GDP growth), after posting an impressive 0.7% in the second quarter (Q2) is likely to be quite negative in Q3. The big question is: how quickly we can regroup after ‘Freedom Day’?
This third plank represents another transitory problem for markets. One day we will be back to normal – or at least a ‘new normal’ – as 80% or more are fully vaccinated. What is going to be difficult is going along with only allowing the fully vaccinated people into certain premises and venues. Large security guards on every door might reasonably define a secure gateway but which businesses could fund those new positions? Expecting a young ‘average’ man or woman in a café, shop or hairdresser to implement government policy is not going to work.
Moving now to the global economy, the data have been a bit mixed of late. We will analyse what we have observed in the ‘Regional Analysis’ sections of this update for clarity.
Importantly for us, we see the bull markets of Australia, US and others continuing for some time. We are currently experiencing what we believe is a brief down-turn but this volatility could continue for much of the rest of 2021 – or it might have nearly finished already!
We take some comfort from our forecasts of aggregate earnings growth collected from brokers analysing individual company reports. After the August reporting season our ASX 200 forecast earnings per share gains for the next 12 months is back to above average. Our S&P 500 forecasts have been stable and above average. With little prospect of any reasonable yield from bonds, it is more a question of how investors manage share-market volatility if they want to benefit from relatively attractive dividends and possible franking credits in Australia.
While August had recorded the 11th consecutive monthly gain on the ASX 200, September produced a loss of 2.7% Energy was the only positive sector and Materials sold off heavily on falling iron ore prices. Just before the end-of-September bounce back, the ASX 200 had fallen by just more than 5% from its recent peak.
With the August reporting season is well and truly done and dusted, the broker forecasts of earnings and dividends have settled down to be consistent with an above average capital gain over the next 12 months. The forecast yield is just below 4% with franking credits, if applicable, to be added to the dividends and capital gain. Of course, from our position, we think that short-run volatility is far from over but the long-run does look reasonably solid.
The S&P 500 also broke its run of positive monthly gains with a short, sharp correction. This index also fell 5% from its recent peak.
Our broker-based forecasts of earnings put our forecast of capital gains for the S&P 500 to be slightly better than for the ASX 200. However, yield is expected to be less than half of that on the ASX 200 and the US does not distribute franking credits.
Bonds and Interest Rates
The US yield curve steepened (longer term interest rates rising more than shorter term interest rates) a lot over September and now more closely resembles the curve earlier in the year. The short-term rates remain locked, close to zero, but the longer end yields are back around 1.5% or near to where they reached at the end of the rally that started at the end of 2020 before dipping in to around 1.2% during mid-2021.
The Fed came out of its September meeting unusually tentative. Fed chair Powell was keen to distance the Fed’s actions from largely unknown outcomes of the Evergrande problems in China. The Fed still has time this year to start tapering its $120 bn / month bond purchases program and have it finished by mid-2022.
While QE was important in keeping the economy afloat through the worst of the COVID19 pandemic and no doubt supported equity markets, few are arguing it is still necessary. With bond yields so low, cash has little alternative but to remain in equities for yield over the foreseeable future.
While the Fed member ‘dot plots’ have shifted a fraction, it is almost certain that the Fed will not raise rates until well after it has ended so that the degree of financial stability or otherwise can be assessed before starting the rate hiking cycle.
The Reserve Bank of Australia (RBA) announced that it has no plans to raise rates until at least 2024 even though house prices are surging. The official house price increase for Q2 was 6.7% and 16.8% over the year. Clearly, forms of regulating house price growth – other than through the official interest rate – are needed. To raise rates to control house prices might destroy the growth prospects of the broader economy.
The price of iron ore continued its decline over September from $US157 / tonne to a low of $US104 but then it retracted some of the losses to close the month at $US118.
The prices of gold and copper recorded modest declines of around 3-4%. The price of oil was up firmly by around 8-10% in September while the $A sold off against the $US by nearly 2%.
The Australian dollar recovered from a low of US$ 0.7133 during August to a range in the mid-73 cents, possibly more a case of the $US weakening on the back of the Afghan withdrawal than economic fundamentals.
At first glance, the Australia Labour Force report in September seemed really good. The unemployment rate fell to 4.5% when 4.9% had been expected. However, 146,000 jobs were lost. This situation could only happen because there was a fall in the participation rate – reflecting a discouraged worker sentiment.
Indeed, 66 million hours of work were lost in the latest month or a fall in hours worked of 3.7%! The picture gets worse when one notes the reported ‘hundreds of thousands’ of workers who, in fact, recorded working zero hours while ‘employed’!
Covid support benefits to individuals are to be cut back when the vaccination rate reaches 70% and to be eliminated two weeks after the 80% target is met. While we are expecting many establishments to re-open at the same time, there will be strict social distancing conditions imposed. And there will be the time between businesses re-opening and people being in a position to take up work. We can reasonably expect the next couple of months of labour data to reflect these disconnects.
On the broader GDP growth front, the Q2 number came in at a reasonably impressive 0.7% when only 0.1% had been expected. Most commentators are expecting a negative number for Q3. The question is, will there be a bounce back in Q4?
They key to answering this question might be found by analysing the household savings ratio. In Q2 it was 9.7% after falling from 11.7% in Q1. When the lockdown first struck in 2020, this ratio rocketed to over 20%. In due course we might expect the ratio to settle down in a range of around 4% to 8%.
The savings ratio jumped up because there were less opportunities and needs to spend – plus the desire by some to save for a rainy day. 15 – 18 months ago there was no clear path forward. No vaccines had then been proven to shield us from Covid-19. The impact of a falling savings ratio will help buffer GDP growth from being too low – or negative.
What we do not yet know is how infection rates will track after Freedom Day. The experience from other countries is that our infection rates will rise substantially. How will the governments then react?
We already have reports of many diagnostic tests for cancer and other potentially severe conditions having been cut back – because people haven’t been going out for tests during lockdowns or there are backlogs in hospitals. Our hospitals are reportedly coping with the pandemic but only just. If Singapore went back to light restrictions on an 80% vaccination rate, we might have to follow suit.
The latest monthly retail sales figure was also disappointing at 1.7%. Without being health experts, the key to a quick bounce back from Q3 growth will depend on the responsibility of Australia’s residents to wear masks and socially distance. We are hopeful for a solid bounce back but we are far from certain.
As for international travel, the hopes of a year ago have been sadly dashed. There is disagreement over whether the unvaccinated should be allowed in or out of certain countries. Indeed, Australia is reportedly not going to accept people with the China ‘sino’ vaccines even with a certificate. Will countries like the US, Canada and France, that do not recommend AZ allow our residents to travel even if fully vaccinated with AZ?
The Organisation for Economic Co-operation and Development (OECD), now headed by our former Australian Finance Minister, Mathias Cormann, has recommended that our Reserve Bank of Australia (RBA) be reviewed. There has been no such review since 1981 Campbell Inquiry. The OECD is also recommending that we broaden the base over which Goods & Services Tax (GST) is charged. In short, once the worst of the pandemic is behind us, we and other countries will need to address the surge in debt caused by the pandemic.
China’s economy continued to slow in September. Indeed, retail sales came in at 2.5% for the month when 7% had been expected. Industrial output was less of a ‘miss’ at 5.3% against an expected 5.8%.
The official monthly manufacturing Purchasing Managers Index (PMI) had been hovering at just above 50 – that separates contraction from expansion – until the end of September when it dropped to 49.6, the first time below 50 since the first month of the lockdown and a long time before the previous sub-50 read!
Now that the Evergrande debt problem is out in the open, we can question how much of China’s slow-down was engineered and how much was due to reduced demand. It now appears that a slice of the slow-down was deliberate, meaning that it can more easily be turned around.
China is also having a problem with the risk of being marginalised by new alliances between other countries. We now have the ‘submarine’ alliance between Australia, the USA and the UK (AUSUK); the ‘Quad’ alliance of Japan, India, USA and Australia is working together on climate change and other matters.
In the past, China has used its economic size in trying to influence Australia through import bans over a number of goods. More restrictions might be expected. There is likely to be continued tension between China and Australia so it is important we have strong allies in ‘our corner’.
The US nonfarm payrolls reported 235,000 new jobs were created in the latest month but 720,000 had been expected. However, the unemployment rate fell to 5.2% and the wage growth was a creditable 4.3%. But, just as in Australia, these data points are heavily affected by those who had jobs and those who lost them. It is generally accepted that lower paid workers are suffering the most and so the wage growth increase is more due to them dropping out of the picture than wage increases being given to those remaining in employment.
Retail sales were unexpectedly up at 0.7% for the month when 0.8% had been expected. Indeed, if ‘auto sales’ were excluded, retail sales were up by 1.8% in just one month! Since we do not know what caused this aberration, we will be conservative in our interpretation.
Consumer Price Index (CPI) inflation marginally beat expectations at 5.3% for the year or 0.3% for the quarter. When volatile items are excluded, the monthly rate fell to 0.1%. The inflation blip hasn’t dissipated as quickly as most expected, but the Fed seems to be holding the line. However, if inflation does not come back to near 2% for the year, the Fed will have to be more aggressive in raising rates and slowing the economy sometime in 2022.
Of relatively minor importance, the ‘Debt ceiling’ negotiations are on again. Every so often, government borrowing comes up against some predetermined limit. If the ceiling is not raised, the government can’t spend. There is often a squabble between the two sides, Republicans and Democrats, and sometimes there is a temporary government shutdown. This time around seems no different. All will no doubt be resolved before any real damage is done. It appears the ‘can got kicked down the road’ for a few weeks at the end of September but a more lasting solution is necessary.
France was understandably upset with Australia after its cancelling the circa $90 billion submarine program in favour of the AUS-UK deal that delivers the US designed nuclear powered alternative capability. Some are questioning our sovereignty in this alliance. Some are questioning our back-door entry into nuclear power. Of course, we might also get ‘pay back’ from France and the rest of the EU. France withdrew its ambassador to Australia on the news.
The UK has been experiencing massive shortages of petrol at the pumps. Some have tried to put this down to Brexit. There is a shortage of lorry (truck) drivers with the appropriate Heavy Goods licences. Some are suggesting that many such drivers came from poorer Eastern European countries and accepted lower wages to work in Britain. With Brexit and a fall in the UK Pound vs the Euro, that labour supply dried up.
There is sufficient fuel. It is just in the wrong place. It has been suggested that the army might help in the interim.
The 16-year term in office of German Chancellor, Angela Merkel, is coming to an end. It is yet to be seen what changes in policy might flow as a result, it will depend on which coalition of parties forms government.
It is reported that it might take a few months before Merkel actually steps aside and her successor and coalition cabinet is announced.
Rest of the World
Fumio Kishida has been voted in to replace Yoshihide Suga as prime minister of Japan. He is from the same political party.
Indonesia is reportedly unhappy with the new Australia deal to build a fleet of nuclear submarines with the US and the UK as it might lead to an arms race in the region.
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