It was another interesting month in February as favourable economic data and a surge in bond yields shaped the performance of markets globally.
Monthly gains were seen across the Australian and Global Developed share markets as company profits rebounded and vaccine rollouts continued to gather pace. However, Emerging Market’s recent run steadied in February and Global Bonds posted negative returns for a second consecutive month due to increasing bond yields.
Both Australia and the US showed signs of improving business conditions, as their respective reporting seasons concluded in February. Over half of Australia’s listed companies beat their profit guidance for the December period, while an impressive 76% of US companies beat their earnings expectations.
The boost in earnings eases the pressure on company valuations and Price to Earnings multiples, which have been tracking at lofty levels not seen since the heights of the Dot-Com Bubble. Had earnings results fallen short of expectations, current market valuations would have been sorely tested and a correction would have been inevitable.
Bond yields surge
Long-term bond yields have been trending upwards over the last couple of months, both domestically and overseas. Although central banks remain committed to doing “whatever it takes” to support the COVID-recovery, their effect on longer-term yields is generally limited. Instead, it’s market expectations in relation to inflation and economic growth that tend to have a greater impact on longer-dated yields.
Economic growth has recently been encouraged by the rollout of COVID vaccines and reduced lockdown measures, while it’s expected that inflationary pressures are likely to build due to accommodative fiscal and monetary policy. Consequently, we’ve seen a significant steepening of the yield curve during February, which is evident in the chart below.
Impact of higher bond yields
Spikes in bond yields will typically cause the performance of bond investments to decline. This is because bond yields and bond prices have an inverse relationship, which simply means as bond yields rise, bond prices generally fall, and this leads to a decline in bond returns.
Banks, on the other hand, can often be the beneficiaries in these types of environments. As banks borrow money over the short-term and lend money over the long-term, a steeper yield curve will increase their net interest margin, which ultimately drives their profitability.
Finally, higher bond yields lead to a higher cost of capital for companies, which reduces their present value and places downward pressure on their share prices. In such circumstances, we also tend to see differing outcomes for Growth and Value companies. As Growth companies expect the majority of their cash flows to be earned well into the future, higher bond yields often transpire into more significant corrections, compared to Value companies, who are typically already generating healthy cash flows today.
Unsurprisingly, February saw a significant contrast in the performance of Growth companies, which tend to be made up of tech and health care stocks, and Value companies that are often comprised of banking, materials, and energy stocks. We would expect this trend to continue should bond yields increase further in upcoming periods.
Australia’s “World Leading” Recovery
Federal Treasurer, Josh Frydenberg has described Australia’s response following the COVID outbreak as “world-leading”, after the economy recorded GDP growth of 3.1% for the December quarter. It is the first time in recorded history that Australia has seen two consecutive quarters of economic growth of more than 3 per cent.
The rise in consumer spending was accountable for most of the growth, although the turnaround in business investment was perhaps the most pleasing aspect of the result. The tax cuts and business investment incentives announced last October are likely to have been driving forces behind the added expenditure.
Purely from an output perspective, Australia is now only 1.1% behind where it was pre-COVID, which is well ahead of original expectations. However, there are many sectors still struggling, such as tourism, hospitality and education. Additionally, there are approximately 1.3 million people still reliant on JobKeeper, which is due to terminate at the end of March. Needless to say, there is still a way to go on our road to recovery.
Missed Luke’s January update? Watch it here.