Economic Update March 2021
by Infocus Author
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.