insights from the CIO

We currently find ourselves entering a new financial market landscape. However, it’s one that provides more scope for opportunity than concern.

Over the past year, market returns have been high, and interest rates have been low. How will this affect future returns, and could low interest rates distort that picture?

We can now reflect upon 12 months since financial markets went into freefall as the uncertainty of COVID-19 took hold. From a financial market perspective, we have witnessed a “V” shaped recovery. Across numerous assets and indices, the one-year returns have been incredibly strong.

Globally, we’ve watched as central bank policies have pushed interest rates into record low territories, including here in Australia. The Reserve Bank of Australia has frequently commented that interest rates are not forecasted to increase until appropriate economic conditions have been met; these conditions are not expected to occur until 2024.

Inflation

Inflation concerns are being stoked from a number of corners, which has led to increased volatility in bond yields over recent months. Investors have started forming a view that inflation risk may not have been priced into fixed income assets.

The key risk is that the economy continues to recover so strongly that it overheats. However, this appears unlikely in the near-term given the output gap and labour force employment rates in Australia, and most regions around the world. This persistent slack in the labour market doesn’t support inflationary conditions at this stage.

Equity market volatility

Rising bond yields also had a flow on effect, creating volatility in equity markets. As bonds yields rise, lower risk assets become more attractive, and higher returns are demanded from investors in riskier assets to compensate. To achieve these higher returns, in the absence of strong earnings growth, price becomes the balancing item.

Rising bonds yields have a particularly amplified impact in the tech sector, where anticipated future growth is priced in on a larger scale. As such, rising yields create a larger opportunity cost for investor waiting to realise the future profits from tech stocks.

Nevertheless, financial markets have had much reason for optimism over recent months. Government stimulus has helped economies absorb the demand shock created by the COVID-19 pandemic. Whilst some stimulus measures begin to be withdrawn, such as Job Keeper here in Australia, other stimulus packages, such as Joe Biden’s USD$2Trillion infrastructure package, pave the way for continued economic growth.

COVID-19 vaccine rollout

The rollout of the COVID-19 vaccine continues to stoke optimism across financial markets as restriction-bound economies move closer to re-opening. The world has kept a close eye on the vaccine rollout and many countries have continued to gradually navigate through nation-wide vaccine programs. Despite hurdles along the way, vaccine doses administered globally continue an encouraging climb.