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Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.

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

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact our team.

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.

Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.

A new dawn for the American economy

– January 6 riots in Washington DC highlight the magnitude of the political divide in the US
– Problems with vaccine roll-outs, shortages of supply and slower than forecast inoculation rates
– China’s economy undoubtedly strong, rest of the world coming good but slower than expected

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact your our team.

The Big Picture

Whenever a new President of the United States is sworn in, there is a natural period of reflection on the policies that were promised and a contrast with those that went before.

One expects even more introspection when there is a change in the governing party – as there was from Republican to Democratic on 20th January 2021. In addition, this inauguration focused attention on the end of possibly the most divisive presidency in recent history.

It would be easy to be dismissive of Trump’s term – as many Democrats have been – but, even in losing the election, Trump garnered around 48% of the popular vote. A lot of people liked him and his policies! The Sydney Morning Herald reported a statistic at the end of January that one third of Americans still thought Trump had won!

If we turn the clock back by about four and a half years – to the referendum on Britain’s membership of the EU – the two sides to that argument were also vociferous in putting their cases. The disbelief of the losing side rallied people to predict disarray and worse. Some even demanded a fresh referendum (and so on until they won, we suspect).

As it turns out, Brexit at the end of 2020 went quite smoothly with Britain getting most of what it wanted. The finance industry has not migrated to Europe as many predicted. It seems to be a fact of our times – either through education and/or the internet – people on both sides of most arguments are having their voices aired and magnified like never before.

President Biden had denounced Trump’s “Make America Great Again” slogan. Trump wanted to take on each nation separately in an attempt to get good deals for the US. Biden wants to go back to multilateral agreements. On day one, Biden signed executive orders to go back into the World Health Organisation (WHO) and the Paris Climate Accord.

As with many policies, there is no universally best outcome but one which suits the current mood and opinions of the people it represents. The riots in Washington, DC on January 6th 2021 made it clear that not everyone is happy with the new future under Biden. Trump was impeached in the House of Representatives for his role in those riots and Biden must handle the ‘trial’ in the Senate along with all of his other pressing issues.

Thankfully, there has not been any recurrence of the violence from when the Capitol building was over-run. Biden has a big job on his hands to make both sides see reason. The solution seems a bit like holding a big dumbbell above one’s head but grasping the bar only in the middle. Every slight movement can generate a big, potentially dangerous sway from one side to the other.

It is also important at this time to reflect on the new sizes of the majorities in both houses of Congress. Democrats have only a slim majority in the House of Representatives – but all Democrats are not ‘equal’ and neither are all Republicans. Deal-making will still have to be done within and across parties at a frenetic pace for Biden to get close to what he wants, particularly in his first 100 days.

The balance of power in the Senate is even more precarious. The Vice President, Kamala Harris, has the casting vote but the Senate works largely on a committee structure. Will each committee have to have a 50:50 balance? And then there is the filibuster rule that doesn’t seem to be going away. That rule requires a 60:40 majority vote to avoid them. In other words, bipartisan bills will still need to be crafted.

Nevertheless, Biden has moved swiftly to sign many executive orders. These orders require no vote but the bigger bills need to go to Congress. Biden has already ended building of ‘the wall’ and mandated the wearing of masks on Federal premises and certain air travel. He has provided some relief to those whose jobs were affected by the pandemic.

On another contentious issue, Biden has shut-down work on the Keystone XL oil pipeline from Alberta, Canada to a US pipeline 1,200 miles south. There are obviously economic consequences for the shut-down. The upside is the reduction in the environmental and indigenous population concerns. Most things come at a price.

When we turn to the bills which must be voted on in Congress, perhaps the most important, immediate issue is the $1.9 trn proposed coronavirus relief package. Much has been made of the wish to add $1,400 to the $600 cash payments to individuals that has already just been passed in the $900 billion relief package passed in December.

Some ‘progressives’ want this $2,000 payment to lower income earning individuals to become a recurrent benefit. Others will no doubt want to scale it back, even within the Democratic party. A CNBC TV guest estimated that the package might be scaled back to about $1 trn before it can be passed.

Naturally the new administration has already claimed that the coronavirus situation is a lot worse than they had expected. It is not clear to what problems they are referring that were not in the news in recent weeks. But doesn’t every new government everywhere try to heap as much responsibility as possible on the previous government?

Biden stated, “It’s going to get worse before it gets better”. US COVID deaths are expected to reach 500,000 in February and he said, “deaths are expected to exceed 600,000 before we start to turn the corner”.

There have been important disruptions to the supply and distribution of vaccines in the US. Biden has stated they plan to oversee 100 million vaccinations in his first 100 days. Since two doses are required for each person (although the Financial Times reports some early results from Israel suggesting that the Pfizer vaccine is 90% effective with only one dose), that means only 50 million of the 323 million Americans can be expected to be vaccinated by the end of April – at best. Apparently, herd immunity can be achieved with around 70% to 80% of the community so vaccinated. That still leaves a long way to go but it’s a great start.

There are many unknowns in these vaccine roll-outs. Does the vaccine work as well with the new strains of the virus? Moderna has stated their vaccine is much less effective with some new strains but that they are developing a new ‘booster’ vaccine. Germany is reported to not giving the AstraZeneca vaccine to over 65s because it does not work well enough – but the EU approved it anyway!
Provisional results for Novavax suggest it is 89% effective against the original strain and 85% effective against the UK variant. It is reported to be much less effective against the South Africa variant.

Can immunised people still pass on the virus? For how long does immunisation last? None of these issues, and more, should stop us supporting the initiatives. What we wonder is when will the US and global economy be relatively safe from the effects of the virus?

Much of US economic activity depends on international travel and trade. Unless all other relevant nations’ populations are largely vaccinated, normality cannot return in full. The latest growth figures for the US shows that the stellar result for quarter 3 (Q3) has pulled back to 1% for the Q4 quarter – not bad in itself but GDP for 2020 is still 3.5% below 2019’s figure.

Both the US and Europe are very much engaged in tackling the virus. Poorer countries are at the back of the queue in being allocated sufficient vaccines to produce herd immunity. Even Australia – certainly not a poor country – is facing supply constraints. And now, the EU is placing export restrictions on exports if home demand is not supplied.

Our government pre-ordered some Pfizer and a lot of AstraZeneca, but no Moderna vaccine. It turns out the AstraZeneca vaccine is insufficiently effective to produce herd immunity and we cannot access any more of the Pfizer or Moderna drugs this year – at least.

Our government’s plan is to use the AstraZeneca vaccine, manufactured by CSL in Melbourne, as a stop-gap until better vaccines become available next year. New vaccines are expected from the US, India, China and Russia. We are not yet aware of their final trial results or their availability.

We surmise that the end is potentially in sight as, according to Johns Hopkins university COVID-19 tracking, the reported daily infection rate has been falling for the last month. But we still have a long way to go and there may be fresh outbreaks and shutdowns along the way. We feel that stock markets have priced in a best-case scenario so we would not be surprised to see more market volatility until it is clear that we are indeed defeating the virus and the world can focus beyond it.

Meanwhile the Chinese economy is going from strength to strength. China surprised on the upside with its economic growth figure of 6.5% in quarter 4, 2020 compared to its 6.3% expectation. Its industrial output and fixed asset investment both beat expectations but retail sales missed at 4.6% compared to an expected 5.5%. Exports grew a stellar 18.1% against an expected 15.1%.

China slapped sanctions on 28 people from the Trump administration. Its air force has also recently conducted 20 flights in Taiwan airspace over one weekend in what has been described in some media outlets as a direct challenge to Biden. It is yet to be seen if Biden can smooth things out but there has been no sign yet of him intending to repeal the massive Trump initiated tariffs placed on Chinese imports to the US. If they were as bad as many suggested, why not repeal Trump’s executive orders?

At home, there are still many unresolved issues in the China-Australia trade war. China has held up, or imposed significant tariffs on, a variety of imports from Australia such as coal, wine, barley, copper and timber. It is not clear what China’s end-game is but iron ore prices increased rapidly through 2020 and there seems no end in sight for China’s demand of that ore. Is China trying to craft a strategy to impact iron ore prices?

Our labour market data continued to improve but the consequences of changes in COVID-affected immigration pressures may not have yet fully worked themselves into our economy.

We feel that it is time to set an investment strategy that is looking through to 2022 and beyond – and be prepared to ride out any short-term volatility in the early part of this year.

We see Biden as being too tied up with impeachment proceedings, senate committee structures, coronavirus issues and healing the rift between the two extremes of the political divide in his first 100 days to even think about tax and other policies. He campaigned on raising taxes (income, corporate and capital gains) and no doubt he will eventually make some moves in that direction. In spite of all of the fiscal stimulus packages, he will have to move slowly so as not to rock the boat too much.

We also see Australia continuing to pursue stimulus top-ups as needed. So, as far as we are concerned, there is likely to be a big push of stimulus-induced growth here and in the US. As a result of fiscal stimulus and the Federal Reserve’s quantitative easing programme, we see continued weakness in the US dollar. Providing commodity prices hold, it is possible that the Australian dollar against the US dollar will strengthen. But, again, we emphasise possible stumbles in markets if the re-opening of economies is adversely affected by new COVID outbreaks.

The consensus 2021 forecast for the S&P 500 is for a capital gain of about 10.5% and for the ASX 200 the forecast is 9% but, of course, our dividend yield is usually about 2% points higher than in the US – and many of us also benefit from franking credits. Our in-house forecasts are slightly more optimistic than the consensus but we are not expecting markets to move in a straight line.

There is little hope for interest rate increases in 2021. And in an uncharacteristically forthright announcement the RBA, following its meeting on February 2, committed to holding cash rates and terms out to 3 years at record lows of circa 0.10% out to 2024 and increased their bond buying program by $100 billion. These are appropriate but extremely accommodative policy settings designed to support the Australian economy through COVID-19.

Asset Classes

Australian Equities

The ASX 200 had a flat month in January but the Consumer Discretionary, Financials and Telcos sectors had strong gains. We have noted that the consensus forecast for capital gains is 9% (plus dividends and franking credits). While we have no material issue with the consensus forecast, we are concerned that the market is vulnerable, given its lofty valuations, to unexpected bad news most likely resulting from COVID-19 related events.

International Equities

The S&P 500 gained strongly in January until the last three trading days when it gave away those gains – and then some. It would seem that some disappointing news on vaccines, retail traders taking on short-sellers and the Federal Reserve’s comments about headwinds were the main contributors to the retracement.

We expect the S&P 500 also to have a relatively good year – as does the consensus forecast of 10.5%, though the current high valuations present a risk. While accurate valuation of stocks is difficult at the best of times and markets are expensive now when assessed against historical multiples, in an environment of historically low interest rates higher multiples can be accommodated. Our assessment is that providing interest rates stay low and Governments maintain stimulatory policy settings the current regime could persist for some time. In this environment we remain vigilant but we are fully invested.

Bonds and Interest Rates

It is generally accepted that central banks have done just about all they can to stimulate the global economy. They still need to continue quantitative easing – or the process of buying and selling bonds and other assets to manipulate interest rates. Official rates, being zero or close to it, are unlikely to be cut further. It is all down to elected governments using fiscal policies, as appropriate, to stimulate their respective national economies.

Bond rates are very low by historical standards and they are likely to stay there. Denmark recently announced a 0% interest rate 20-year home loan! Given the fees and break costs in term deposits, together with inflation, this creates a challenging environment for term deposit and bond investors as returns are the lowest in living memory.

Unsurprisingly, in Australia under the current regime there has been an increasing demand for equities exposure to support income return via dividend payments. With the inclusion of franking credits, gross yield is at circa 4.0% – a very big difference to that available in traditional fixed interest investments. However over longer periods, such as 5 or 10 years, Australian equities have always done well – or not too badly. It’s a question of having sufficient cash or bonds to ride out the dips in order to avail oneself of the higher yields in equities – but, of course, with an appropriately diversified portfolio.

Other Assets

Bitcoin and other crypto-currencies have been in the news again. New highs were reached recently and some hopes were dashed. The story of one particular ‘investor’ accidentally throwing out his hard drive to the tip – only to then offer the council $50 million to dig it up (because it contained his Bitcoin ‘wallet’) tells it all. There was another story of an ‘investor’ having failed on his first eight of ten password attempts facing the prospect of losing the lot if his next two guesses also fail! And there was the Mt Gox exchange hack that cost investors dearly.

Obviously, profits can be made in any asset class such as art, vintage cars and the like. But, for normal risk-averse investors, stocks, property, bonds and cash define the bulk of the universe for prudent capital allocation.

More traditional ‘other assets’ like iron ore, copper and gold had a flat to weak month but the price of oil rose by around 8%. Volatility on Wall Street was well down until it spiked during the end-of-month sell-off. Our dollar against the US dollar was stable over January.

Regional Review

Australia

Australia’s economy always has a ‘sleepy month’ in January. 2021 was no exception. The only important data to be released maintained the view that our labour market is doing quite well given the existence of the pandemic. The unemployment rate is down to 6.6% after peaking at 7.5% in July 2020. This rate was 5.1% in December 2019. The government is predicting that it will take four years for unemployment to get back to pre-COVID rates.

There were big concerns about fresh breakouts in COVID-19 following Christmas and New Year celebrations. There are restrictions of various types across the country but it seems there is a will to get back to normal quickly.

Australia is much better off than the US or UK in handling the virus. We ranked eighth in a study of 100 countries in how well we have dealt with, and are dealing with, the virus. New Zealand came first.

Arguably, our biggest problem is that we backed the wrong horse in the vaccination stakes. The Oxford University – AstraZeneca vaccine turned out to be an underperformer as we reported in these updates last year. Its ‘efficacy’, or the ability to immunise people from the virus is too low to prevent herd immunity. Herd immunity is the concept that the proportion of people in the community that are immune is so high as to make transmission rates to others to be very low and eventually fizzle out.

Our government tried to get more of the superior Pfizer and Moderna vaccines but that event is ‘sold out’. We will have to use a less-than-premium vaccine until we can secure supplies of something as good as the US is rolling out.

There is no question of safety. It is just that efficacy rates are about 60% compared to the 95% of the “mRNA” vaccines produced by Pfizer and Moderna. Unfortunately, it is a ‘watch this space’ for news on how we will cope with the medical side of the pandemic.

Naturally, our economy cannot get back to anything like normal while we are not safe from the virus. Between now and then we expect short periods of lockdowns and disruptions that will slow down economic growth. The same is true for other countries but we have a less than optimal vaccine solution which is likely to see greater focus on social measures such has lockdowns, social distancing etc.

China

China is angling for a new relationship with the US after the end of the ‘hard-ball’ Trump administration. They certainly have focused their ire on Australia for the last few months so it is a question of whether Biden marches arm-in-arm with Australia down Pennsylvania Avenue or whether he throws us under the bus.

We are yet to see where Australia-US relations will head. On our own, we may have problems dealing with China’s wrath on Australia because of our prior allegiances to the US and our comments on China’s role in starting the pandemic.

On the bright side, China’s economic data has looked pretty good. First in – first out of the pandemic has put China in good stead. Their economic growth just came in at 6.5% p.a. which would have been seen as a positive pre-COVID.

Exports recorded a growth of 18.1% against an expected 15% while imports came in at 6.5% against a 5% expectation.

US

The US economy is going through a massive transition as its economy deals with the consequences of COVID-19. Jobs and other economic data are worse than pre-COVID days but much better than at the height of the February 2020 to July 2020 part of the crisis.

The latest nonfarm payrolls data recorded a loss of 140,000 jobs when +50,000 new jobs were expected. The unemployment rate was 6.7% against an expected 6.8%.

Q4 GDP growth came in at 4% (annualised) or 1% quarter-on-quarter. Since the economy is still rebounding from the Q2 low, 1% is not great however, in an ordinary year it would have been. That growth in GDP in 2020 over 2019 was 3.5%, a lot more growth is needed to get back to previous highs.

The Case-Shiller house price index across 20 cities was up 9.5% over the 12 months to November – which is near record highs.

The big thing that we don’t know is how Americans will react to new rules and regulations over COVID. First amendment rights seemingly reign supreme in the US. Will they wear masks – especially after some have the comfort of having been vaccinated? Americans are very different people from Australians, British and Europeans.

We see that there is a clear light at the end of the tunnel. But it will not be an easy road to get there. Biden has promised much and hopefully he will achieve. But, what if he doesn’t? It is a country politically divided by so much.

Europe

A month after Brexit, there still seem to be no major fall outs after the exit. Of course, Britain is in a bit of a mess over their handling of COVID-19 but that has nothing to do with Europe and the Brexit negotiations.

The EU and UK economies are not doing well. But, in the short-term, it is more of what governments are prepared to borrow to stimulate economies rather than what economies can do for themselves.

Given that the EU is now restricting exports of vaccines if they need it first, there seems little chance that Australia will get its fair share – or even what it ordered – this year.

Rest of the World

While all of the vaccine roll-outs get underway, little seems to be written about when the rest-of-the-world can access the vaccine. One SBS News report did mention a full global roll-out might take until well into 2024. Israel and certain Arab Gulf states are well ahead in vaccinations. Israel has already vaccinated over 25% of its population.

Until all nations that interact with the developed world are largely vaccinated, there can be no complete herd immunity. And that brings us to who will pay for those vaccinations?

Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.

Recovery continues but short-term uncertainty taints 2021 prospects

• COVID-19 vaccines rolling out but slower than anticipated – a more contagious strain emerges
• China trade dispute with Australia showing no signs of easing
• Brexit deal clinched finally and on terms favourable to the UK

The Big Picture

When we try to look back through the events of 2020, it is hard to see back through to the beginning of the year without getting caught up in the impact of the pandemic. On reviewing our monthly update reports we can get a clearer view about what we and others were writing about throughout the year – and not coloured by opinions as they evolved over time.

Twelve months ago, the big news was that the anticipated China Phase I trade deal might end the tariff war with the US and the prospective impeachment of Trump. Of course, at home we also had massive bushfires and floods to deal with.

In our March issue we noted that COVID-19 had not yet been classed as a pandemic and that the World Health Organization (WHO) proclaimed that the virus was ‘flu-like and would only have a mild impact on most people’.

Come the run-up to the November US presidential elections everyone seemed to believe that they knew back in January what they would have or should have done. Everything is easy in hindsight.

Many countries tried different approaches to containing the virus with very different outcomes. There were no real winners but Australia and New Zealand didn’t fare too badly by comparison.

With vaccines starting to be rolled out in the UK, US, Europe and soon Australia, health authorities can start to get on top of the virus. However, there are likely to be a number of hiccups along the way. We think the markets were a bit too optimistic in the last two months of 2020 given the potential downside risks.

Not all of the vaccines have proven to be effective and some clinical trials were contaminated with miscommunications about dosages. Of course, there are major distribution issues to be dealt with. And we cannot ignore the irresponsible attitudes of some groups of people in Australia and overseas.

In addition to the virus, the China-US trade spat dissipated leaving China’s ire directed at Australia. With very little explanation, China has been refusing significant imports of coal, lobsters, wine, beer, barley, timber, etc. If this situation continues and/or escalates, there will be a significant impact on Australia’s trade balance, with potential consequences for economic growth.

It is too early to tell what impact Christmas and New Year’s celebrations will have on future restrictions to combat the spread of the virus. Our quarter three (Q3) economic growth came in at a solid 3.3% p.a. after the two negative quarters of growth. We could easily slip back into negative growth in the first half of 2021 as the reintroduction of measures such as lockdowns to contain the virus if people are not vigilant in practicing COVID safe behaviours such as mask wearing and social distancing.

Macro-economic data for Australia, the US and China largely finished the year quite strongly but the job is far from done. A new more infectious variant of COVID-19 was identified in London and the surrounding south east of the country. That brought about a fresh lockdown in that region. There are reports of this and other new strains appearing in other countries including Australia. What is not yet known is whether the vaccines will deal with the new strains as effectively as they apparently deal with the original virus.

On top of the uncertainty due to new strains developing, we do not yet know if those who have been vaccinated can still pass on the virus to others. Also, it is not known how long immunity from the virus will last after vaccination. Spokespeople are seemingly confident in their media releases but what else can they say? There is yet no data.

Our research points to markets remaining generally positive in the medium term but we cannot rule out a dip in share markets in the first part of 2021. This assessment is based more on share markets potentially getting ahead of themselves when supported by the ongoing and strongly accommodative monetary and fiscal policy plus the roll out of the vaccines to treat COVID-19.

The Georgia run-off senate elections on January 5th will have a big impact on who will really govern the US for the next period. The initial results announced this morning resulted in a win for both democrat candidates and, in effect handing control to the Democrats as Vice President Harris having the casting vote in Senate now composed of 50 seats to both the Republicans and the Democrats. This result is expected to initially buoy markets as impediments to stimulus spending under a Biden administration are largely removed.

But 2020 did end with one very good piece of news. The UK reached a trade deal with the EU which rules out tariffs and quotas. There has been no reported large-scale migration of the London finance sector to Europe. For the last four and a half years many were predicting a disaster for Britain. It has had a very bad year because of the virus but the longer-run future is now looking somewhat brighter.

In its negotiations with the EU Britain got most of what it wanted. The only real disappointment was EU access to UK fishing resources. The EU’s share will be scaled back over the next five years from a 50% share now to 25%.

Our outlook for 2021 remains largely positive subject to some speed bumps along the way. Vaccines may well eliminate or significantly reduce the main threat of infection by the end of 2021. Some businesses and jobs may have been lost forever but there is also a pent-up demand for certain goods and services that can be satiated in part by rising confidence in the household sector as they drawdown on their increased household savings accumulated over 2020.

Asset Classes
Australian Equities

The ASX 200, not including dividends, finished down  1.2% over 2020 but that statistic doesn’t tell the full story. The index was up +7% to its peak in February 2020, but then plummeted  37% to its March low – and then rose +45% into the end of the year. If we look at the sectors over the whole of 2020, about half were up and half were down. But, at the extremes, the IT sector was up 56% and the Energy sector was down by  30%. It was easy for stock pickers to get on the wrong side. And that’s why prudent investors try to diversify their risks.

We had the market precariously over-priced at the February peak and massively under-priced in March. We believe that the market was over-sold in March because nobody really knew how bad or how long the shutdown would be. So, sell now and ask questions later was the plan for many investors.

We had the market quite over-priced again in December for the opposite reason. Investors were ‘relieved’ that vaccines were at last going to be available and scrambled to get back in for fear of missing out. We have broker forecasts of dividends and earnings pointing to a strong twelve months’ capital gain. But, with the market slightly over-priced by our measures and certain headwinds possibly in the future, caution should, as always, be exercised.

International Equities 

The S&P 500, the Japanese Nikkei, Emerging markets and the world index all posted double digit growth in 2020. Of the other indexes we follow, the German DAX was flat and Britain’s FTSE was down 14%.

The S&P 500 was quicker out of the blocks than the ASX 200 in 2020 posting +15% to our +7% to the February peak. But this index fell a little further than ours at  40% compared to our  37% in March. However, it climbed much better to the end of the year at +67% to the ASX’s +45%.

Many analysts are saying that it is hard to work out what, or by how much, stocks are over-priced when bonds have close to a zero return. We agree, but we are less inclined to brush the problem under the carpet. We prefer to hold a more conservative view that the US market is a bit over-priced.

Much of 2020s gains on Wall Street were due to the growth in big tech companies. At the best of times, these companies are hard to price. We remember the dotcom boom and bust. However, it is a new age and we must take on some additional risk to stay with the trade.

The Yahoo Finance website lists the forecasts of a dozen respected houses for the end-of-year S&P 500 index. The median is 4,150 with the low and the high forecasts being 3,800 and 4,400. Our forecast is between this median and the high value. The end-of-year close for the index was 3,742 making the median forecast being 10%.

Bonds and Interest Rates

The US Federal Reserve cut its ‘Fed funds rate’ three time during 2019 down to a range of 1.50% to 1.75%. At the beginning of 2020 the Fed was predicting one 0.25% hike in 2020 and another in 2021. Instead, it effectively did six cuts in March 2020 down to a zero rate. Further QE (quantitative easing) took place throughout 2020 and it is predicted to continue.

The Fed has repeatedly stated that rates are lower for longer. Not only do they and market participants now expect no hikes in 2021, they do not expect any in the following year.

The Reserve Bank of Australia’s (RBA) overnight cash rate started 2020 at 0.75% and it cut to a ‘creative’ 0.1%. It has been trading bonds to keep the three-year rate at about 0.1% and longer rates lower than they otherwise would have been.

Central banks in the US, Australia and most other countries have done about all they can to help their flagging economies from grinding to a halt. Since the ‘recession’ was wilfully created by public health measures to stop the spread of the virus, it was left to governments (as is their role in such situations) to expand fiscal policy for more economic stimulus.

The US government launched a massive aid programme earlier in the year but it dragged its feet in keeping that initiative going. Eventually, Trump signed a bill for around $900bn of coronavirus aid just after Christmas. The Democrat-led lower house then sought to increase one-off payments in the bill from $600 to $2,000. So far, the Senate has rejected that plan, despite support from President Trump.

The Australian government was far more proactive in providing aid. Various programs such as JobKeeper and JobSeeker have helped those in most financial need. However, these programs are being scaled back as the economy recovers.

We start 2021 with central banks left with little wiggle room on interest rate settings but governments remain willing to create a mountain of debt to prevent economic disaster. Australia is now looking at a one trillion-dollar government debt in 2021.

With interest rates near zero, the debt is less of an issue but steps must be taken to address the problem as soon as the economy improves.

Other Assets 

There were major movements in commodity prices over 2020. The price of iron ore was up about 75%; oil prices were down around 20% to 25%; the prices of copper and gold were each up around 25%.
The Australian dollar (against the US dollar) started the year at 70 cents, plummeted to 56 cents in March and finished the year having gone above 77 cents.

It should be stressed that some of the recent apparent strength in our dollar has been due to the weakness in the US dollar rather than an inherent strength in Australia. If China continues to intensify its trade war with us, our dollar could start to retreat.

Volatility on Wall Street, as measured by the VIX ‘fear’ index, started the year at an average level of 14 but climbed to 82 at the worst of the pandemic crisis. It finished the year moderately above average at 23.

Regional Review
Australia

Australia was unable to avoid a recession using the simplistic definition of two consecutive quarters of negative economic growth. This policy-induced recession was the price of maintaining public health standards. The economy bounced back sharply in Q3 with a growth of 3.3% in just one quarter but that left GDP still 4% below where it was in the last quarter of 2019.

Unemployment was unexpectedly quite resilient in 2020. It was 5.1% in December 2019 and rose to a peak of 7.5% in July and finished the year at 6.8%. The RBA had predicted the unemployment rate would finish 2020 at 9.3%. It, like many other agencies, admitted that, in hindsight, they were far too pessimistic at the height of the pandemic fallout in March. Of course, the cap on the unemployment rate must at least in part be due to the government’s action with jobs programs.

It is too early to tell how big any ‘new waves’ of virus outbreaks will be – following Christmas and New Year celebrations. The federal health minister has predicted 80% of Australians can be vaccinated by October 2021 – with health workers and aged care residents being at the head of the queue.

We think it is quite possible we will see modest or negative economic growth in 2020 Q4 and/or 2021 Q1. But, providing the government keeps doing what it has been doing, the impact on the population will be largely contained. However, the fly in the ointment is China.

For at least two months, China has been refusing imports of various Australian exports: coal, lobsters, wine, barley, timber, etc. Although some vague environmental reasons have been given, these actions are widely interpreted as payback for Australia’s stance against China on its handling of the coronavirus and our close ties with the US.

If the China-Australia trade spat is not resolved – or, indeed, if it escalates – the chance of negative economic growth in Australia increases.

It is for the reasons of possible fresh lockdowns and trade wars that we are pencilling in a possible temporary downturn in the ASX 200 in the first half of 2021 despite our positive forecasts for the longer term. We think it is too hard to try and trade through any market volatility. If one’s investment strategy was appropriate for the longer term before any major volatility begins then riding the waves is the prudent way to go if one believes the long-run is indeed solid.

China 

China was first into the pandemic and arguably the first out. Because of its style of government, it was better able to control lockdowns and fiscal stimulus. In recent months its economic data were consistently strong.

China weathered the trade war with the US. Big tariffs are still in place with much of its trade with the US. It is not clear what Biden will do, if anything, come his inauguration on January 20th.

China certainly turned its attention to Australia later in 2020. Given its size, Australia is a smaller target than the US and it is seen as a close ally to it.

At first, refusing entry of lobsters and some shiploads of coal seemed a bit random. But the list keeps growing without resolving any of the former issues. Since there seem to be no clear guidelines on what will happen going forward, owners of the exports do not know what to do with their cargoes and the shipowners have their capital languishing around Chinese ports. It is a brave (or is it foolish?) person who predicts what China may or may not do.

US

Although the US presidential election result was called some time ago, Trump has not yet publicly accepted defeat. Nevertheless, Biden will be sworn in as president on January 20th. And now, winning both of the Georgia Senate seats has handed control of the Senate and the Congress to the Democrats in turn empowering the Biden administration to govern without the frustration of having to deal with a Republican controlled Senate.

Different US states can have different voting rules. Georgia is not a first-past-the-post state so it must hold a fresh election after no candidate reached 50% of the vote in November. (They do not have preferential voting as we do in Australia)

It is also unusual for two seats to be up for election at the same time. The second seat came into play because a sitting senator resigned before the election and so a temporary senator was sworn in.

US economic data picked up strongly in Q3 but renewed lockdowns of varying intensities lead some to predict negative growth in coming quarters.

Biden is committed to a variety of tax increases (income, company and capital gains) but the fragile nature of the US economy could soften his agenda.

Because Trump delayed in signing the latest COVID relief package, millions of Americans will have gaps in their welfare payments. Many will now get only a $600 relief cheque compared to $1,200 in 2020 and the $2,000 wanted by many for 2021.

No doubt the US will muddle through managing its economy but we do not see the new government moving swiftly through its agenda. Despite now having the balance of power in Congress the majority is slim and there are factions to deal with within both parties – as there are in our governments.

Europe 

Boris Johnson and his team of negotiators pulled a rabbit out of the hat on Christmas Eve. Brexit negotiations which seemed to go nowhere for four and a half years suddenly came to fruition and both sides claim to be winners!

Britain got what it wanted on trade, regulation, competition policy and the movement of labour. They did have to give ground on access to British waters. The deal allows for Europe to have a 50:50 share of fish trawled in 2021 falling to a 25% share in five and a half years.

What is surprising is that the side that was pro-Europe in the referendum and thereafter were calling for all sorts of mayhem including a mass exodus from London’s financial centre. Clearly that is now seen to have been a massive miscalculation.

But Europe has imposed strong travel bans on flights from the UK because of the new strain of the virus. Because there will effectively be free trade between the UK and Europe, and certain drains on UK resources to Europe will cease or be limited, UK growth may recover strongly from its disastrous growth in 2020. However, the transition will not be quick.

Rest of the World 

While vaccines are being rolled out in some of the wealthier economies, it is not yet clear how developing countries will be allocated vaccine supplies. In order to insulate the world from further outbreaks, all countries need access to appropriate healthcare.