Global markets on edge over US inflation figures

US CPI figures are keeping global markets, including the ASX, on edge. Picture: Gaye Gerard

US inflation data has been shaping up as a key short-term driver of global markets.

Plunging bond yields helped lift the local sharemarket to another record high on Thursday, as the S&P/ASX 200 share index rose 0.4 per cent to 7302.5 points. Meanwhile, the 10-year bond yield fell as much as 10 basis points to a near four-month low of 1.478 per cent, after US bond yields hit a more than three-month low before the overnight release of US CPI data for May.

Last month, inflation jitters caused by surging commodity prices and the release of surprisingly strong April US CPI data sparked a modest 3.5 per cent dip in the Australian sharemarket.

But it rose 6 per cent to a record high of 7334.9 in the next three weeks as US 10-year bond yields fell from 1.82 per cent to 1.48 per cent despite signs that central banks will achieve their goal of increasing inflation and warnings from analysts about the risk of an overshoot.

JP Morgan’s head of global derivatives strategy, Nikolaos Panigirtzoglou, said the bond market rally was driven by risk parity funds and macro hedge funds increasing their duration exposure, and CTAs buying 10-year US Treasuries, at time when short interest in the US bond market was relatively high.

However, with US inflation signals building rapidly in the past two months and the Fed saying that a number of FOMC members at its late April meeting said that might be soon be appropriate for the Fed to start discussing a plan for reducing its asset purchases if the economy keeps making rapid progress toward its goals, the US CPI numbers were expected to be very important.

Despite the surprising fall in bond yields of late, the “rise in yields is not over”, according to Macquarie’s Australian equity strategist, Matthew Brooks.

He continues to expect higher bond yields due to economic reopening and higher inflation.

The US 10-year bond yield should hit 2.25 per cent by December and 2.50 per cent in 2022, with the “real yield” component expected to take off after the Fed signals the potential for “tapering” of its asset purchases – something expects to happen at either the Jackson Hole central bankers’ summit on August 26-28 or at the Fed’s September, November or December meetings.

Brooks thinks that rising real bond yields will be a “bigger valuation headwind” for the sharemarket than in the 2013 “taper tantrum” since the average price-to-earnings multiple is 30 per cent higher, albeit with much upgrades in earnings per share recently.

In 2013, a sustained rise in real yields didn’t occur until after the Fed signalled the potential for reduced asset purchases in its May statement, and since the Fed’s latest statement in April doesn’t refer to the potential for reduced asset purchases, “the sustained rise in real yields is yet to come”.

“We continue to think the growth cycle has peaked and that slowing cyclical momentum in the second half of 2021 could drive some rotation to defensives,” Brooks says.

“We still think Financials, Resources and value should outperform as yields rise, and note that Health was the best defensive in the 2013 taper tantrum,” he says.

“We continue to favour reflation trades in the expectation of higher yields, including Financials (including) banks and general insurance, value and Resources, with a shift towards Energy.”

Banks are now seen as defensive as they have the best EPS revisions and potential capital returns.

But while quality growth stocks including some in the Health Care sector are set for a comeback in 2022, it’s more because economic growth will slow next year according to T. Rowe Price.

While the Covid-19 vaccine rollout and policy stimulus have underpinned global reflation in 2021 — favouring Australian companies geared to commodity prices and the global business cycle — strong GDP growth this year is already priced into Australian share prices and growth and inflation may peak in 2021, warns the US fund manager’s Head of Australian equities, Randal Jenneke.

Contrary to the consensus view, he sees “limited scope for interest rates to move much higher given the historically high post-COVID levels of domestic household debt.”

Still, he expects economic growth to fade in 2022 as fiscal stimulus begins to unwind, after being “heavily front-loaded into the first half of this year.”

As a result, consensus earnings growth estimates will likely be trimmed and earnings momentum — upgrades less downgrades — may turn negative, he warns.

“Under this scenario, value is unlikely to continue to outperform growth,” Jenneke says.

“We expect the value rotation trade to first fade and later reverse.”

T. Rowe’s portfolios are now “positioning for the return to favour of quality growth in 2022.”

“In our view, it is not too soon to think of taking profit on some of the value positions that have done well, and to begin positioning Australian equity portfolios for the return to favour of quality growth in 2022,” Jenneke says.

“We note that stimulus as measured by the fiscal impulse — the change in the cyclically- adjusted primary budget balance as a percentage of GDP — is much less in 2021 than it was in 2020.”

In 2022 that’s set to turn negative, causing a “fiscal cliff” that will subtract from GDP growth.

“Under these conditions – a return to slower growth and sustained low interest rates – we believe growth stocks should return to favour,” Jenneke says.

His focus is on “quality growth” via active positions in higher quality businesses and cyclical growth.

“The quality category has underperformed over the past year and has created opportunities within out of favour businesses such as select health care names.”