Whilst equity markets have staged a remarkable recovery from the COVID crisis, the bond market does not seem to know where to go. And the arrival of the Delta strain, renewed lockdowns and declining bond yields all point to new risks. Where does this zig-zagging leave investors?
Large tech platforms were the initial beneficiaries of the COVID crisis. But from November 2020 the discovery of effective vaccines put a rocket under bond market yields and ushered in a solid rotation to “value” stocks as the business cycle look set to return to some election of normality. The arrival of the Delta strain, renewed lockdowns and declining bond yields all point to new risks and new macro themes.
Rotation to value is not finished
Whilst some are calling the end of the rotation to value stocks, we think this is premature. The rotation to value is really a rotation to economic recovery and that remains incomplete. Absent shorter-term disruptions, it is clear that economic momentum − both home and abroad − remains strong. Fears of softer jobs data in the US recently were unfounded with strong non-farm payrolls of 943,000 in July, a drop in the unemployment rate of 5.4% and a rise in job openings to a massive 10.1 million jobs − the fourth straight all-time monthly high. Job openings now exceed the unemployed, much like the booming pre-Covid jobs market, and suggest that employment growth will continue for an extended period.
Locally, business and consumer confidence have fallen off recent highs, but the Australian recovery remains one of the most advanced in the world and well ahead of forecasts in 2020. Despite concerns about lockdowns in NSW and Victoria the unemployment rate fell again to 4.6% for July and jobs rose modestly (up +2,200 vs expected -46,200 job losses expected) as other states offset lockdowns. Recent Treasury modelling also noted that states in lockdown can expect strong catchup growth once lockdowns are lifted. As the chart below shows, this would be the shortest and weakest of major value cycles in recent years.
Chart 1: Value of $100 invested in a portfolio that is long value stocks and short growth stocks
What are bonds trying to say?
Whilst confidence will undoubtedly remain febrile in the short term, bond market yields may be at an inflection point in early August as they absorb better than expected news on the economy and Delta, especially the reduced fears of a wave of infections and deaths in the UK as they exit lockdown, neither of which has materialised. Bond yields remain well below the levels they should be at given the strength of data such as the PMIs, suppressed in part by the $120 billion per month in Fed purchases. With recent Fed minutes suggesting that tapering could occur in the latter part of this year, we believe that this gap between economic strength and extremely low yields will need to be bridged, with at least part of it in the form of a significant rise in bond yields. As the US Government signs off on a US$ 1 trillion infrastructure bill and Democrats move to legislate a US$ 3.5 trillion antipoverty and climate plan, we think bond markets will be further pressured.
Chart 2: Australian Large Cap Value vs Growth Forward Price to Earnings Ratio
Regarding inflation there has been a false choice with many market watchers pressured to nominate to be either in the transitory inflation camp or sustained inflation camp when, in reality, there will be elements of both. Some of the inflation we have seem (like used cars and higher freight rates) was sure to be traded away, but as rents follow house prices up and wage pressures build, more sustained inflation pressure will come to the fore. More importantly, however, are the implications for equity markets. Whilst the recovery in value stocks since late 2020 has been impressive, as the chart below shows, we are yet to experience much of a correction in expensive growth stocks, despite trading near the extremely high levels of the dotcom period. These valuations, combined with rising bond yields, could be a toxic combination. Choosing carefully on how and when to gain exposure to the opportunities in growth and value markets has rarely been more important.
Volatility may occasionally spook markets but our long-term view is that active management across all investment styles comes to the fore when market indices experience tough times.
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