Reflation Trade – The Known Known

March 2021 Monthly CiN-sights

Global equity markets continued higher in February, albeit the last few trading sessions of the month saw a correction as inflation concerns and a global bond market sell-off hit risk asset sentiment. Once again all three major US indices hit all-time highs, however the final monthly performance was more subdued with the S&P500 only +2.6% (vs. +6% at the peak) and the ASX200 +1.0%. The recent domestic reporting season has largely been positive for Australian corporates, with Financials leading the way with improved earnings.

At policy level, the RBA left the official cash rate unchanged at 0.1% in February’s meeting, but increased their bond purchase program by a further A$100bil of government and semi-government securities (plus extending the timing by 6 months), whilst maintaining its current purchase run-rate of A$5bil per week.

The impact of co-ordinated major fiscal and monetary injections are now being seen in the real economy with recent data pointing to better unemployment outcomes in both Australia and the US. The latest retail sales in the US printed a large beat as the December stimulus cheques positively impacted spending, which is likely to be repeated with the impending $1.9tril Biden stimulus package. This stimulus accompanied by the large-scale roll out of high efficacy vaccines globally, indicate life might resume to pseudo-normal quicker than expected.

Markets are now looking through to where the price of money should be in a “non-emergency” world i.e. after adjusting the price of money for inflation. The main consequence being a strong rise in longer-term rates, despite short-term rates being anchored by Central Banks globally at near zero.

In Australia, the yield curve has seen a notable steepening in recent months. Rates at the short end of the curve out to 3 years are being held down by the RBA – Bank Bill rates are at 0.02% and 3-year bonds are trading at 0.11%, but 10-year bond rates are now at 1.73%. After adjusting for inflation, investors are losing money in the short part of the curve (blue line in the RBA graph on the right).

In the US, T-bill yields are heading to sub-zero while 10-year bond rates have climbed significantly back to pre-Covid levels at the 1.3-1.5% range. Whilst the US Bond market has risen in nominal terms, the move in real yields has been more muted (despite headlines). We watch this carefully, as this is far more a critical driver of market economics than nominal yields.

In our recent out-of-cycle Dynamic Asset Allocation call, we moved to further underweight Fixed Income, as investor focus in this environment has returned to the outlook for inflation and the resultant bond yield trajectory. We allocated these funds equally to Equities (already an overweight position) and Cash, giving us available liquidity to deploy when attractive market opportunities appear.

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