Market Update
“Today is a gift, that’s why they call it the present” Anonymous
Things on the domestic front remain a little mixed. Westpac forecasts business investment to grow from 3.7% to 6.7% in 2021 and 5 to 5.9% in 2022. Offsetting that was a reduction in our forecast for consumer spending in 2021 from 5.8% to 4.7% although the expectation is that most of the lost ground will be made up in 2022. Whilst consumer spending contracted slightly during the March quarter, the current savings rate of around 12% is well above Westpac’s estimated 5% equilibrium suggesting there is plenty of scope for falling savings rates to boost household spending.
The latest lockdowns have somewhat dented optimism around labour market prospects in Australia. The Westpac Melbourne Institute Index of Unemployment Expectations jumped 8.2% in June (recall that higher readings on the Index mean more consumers expect unemployment to rise in the year ahead). ‘Jobs confidence’ is still positive, the index was coming off its best read in a decade in May, but the fall has taken the index nationally back to the levels seen leading into last Christmas. As we have stated before aside from inflationary pressures a tightening labour market will be major factors influencing the RBA on what it does with interest rates going forwards.
In terms of the landscape overseas, turning to the US, the focus has been on the May CPI print. Like the April read before it, May was another upside surprise, headline prices rising 0.6% to leave annual inflation at 5% — another record high back to 2008. Inflation will remain a key focus for the Fed in determining future monetary policy. The ECB has also left its policy stance unchanged which is no surprise. The reality is that most central banks around the world will take the lead from the Fed, until this changes its unlikely we’ll see much change to the status quo.
It’s still somewhat unbelievable to think that economies around the world seem to be performing better than they were prior to the pandemic. It’s almost worth asking the question how things may have looked if we didn’t have a pandemic. I think it’s fair to say that the primary reason for this V shaped recovery was that central bank around the world essentially super-charged economies hence the current climate. The question that remains is how the central banks are going to pay down the debt, but what’s for certain is that interest rates are going to remain low for some time and higher-yielding investments are very much in return.
The chart below paints an interesting picture. It shows the spread between short-dated (5 YR) and longer-dated (30 YR) bond yields. The key takeaway from this is that the US market, and the same can be said for markets elsewhere, are very much already factoring in higher interest rates.
This week’s topic relates to what is known as “rational expectations theory”. Rational expectations theory states that players in the economy will act in a way that conforms to what can logically be expected in the economy. That is, a person will invest, spend, etc. According to what they rationally believe will happen in the future. By doing so the person created a self-fulfilling prophecy.
Although this theory has become quite important to economics, its utility is doubtful. For example, an investor thinks a bond is going to go up, and by buying it, this act causes the stock to go up. This same transaction can be framed outside of rational expectations theory. An investor notices that a stock is undervalued, buys it, and watches as other investors notice the same thing, thus pushing the price up to its proper market value. This highlights the main problem with rational expectations theory: It can be changed to explain everything, but it tells us nothing.
In summary, central banks around the world are essentially conducting the global orchestra for now, and a few key instruments are dictating the tempo of the music – inflation, tightening labour markets and wages growth. We can’t see this changing in the short term and continue to direct investors to the high yield opportunities below.