2021 April Newsletter

The recent sharp rise in bond rates may not be a big topic of conversation around the Sunday barbecue, but it has set pulses racing on financial markets amid talk of inflation and what that might mean for investors.

US 10-year government bond yields touched 1.61 per cent in early March after starting the year at 0.9 per cent.i Australian 10-year bonds followed suit, jumping from 0.97 per cent at the start of the year to a recent high of 1.81 per cent.ii

That may not seem like much, but to bond watchers it’s significant. Rates have since settled a little lower, but the market is still jittery.

Why are bond yields rising?

Bond yields have been rising due to concerns that global economic growth, and inflation, may bounce back faster and higher than previously expected.

While a return to more ‘normal’ business activity after the pandemic is a good thing, there are fears that massive government stimulus and central bank bond buying programs may reinflate national economies too quickly.

The risk of inflation

Despite short-term interest rates languishing close to zero, a sharp rise in long-term interest rates indicates investors are readjusting their expectations of future inflation. Australia’s inflation rate currently sits at 0.9 per cent, half the long bond yield.

To quash inflation fears, Reserve Bank of Australia (RBA) Governor Philip Lowe recently repeated his intention to keep interest rates low until 2024. The RBA cut official rates to a record low of 0.1 per cent last year and launched a $200 billion program to buy government bonds with the aim of keeping yields on these bonds at record lows.iii

Governor Lowe said inflation (currently 0.9 per cent) would not be anywhere near the RBA’s target of between 2 and 3 per cent until annual wages growth rises above 3 per cent from 1.4 per cent now. This would require unemployment falling closer to 4 per cent from the current 6.4 per cent.

In other words, there’s some arm wrestling going on between central banks and the market over whose view of inflation and interest rates will prevail, with no clear winner.

What does this mean for investors?

Bond prices have been falling because investors are concerned that rising inflation will erode the value of the yields on their existing bond holdings, so they sell.

For income investors, falling bond prices could mean capital losses as the value of their existing bond holdings is eroded by rising rates, but healthier income in future.

The prospect of higher interest rates also has implications for other investments.

Shares shaken but not stirred

In recent years, low interest rates have sent investors flocking to shares for their dividend yields and capital growth. In 2020, US shares led the charge with the tech-heavy Nasdaq index up 43.6%.iv

It’s these high growth stocks that are most sensitive to rate change. As the debate over inflation raged, the so-called FAANG stocks – Facebook, Amazon, Apple, Netflix and Google - fell nearly 17 per cent from mid to late February and remain volatile.v

That doesn’t mean all shares are vulnerable. Instead, market analysts expect a shift to ‘value’ stocks. These include traditional industrial companies and banks which were sold off during the pandemic but stand to gain from economic recovery.

Property market resilient

Against expectations, the Australian residential property market has also performed strongly despite the pandemic, fuelled by low interest rates.

National housing values rose 4 per cent in the year to February, while total returns including rental yields rose 7.6 per cent. But averages hide a patchy performance, with Darwin leading the pack (up 13.8 per cent) and Melbourne dragging up the rear (down 1.3 per cent).vi

There are concerns that ultra-low interest rates risk fuelling a house price bubble and worsening housing affordability. In answer to these fears, Governor Lowe said he was prepared to tighten lending standards quickly if the market gets out of hand.

Only time will tell who wins the tussle between those who think inflation is a threat and those who think it’s under control. As always, patient investors with a well-diversified portfolio are best placed to weather any short-term market fluctuations.

If you would like to discuss your overall investment strategy, give us a call.

i Trading economics, viewed 11 March 2021, https://tradingeconomics.com/united-states/government-bond-yield
ii Trading economics, viewed 11 March 2021, https://tradingeconomics.com/australia/government-bond-yield
iii https://www.reuters.com/article/us-oecd-economy-idUSKBN2B112G
iv https://www.smh.com.au/politics/federal/growth-prospects-for-australia-and-world-upgraded-by-oecd-20210309-p57973.html
v https://rba.gov.au/speeches/2021/sp-gov-2021-03-10.html
vi https://www.washingtonpost.com/business/2020/12/31/stock-market-record-2020/
vii https://www.corelogic.com.au/sites/default/files/2021-03/210301_CoreLogic_HVI.pdf

 

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Vanguard economic and market update - March 2021

Key points

• Economic growth levels across most developed countries are increasing, supported by major fiscal stimulus programs and the ongoing rollout of COVID-19 vaccinations.
• On a monetary policy level, central banks are leaving official interest rates unchanged and in some cases increasing purchases of government bonds to counter higher longterm yields.
• Headline inflation levels are expected to rise gradually in key markets, but longer-term structural trends will likely limit the extent of consumer price rises.
• Employment trends remain mixed, in line with the pace of recovery in specific countries as they deal with the impacts of the pandemic.

 

Economic growth

With the passage of the US$1.9 trillion American Rescue Plan Act of 2021 on March 11, Vanguard foresees the United States economy growing in a range of 7% to 7.5% for all of 2021, an increase of 2 to 2.5 percentage points compared to what our projection would have been without the new stimulus.

We expect first-quarter growth to be modestly above 5% as most Americans receive stimulus payments, and that the current pace of COVID-19 vaccination will support a significant pickup in economic activity in the second half of the year.

A slower pace of COVID-19 vaccinations puts the euro area behind both the United Kingdom and the U.S. on that front and increases the risks related to its timetable for easing COVID-19 restrictions. We foresee euro area GDP growth around 5% for 2021, with GDP reaching its pre-pandemic level in the next 12 months or so.

GDP in the United Kingdom is estimated to have fallen by –2.9% in January, attributable to restrictions related to COVID-19. The services sector, which contracted by –3.5%, bore the brunt of the effect. But better days appear to be ahead as case numbers fall, the pace of vaccination increases, and restrictions are expected to be lifted by the end of the second quarter. Although we expect a first-quarter contraction in activity, we foresee a meaningful economic rebound in the second and third quarters and full-year 2021 growth around 6%.

In China, robust industrial production and exports offset moderate weakness in consumption in January and February. The resilience in the economy is bringing consensus estimates for China's full-year 2021 growth closer to Vanguard's forecast around 9%. At the annual National People's Conference in early March, Chinese officials set a 6% growth target for the year and a goal of doubling the size of the economy by 2035, which implies average annual growth around 4.7%.

GDP rose more than expected in the fourth quarter in Australia, by 3.1% compared with the third quarter on a seasonally adjusted basis, topping consensus estimates of 2.5%. The more solid base makes Vanguard more optimistic about prospects for Australia's growth in 2021; we now foresee growth for the full year around 5%, and the economy reaching its full potential by the second half of 2022. Full-year 2020 growth came in at negative 2.4%.

Vaccine breakthroughs and rollouts in developed economies make Vanguard optimistic that emerging markets on aggregate will grow by more than the 6% outlook we communicated at the end of 2020. We continue to see emerging Asia lead the way, with 2021 growth above 8%. The region's pandemic management continues to bear fruit and export-driven models are benefiting as global recovery takes hold.

Monetary policy

The U.S. Federal Open Market Committee voted on March 17 to leave the target range for its federal funds rate unchanged at 0%–0.25% and its bond-buying program unchanged. Vanguard foresees a potential third-quarter 2023 lift-off for the Fed's rate target. We believe the Fed would need to see substantial progress toward achieving its dual mandate of stable prices and maximum employment, which Fed governors saw as being some time off, before slowing its US$120 billion per month in purchases of U.S. treasuries and agency mortgage-backed securities.

The European Central Bank (ECB) left its key rates intact at its March 11 policy meeting but signalled a "significantly higher pace" of asset purchases under its Pandemic Emergency Purchase Programme (PEPP). The unspecified increase in bond-buying is intended to counter rising borrowing costs within a European Union still struggling with the health and economic effects of COVID-19. Vanguard expects that the ECB will increase its purchases from around €12 billion per week to around €20 billion per week to counter higher yields on longer-dated bonds.

The Bank of England (BOE) maintained its bank rate at 0.1% at its March 17 Monetary Policy Committee meeting and left its UK government bond purchase program target unchanged at £875 billion. The BOE noted that global GDP growth had been stronger than anticipated since its last meeting. We expect the bank's asset purchases to continue through the end of 2021, with an increase in the bank rate likely only a year later.

The Reserve Bank of Australia (RBA) left its cash rate and three-year government bond target intact at 0.10% at its March 2 policy meeting. The RBA reiterated it was unlikely to raise the cash rate until 2024, the earliest it foresees actual inflation sustainably within its 2% to 3% target. For that to occur, the RBA said, significant gains in employment and a return to a tight labour market would be required to push wages higher.

Policymakers in China are likely to recalibrate policy in their effort to stem gains in debt-to-GDP levels and to ward off financial bubbles. Vanguard expects China to gradually withdraw both monetary and fiscal support to achieve these aims. On the fiscal side, the government will aim to reduce its official fiscal deficit target from 3.6% to 3.2% in 2021. On the monetary side, policymakers will aim to slow credit growth, though in our view the People's Bank of China will refrain from outright policy rate hikes this year.

Vanguard expects central banks in emerging markets to continue to maintain an easy monetary policy, but rising yields in the United States could constrain that effort to a degree.

Inflation

The Consumer Price Index (CPI) in the U.S. rose 0.4% in February on a seasonally adjusted basis compared with January, with petrol prices accounting for more than half the rise. Core CPI, which removes volatile food and energy prices, rose just 0.1%. Compared with a year earlier, the broad price index rose 1.7%, while core prices were up by 1.3%. Vanguard expects core U.S. inflation to surpass 2% in the coming months as base effects—comparisons to low year-earlier numbers—magnify price rises as people re-engage in face-to-face activities. But we expect the rise above 2% to be short-lived, and that long-term structural trends that have kept inflation low for more than a decade will continue to limit price rises.

Headline inflation rose by 0.9% in the euro area in February on an annual basis, unchanged from January, according to the final estimate from Eurostat, the European Union's statistical agency. Underlying price pressures remain subdued amid weak labour bargaining power and low inflation expectations. We expect core inflation to gradually rise toward 1.5% as the pace of economic recovery increases in the second half of the year, with occasional upside volatility owing to supply-chain bottlenecks related to Brexit and a global semiconductor shortage.

Vanguard expects both headline and core inflation in the UK to rise toward the Bank of England's 2% target over the next year as the effects of lower energy prices unwind and the economy strengthens. Headline inflation rose by 0.7% in January compared with a year earlier, up from a 0.6% rise in December.

Despite some modest base effects, or comparisons to low year-earlier prices, Vanguard doesn't expect core inflation in Australia to approach the RBA's 2% to 3% target range anytime soon. We expect that spare capacity in the broad economy and in the labour market will leave core inflation around 1.5% by year's end, higher than the RBA's forecast of 1.25%.

Vanguard expects core consumer prices in China to strengthen in the second quarter as activity normalises further. We expect higher commodities prices to feed into producer prices, but pass-through effects to consumers may be capped. Consumer prices rose by 0.6% in February compared with January but were down – 0.2% compared with February 2020. The Producer Price Index rose 1.7% in February compared with a year earlier, and 0.8% compared with January.

Emerging markets continue to diverge, with disinflation (inflation well below target), a concern in parts of Southeast Asia, notably Indonesia and the Philippines.

Employment

The unemployment rate in the U.S. fell slightly in February, to 6.2% compared with 6.3% in January, while the U.S. labour market added 379,000 jobs. Vanguard foresees the headline unemployment rate falling toward 5% by year's end, and into the low 4% range, closer to pre-pandemic levels, by the end of 2022.

Unemployment in the euro area was 8.1% in January 2021 on a seasonally adjusted basis, unchanged from a revised 8.1% in December 2020, and up from 7.4% in January 2020. The unemployment rate in the UK rose to 5.1% in the three months ended in December 2020, up slightly from 5.0% a month earlier and a sixth straight month of increase.

The unemployment rate in Australia fell to 5.8% in February from a revised 6.3% in January. Despite relatively upbeat recent labour market reports, Vanguard doesn't expect Australia will reach full employment, which the RBA has suggested it would consider to be around 4.5%, before 2022.

Asset class returns

Our 10-year annualised nominal return projections are as follows.

Asset class	Median volatility	10-year annualised return forecast
Australian equities	21.0%	4.7%-6.7%
Global ex-Australia equities (unhedged)	19.4%	4.3%−6.3%
Australian aggregate bonds	4.6%	0.6%−1.6%
Global bonds ex-Australia (hedged)	3.1%	0.9%-1.9%

IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modelled asset class. Simulations are as of September 30, 2020. Results from the model may vary with each use and over time.

 

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Please note this information is of a general nature only and has been provided without taking account of your objectives, financial situation or needs. Because of this, we recommend you consider, with or without the assistance of a financial advisor, whether the information is appropriate in light of your particular needs and circumstances.

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