Economy, bond yields fuel ASX fire, but sentiment mixed

Among previously unloved stocks taking off on Wednesday, Nine Entertainment rose 9.7 per cent, Blackmores rose 6.3 per cent and Viva Energy jumped 6 per cent after their earnings reports.

Optimism about economic reopening after the coronavirus pandemic, and the related surge in bond yields to their highest levels in a year, is having mixed effects on the Australian sharemarket.

Sydney Airport continued to outperform with a 2.5 per cent rise despite weaker than expected 2020 earnings and a lack of guidance on earnings and dividends – albeit the company is “cautiously optimistic that 2021 will see the industry begin to recover”. But other travel stocks stalled.

Still, some other “vaccine winners” – previously seen as “COVID-19 losers” – were finding support from investors at the expense of “COVID-winners”, some of which are also having their valuations tested by the doubling of 10-year bond yields from 0.80 per cent to 1.6 per cent in the past four months.

Among previously unloved stocks taking off on Wednesday, Nine Entertainment rose 9.7 per cent, Blackmores rose 6.3 per cent and Viva Energy jumped 6 per cent after their earnings reports.

IDP Education went from strength to strength, surging 7.2 per cent to be up 169 per cent from its March 2020 low, although it did pare well over half of a 17 per cent intraday rise.

But buy now, pay later favourite Afterpay lost 3 per cent before its interim report on Thursday, Appen dived 12 per cent after disappointing earnings guidance, Xero lost 3.2 per cent, Seek dropped 7.8 per cent on broker downgrades, AP Eagers fell 7.3 per cent and REA Group lost 4.4 per cent. As IG market analyst Kyle Rodda put it, the prevailing issue in markets now is the “simultaneous hope and concern that has come with steepening yield curves across the globe.”

Overall “the trend higher in long-term yields is keeping risk appetite dulled overall,” he says

After such strong gains in the past 11 months, perhaps the feelings of “FOMO” (fear of missing out) and “TINA” (there is no alternative) have been interrupted by a rise in bond yields reminiscent of the early stages of previous bond market routs.

Upgrades of consensus earnings estimates from corporate America and Australia have certainly kept up with the rise in bond yields through the respective earnings periods, but that needs to continue if shares are to rise alongside bond yields, and perhaps upgrades will stall after these earnings periods.

In that regard, JP Morgan global market strategist Nikolaos Panigirtzoglou, notes that the “bond-equity” correlation has actually been rising sharply in recent months – heading towards a situation where the bond market may not give its usual protection from a sharemarket correction.

“The bond market sell-off over the past weeks has been accompanied by a drift up in bond-equity correlation, raising concerns about de-risking by multi-asset investors, such as risk parity funds and balanced mutual funds,” he cautions.

Panigirtzoglou explains that these two types of investors normally benefit from the structurally negative correlation between bonds and equities. It both suppresses the volatility of bond-equity portfolios — allowing investors like risk parity funds to apply higher leverage and thus boost their returns — and improves risk-adjusted returns for balanced mutual funds as equity drawdowns are mitigated by bond allocations. But the opposite takes place when this correlation turns positive as the volatility of bond-equity portfolios increases, inducing these investors to de-risk.

He notes that in the post-GFC period there have been five major episodes where the bond-equity correlation turned positive: the Fed taper tantrum of May-June 2013, the German bund tantrum of May-June 2015, the period heading into the US election Oct-Nov 2016, Feb 2018 and the fourth quarter of 2018.

“Outside these episodes the bond-equity correlation has been predominantly negative, helping to contain the volatility of risk parity funds and balanced mutual funds,” Panigirtzoglou says.

“For the $US150bn ($190bn) risk parity fund universe, the most problematic episode was the taper tantrum of May-June 2013 as they had entered that episode with very high leverage,” he says.

“As a result they were forced to de-risk abruptly and suffered a heavy 10 per cent loss.”

They may not be such a force now since S&P 500 volatility — as per the VIX index — has been mostly well north of 20 per cent since the pandemic, compared to 13 per cent back in May-June 2013.

Balanced mutual funds, a $US1.5 trillion universe in the US and $7 trillion globally, typically give higher allocation to equities (around 60 per cent) but are less mechanical and thus have more flexibility in responding to changes in volatilities and correlations.

“As a result of this flexibility and their higher equity allocation, they posted modest losses during the episodes of May-June 2013, May-June 2015 and Oct-Nov 2016,” says JP Morgan’s Panigirtzolou.

But they suffered heavy losses during the February 2018 and Q4 2018 episodes, as they were caught up with higher equity positioning and thus forced to de-risk by more than the former episodes, which shows the importance of the starting point of risk positioning in determining the eventual loss.

In his view the balanced mutual funds look more vulnerable than risk parity funds now, because after de-risking in January balanced mutual funds appear to have raised their risk positioning by increasing their equity overweights and bond underweights, to high levels in February. Meanwhile risk parity funds kept leverage below average after de-risking in January.

“In other words, if the bond-equity correlation continues to creep up — via a worsening of the equity market drawdown even as yields continue to grind higher — balanced mutual funds pose a greater vulnerability for the equity market.”

Month-end rebalancing (in this case buying of bonds and selling of equities) is also a risk, but Panigirtzolou thinks they fully rebalanced in January and can delay any such action until March.