Bond bloodbath, tech correction triggered by inflation

February in the rear-view mirror – bonds, corrections and inflation

• The Australian economy has emerged from the pandemic almost unscathed, with the economy growing 3.1% in the December quarter, among the fastest in the developed world. For the full year, the economy contracted by just 1.1%, with China one of the few countries recovering faster. The result came amid suggestions that the Federal Government may have offered too much fiscal support, evidenced by the many Job Keeper repayments, however, a closer look at the issues facing the hospitality and tourism sectors suggests this is unlikely to be the case.

• Inflation, inflation, inflation. This was the word on everyone’s lips during the month with experts and pundits alike flagging the risk of an inflationary outbreak. The reasons are obvious, huge monetary and fiscal stimulus into economies around the world that are recovering more quickly than expected. Yet despite the concern, central banks across Europe, the US and Australia have confirmed their intention to keep interest rates near all-time lows for at least the next few years.

• The immediate impact of higher inflation expectations was the worst monthly return for Australian Government bonds in history. The Australian bond index, which carries an average maturity of close to eight years, delivered capital losses of 3.6% to investors, that’s around triple the current interest payment on offer. Bond rates are an important input into the valuations of higher-risk assets like shares, as they are considered the ‘risk-free’ return or alternatively the discount rate from which every other asset is valued. They also represent the cost of capital for companies therefore those struggling to turn a profit in a low interest rate environment are likely to face significant issues should the cost of capital increase.

• February saw the all-important reporting season for the ASX. According to CommSec, 141 of the ASX 200 companies reported in February, with 86 per cent reporting statutory or ‘real’ profits and around 79 per cent issuing a dividend; an improvement of 5% on this time last year. There were a number of key trends, discussed later in this report, with the repayment of JobKeeper benefits, increasing cash balances and the return of dividends among the most popular. The clear winners of reporting season were the banking and commodities sectors, with the former benefiting from what appears to be a normalisation of interest rates and the realisation that doomsday scenarios around loan defaults were well off expectations. Commodities have been the successful, with record dividends from iron ore miners including Fortescue (ASX: FMG), Rio Tinto (ASX: RIO) and BHP (ASX: BHP), after the iron ore price hit a nine-year high in 2021.

• It was a similar story in the US where the S&P 500 overcame expectations of a 10% contraction in earnings to grow them by 2.4%, on a 2.0% increase in revenue. Dispersion continues to grow, with just five sectors of the market delivering positive earnings growth (similar to Australia), centred around the booming IT sector and financials. It is clear that middle-class consumers have benefited significantly from stimulus payments, sending savings higher, with travel bans incentivising house renovations and upgrades, and e-commerce spending. As expected, big business, including the likes of Amazon and Apple, is benefiting most while smaller businesses bore the brunt of lockdowns. 

• “There is no alternative,” or TINA, has become the buzzword of 2021. As part of our Investment Committee meeting this week it was reiterated that those retiring in 2021 likely face the most difficult and uncertain outlook in recent history. As it stands, nearly every asset class is broadly considered ‘expensive’. Whether that is equity markets, which some are calling bubbles, low-risk bonds which are now delivering capital losses, residential property booming, or term deposits yielding less than 1% for five years; it has rarely been this hard to find a consistent income or reasonably priced asset. For instance, in 2007, at the height of the equity market, retirees could still find term deposits offering interest rates of over 6%. If it wasn’t clear already, it must be now, that a change in approach from what worked in the last two decades is required.

• Does the fiscal cliff lie ahead? There is a near-consensus that the economic recovery, both Australia and around the world, is a near certainty as we move deeper into 2021. But are we under-appreciating the risk that lies ahead? Much-needed support programs including JobKeeper are set to cease in Australia in March, yet with international borders closed and CBDs barren, hospitality and tourism businesses are clearly still on their knees. Australia’s unemployment rate has fallen to just 6.4% after hitting a high of 7.5% in June last year, but many experts are now suggesting thousands of jobs may be lost as the calendar ticks over to April. With retail sales showing resilience, up 0.5% in January despite a strong showing in December, and saving rates said to remain in the high teens, it is clear we are in a for a bumpy ride.

• Reporting season saw a 50% increase in cash holdings across the S&P/ASX 200, with cost-cutting, redundancies and the rundown of inventory key to delivering higher profits. As the economy turns, businesses are once again turning to mergers and acquisitions as they seek to capitalise on the weakness of their competitors. It was a busy month on this front, with a long list of players entering the fray, including Link (ASX:LNK) seeking to demerge its PEXA unit, Vocus (ASX:VOC) getting an offer from Macquarie, AMP Capital’s private markets business being sought by Ares Capital and both Dominos (ASX:DMP) and Cleanaway (ASX:CWY) seeking significant purchases.

Drew Meredith

Drew is publisher of the Inside Network's mastheads and a principal adviser at Wattle Partners.