Bond yields spike
- US inflation fears bubble up and the 10-year bond interest rate rises to reflect this
- Globally COVID 19 cases have declined for 6 weeks, millions vaccinated in the US and UK
- Corporate earnings strongly surprise on the upside and governments continue spending
The Big Picture
As if there wasn’t enough to contend with in coping with the pandemic, US 10-year bond yields spiked at the end of February and that sent Wall Street into a tail spin. The two phenomena are actually connected but not in an obvious way.
President Biden and his team are making great inroads into vaccinating all US adults who want the vaccine sooner than many expected. That was the bad news! Such was the glee at starting to put an end to the pandemic (or so many think – but more of that later) investors and analysts started to think about a rapid recovery for the US economy.
If/when the US economy fully recovers, that will/might bring with it inflation – a problem that the US has not struggled with for more than a decade. Significant inflation means that the US Federal Reserve (“The Fed”) will have to start raising its federal funds rates from almost zero up to something a bit more in line with historical norms.
With participants suddenly confronted with the possibility of tighter monetary policy, the yields on longer-dated US Treasuries started to rise – and quickly. The next piece in the jigsaw is that 10-year yields are just about up to dividend yields on the S&P 500. At long last there seemed to be some alternative to investing in shares!
While this sequence of events seems logical, we think the argument is flawed. And the Fed chairman, Jay Powell, agrees.
Markets react harshly when they are blinded-sided. The S&P 500 fell 2.5% on the last Thursday of February and then fell a further 0.5% the next day. Ouch!
For the US to achieve “herd immunity” where the virus dies out on its own, it is widely accepted that the US needs to vaccinate around 70% or more with an “efficacious” vaccine like the ones from Pfizer and Moderna they are using.
Biden has assured us that he will have 600m doses available by the end of July but that’s a long way away from getting two jabs into well over 200m American arms. There are two major problems that Biden is not yet addressing.
First, there is a lot of push back in the US to being vaccinated. Whatever their reasons, it is not likely that the US can get enough people vaccinated quickly enough especially as two jabs are required. How do you find the person for the second jab and how do you record a successful pair of vaccinations – on a digital passport?
Tracking may well offend some US citizens as they might see it as another case of big brother. Tracking is, however, working well in Australia for finding sources of COVID infection.
The second problem is even bigger! People who have been vaccinated can still get infected and pass it on but they won’t get sick themselves! Masks and social distancing aren’t going away any time soon. Coupled with this problem is the fact that the rest of the world is not moving at the same rate. We only just started our vaccinations in the last week of February while the US had reportedly already vaccinated over 60 million people. And what about poorer nations?
For the US economy to boom again it also needs people and goods crossing its international borders. And what about Mexico? How many new illegal immigrants will have been vaccinated. How many illegal immigrants in the US will come forward for a jab? And then we have the problems about new strains emerging. If there are pockets of people scattered around the world being exposed to COVID, new, more virulent strains such as the UK and SA variants (and worse) may be created.
We applaud the work the US is doing in trying to eradicate the virus. We just think it will take a lot longer before they are back to ‘normal’.
We did not see all of Jay Powell’s testimony to the two chambers of Congress but we did see his conclusion. Paraphrased he said that it will be at least three years before we can reach the inflation target. And he thinks it will be a similar length of time before they achieve full employment.
So, if the inflation scare was a false dawn, what might we expect about bonds and share dividends? The US 10-year yield was around 1.8% to 1.9% in the weeks around the start of 2020 – before most of us knew anything about COVID. This yield fell to around 0.6% to 0.7% in the middle of 2020 and started to rise gently from when the vaccines were announced in November 2020 to about 1.0% to 1.1% in mid-February.
That was a massive fall in yields to 0.5% and a massive rise to 1.1% on the way back. But the even more massive rise to a short-lived 1.614% near the end of February is what spooked the markets.
We think some people extrapolated the recent short, sharp rise in yield without context. If the yield gets back 1.9% that is still only where it was positioned before the pandemic. Why should it continue to rise above that without a new big impetus? And if, as we suggested, the economy will only glide back to pre-COVID strength, why should it have even got to 1.6%? We think it was an over-reaction. It fell to 1.41% in just over 24 hours!
With bond yields getting back to near dividend yields on shares, we should also ask the question of why dividend yields fell so low. Historically, yield on the S&P 500 was around 2.5%, a full 1% point above where they are now.
Earnings fell in 2020 (from where dividends are paid) and companies became more risk-averse as they found it hard to predict where the economy was going. So, they retained a bigger share of earnings than normal.
Reporting season for quarter 4 (Q4) in the US was very strong and, on average, beat earnings estimates. Earnings are predicted to rise from here so we expect dividend yields to start to rise. That means bonds are not a great alternative to shares going forward – at least for a year or two.
As we have highlighted previously, we expected any number of shocks to equity markets as news about the pandemic emerged. This recent sell off in the bond market was just one of them. There will be more. These events are disconcerting for investors and while we don’t know the exact outcome in the short term, we do know having a well-founded long term investment strategy is the prudent approach to look through bouts of volatility.
Turning to Australia, our situation is quite different from that in the US. They vaccinated over 60 million people in the US before Scott Morrison got his jab at the head of the queue.
We only have enough efficacious Pfizer vaccine for less than 10 million people in Australia and no Moderna, a similar and equally efficacious vaccine. We were not able to secure more of these two vaccines used in the US so we are left with 53.8 million doses of AstraZeneca’s (AZ) vaccine.
Importantly, the US has not yet approved AZ for the US and South Africa has suspended the use of AZ. A dozen or more European countries are not recommending and/or allowing over 65s to be given AZ. The reason is that there is great debate about its efficacy (or usefulness). Nobody is suggesting it will harm anyone; it’s just much less useful than the Pfizer/Moderna formulations. Indeed, many say that AZ is not strong enough to produce herd immunity – the end game.
We clearly need a plan B but approval has not yet even been given for the 50 of the 53.8 million doses of AZ being manufactured in Melbourne by CSL. We have 51 million doses of Novavax on order but that is not only yet to be approved but there is very little known about the trial results.
Australians and the authorities have done a spectacular job in containing COVID. But, without an efficacious vaccine, it may well be 2022 before we start to tackle the underlying problem. Not only will Americans have to continue with masks and social distancing, etc we will have to be even more vigilant and for longer.
Our labour market is, however, continuing to improve. The latest unemployment rate fell from 6.6% to 6.4% and over 29,000 now jobs were created. Our Westpac and NAB confidence and conditions surveys are still pointing to a mildly optimistic sentiment across consumers and businesses. However, our retail sales only grew by 0.6% for the month when 2.0% had been expected.
Our government and central bank (RBA) continue to work hard at keeping the economy together. The RBA just extended its Quantitative Easing (QE) programme by $100bn from mid-April at $5bn per week buying long-dated bonds that they estimate keeps the bond yield down by about 30 basis points (bps) or 0.3 percentage points.
In conclusion, we believe that the US and Australia are doing enough to promote economic growth or at least keep it above what it would have otherwise been. The US Congress is close to putting another $1.9 trn into the system in the form of cash payments, top-up benefits and COVID needs. Much of that expenditure just perpetuates what was already passed but would have run out by March 14th without it.
We do not feel the need to alter our investment strategy for the year ahead at this point however, we must expect more speed bumps along the way.
Asset Classes
Australian Equities
The month of February was good for the ASX 200 in that the harsh sell off on the last day still left the index up by 1.0% for the month. The Energy sector (+2.1%) had a good month but Financials (+4.5%) and Materials (+7.2%) were spectacular; Utilities ( 8.8%) was the main laggard.
The last few months have been difficult for investors as the ‘style’ of stocks (growth, value, cyclicals, defensives, etc) in favour have switched back and forth, largely on news about the pandemic.
The second half of 2020 reporting season is all but over. The results were not only largely very strong relative to forecasts but historical estimates of earnings were revised upwards as actuals were published.
International Equities
The S&P 500 (+2.5%) gained strongly in February despite losing 3.0% in the last two days of the month. Most other major indexes also did well.
US fourth quarter reported earnings were also strong but there have been some major moves in certain sectors. Technology had been the poster child of the index for some time. It is always hard to value high growth stocks and some tech stocks were sold off quite heavily during the month. That means the tech-based Nasdaq underperformed the Dow and the S&P 500 for the first time in a while.
Bonds and Interest Rates
We discussed the bond yield spike in some detail in the overview – such is the importance of the topic. Suffice it to say here that the short duration end of the US yield curve has been well anchored out to about two years duration. The yield curve has been steepening quite sharply (yields on long durations securities e.g. 10-year bonds rising faster than short duration instruments such as cash) since around the time of the presidential election in November 2020 and the announcements of vaccines being approved.
The Australian 10-yr bond stands at 1.9% or a full 50 bps above the US yield. The RBA has about six months of Quantitative Easing (QE) ready to help keep yields on longer dated government bonds in check, but there is the possibility that more may be needed.
We do not expect the Fed or the RBA will try to lift Official interest rates anytime this year and probably next – if not even longer. We think much of the recent rally in bond yields is already incorporated into central bank’s view of interest rate policy.
Other Assets
February has been a big month for some commodity prices. Oil prices were up about 18% and the iron ore price was up 10%. The copper price was up 16%. The price of gold was down 7%. Partly as a result, the Australian dollar rose 2.4% against the US$ (from 76.45c to 78.29c) passing through 80c on the way through the month.
The VIX (equity market volatility Index) ‘fear index was down from 33 to 28 over February but hit a low of 20 along the way!
Regional Review
Australia
The unemployment rate just prior to the pandemic bottomed at 5.1% and then peaked at 7.5% in later 2020. This rate has now fallen back to 6.4% last reported in February. Of course, we could debate measurement issues concerning hidden unemployment and the like however, such problems always exist so we should just compare apples with apples. That aside the government seems to have made a reasonable fist of tackling the problems.
Because of COVID 19 vaccination problems we do not expect to have seen the last of partial shutdowns but the future looks brighter than it did prior to Christmas.
There is now talk of an early federal election for the coalition to capitalise on its perceived handling of the pandemic. That is not for us to speculate on but the main worry for many investors in the last election was the opposition’s intent to remove franking credits and increase capital gains tax. They have now renounced those plans so the main differences are now the usual social positions rather than financial – especially for self-funded retirees.
China
If China was expecting Biden to rescind Trump’s tariffs and other restrictions, they were sadly mistaken – and they have hinted at that. Biden doesn’t seem to be in a hurry to placate them even though the Democrats were vocal opponents of the introductions of the tariffs at the time.
The ongoing trade war with China seems to have softened but not reversed. China needs our high-grade coal but seems to be prepared to suffer a little more rather than let our ships unload.
The Chinese Purchasing Managers Index (PMI) – a measure of activity and by implication confidence for manufacturing – came in at 51.3 which was just a little off the expected 51.6.
US
The House of Representatives has passed the US$1.9 trn relief package to aid the economy to deal with the pandemic, but it seems that the doubling of the minimum wage missed out on being part of the bill.
The Biden administration is proposing a bill that will avoid needing any Republican support – it is a quirk of the US system that allows a limited number of bills to pass the Senate without the 60% majority normally required for a vote to pass.
Although US$1.9 trn sounds a lot – and it is a lot following hot on the heels of the US$0.9 trn package passed in December – it is largely keeping current financial assistance levels going for a lot longer. It is far too soon to remove the economy from life support.
The latest monthly retail sales growth was a bumper, up 5.3% as that month included the $600 cheques that went to millions of people. With another $1,400 cheque almost in the mail, we can expect even bigger numbers sometime soon.
The latest Consumer Price Index (CPI) inflation measure was only +0.3% but that reduces to 0.0% core inflation when energy and food are removed from the basket of goods and services comprising the index. And some folks thought inflation was getting out of control?
The nonfarm payrolls (jobs) data were on expectations at 49,000 new jobs and an unemployment rate of 6.3% (when 6.7% had been expected). The market is expecting over 200,000 new jobs in the next release due on the first Friday in March. The outcome could be a lot bigger than that without causing a problem. 200,000 was a ball-park average before the pandemic set in. There are still millions of jobs lost in the shutdown that haven’t yet been recovered.
Europe
We still have not seen any significant fallout from Brexit at the start of the year. Britain is having lots of trouble with controlling COVID 19 but they are planning to get spectators back at football matches from May onwards.
Different countries have reacted quite differently to the use of the AZ vaccine. Clearly, what is needed is more data so that a prudent and informed decision can be made. There are real issues with the clinical trials that are in turn causing confusion.
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