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Macquarie Wealth Management: 05 July 2021 Research - The Financial Year That Was: Better than expected ... and likely to continue

  • The global and domestic economies recovered much faster than expected through fiscal 2021, driven by unprecedented monetary and fiscal policy supports, a faster than expected re-opening of economies, earlier than expected vaccine rollouts, the release of pent-up demand and (surprisingly) resilient business and consumer confidence, which supported a sharp rebound in hiring, investment and spending once social restrictions were relaxed.
  • Global equity markets rose 40% with Australia, while an unfortunate laggard, still posted an impressive 28% gain. Equities were boosted by a depressed starting point, record low interest rates (supporting valuations), a faster than expected improvement in fundamentals (earnings & dividends), strong policy guidance by central banks, elevated confidence and a lack of alternative investments as bond yields fell to cycle lows.
  • Bonds yields fell to record lows early in the financial year but rose substantially when news of a vaccine emerged and confidence in the economic recovery began to gain momentum. Rising inflation fears drove another leg up in yields but not enough to undermine the economic recovery nor equity markets despite being expensive.
  • Rate sensitive assets, such as housing, had a stellar rebound, as did commodities due to demand outstripping supply, and other alternative assets such as cryptocurrencies, which began to gain broader acceptance. While the outlook for most assets looks more sanguine after the size of gains in 2021, the combination of above average economic growth, above average levels of liquidity and below average levels of interest rates will continue to be a positive tailwind into 2022.

Economic Backdrop

Policy support combined with vaccine progress…

During 2Q20, the global economy suffered its deepest economic downturn since WWII as a consequence of the sudden stop to economic activity brought on by COVID-19 lockdowns. However, by the time the 2021 financial year began, China had already undergone a V-shaped recovery and most developed economies were beginning theirs. The speed of economic recovery was largely due to the unprecedented levels of monetary and fiscal policy support provided by central banks and governments in an effort to limit the damage and provide a springboard for recovery. In addition, policy supports were given a major boost in November by news that (multiple) vaccines with high efficacy rates had been developed, providing a fillip for both business and consumer confidence across the world. Markets followed a similar path, rebounding strongly into the start of the financial year (bottoming in early April-20) and never looking back as they absorbed the hits from - rising rates, further COVID-19 outbreaks, rising political tensions, elevated valuations and fears of earlier than expected rate hikes – to post their best financial year returns since 1987.

…drives V-shaped recovery

By the end of FY21, global GDP had already recovered back to its pre-COVID level – surpassing even the most optimistic of forecasts made a year earlier. The US economy led the way, supported by a powerful cocktail of successful vaccination rollouts, and unprecedented monetary and fiscal stimulus as President Biden unveiled one massive stimulus package after another. The Eurozone lagged, dragged down by further COVID-19 outbreaks, but by the end of the financial year it too was recovering. China’s economy, having recovered earlier than others, has been a victim of its own success, with authorities having to tighten policy in order to prevent the economy from overheating and to rein in speculative activity in certain areas (i.e. commodities).

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Reflation triggers inflation fears

One of the biggest developments within financial markets over the past year was the US-led rise in inflation expectations, which drove a sharp increase in global bond yields through Nov-20 into Mar-21. The increase was driven by a combination of factors including supply chain disruptions (brought about by border closures and lockdowns) on top of extraordinary levels of monetary and fiscal policy support. Many believe we are on the cusp of a structural increase in inflation although the jury is out with central banks continuing to attribute transitory factors to the increase and continuing with a long-held view that as economies normalise, broader inflation headwinds will resume. Irrespective, it’s likely that bond yields hit their cycle lows during the past year and will continue to creep higher as the economic recovery gains momentum both here in Australia and offshore. At this stage, neither the RBA nor the Fed have drastically altered their interest rate tightening timetable with growth rather than inflation concerns likely to be the driver of an accelerated rate hike cycle.

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The Australian economy recovers strongly…

The Australian economy recovered strongly over the past 12 months, with both GDP and employment now surpassing pre-COVID highs and business (predominantly domestically exposed) reporting record strong trading conditions. The Australian housing market was a bright spot for the economy, with house prices and construction activity rising sharply, supported by government policies and incentives, elevated consumer confidence and ultra-low interest rates. The Federal Budget delivered in October was highly expansionary and was a clear indication that the Federal Govt. was prepared to put the economy ahead of long-term debt concerns. However, a steadily worsening ‘trade war’ between Australia and China, while not having a major economic impact, remains an ongoing risk that could easily escalate into a more significant economic drag.

Markets Backdrop

Risk assets benefit from a policy tsunami…

Equity markets had a phenomenal year – both here in Australia and across the global - boosted by a depressed starting point, record low interest rates (supporting valuations), a faster than expected improvement in fundamentals (earnings & dividends), strong policy guidance by central banks, elevated confidence and a lack of alternative investments as bond yields fell to cycle lows. The MSCI World Index rallied to record highs and posted its best financial year return since 1987, rising 40% (total return in US$).

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…Positive returns but substantial dispersion

US equities led most global markets higher, posting a 41% total return. This largely reflecting the relative strength of the US economic recovery alongside ongoing monetary policy commitment and a high weighting towards structural growth stocks.

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Every major global sector posted positive returns through FY21. However, there was substantial dispersion in returns as cyclical sectors generally outperformed defensive sectors – a reversal of the early year trend as stocks and sectors that had been ‘winners’ from COVID lockdowns became ‘losers’ following the vaccine-triggered rotation in early November. Financials were a standout given the outperformance of the Banks sub-sector, both domestically and overseas, where the demand for credit rebounded strongly, curve steepening boosted expectations of margin expansion and recovering housing markets saw a write-back of loan losses taken during the worst of the pandemic.

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The long awaited ‘value’ rotation arrives

Following the US election outcome alongside positive vaccine announcements that boosted expectations around the strength and sustainability of the global recovery, ‘value’ stocks finally began outperforming growth stocks, which had been supported for years by a lack of growth and low rates. Over the following seven months, the style shift would remain in place albeit with mini-reversal periods as expectations of rates and inflation fluctuated.

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Australian equities hit a record high

Australian equities (+28%) posted their best total return since 2007 and second-best since 1987. The sector trends in Australia were similar to the rest of the world – being led by a sharp rebound in domestically orientated cyclicals and financials - although the Utilities sector posted a negative return, weighed down by concerns over climate change and decarbonisation in particular. For the most part, thematic trends seen in offshore markets were replicated in domestic performance with value (+39%) outperforming growth (+16%) and small caps (+33%) outperforming large caps (+28%).

The banks sub-sector (+51%) was the standout performer in the Australian market, benefitting from strong credit demand, better than expected credit quality (due to a red-hot housing market), weak competition for deposits and margin gains as the yield curve steepened. The gold sub-sector (-18.5%) was the worst performer, weighed down by a gold price that weakened sharply after peaking in August.

As is typical during rallies, IPO and M&A activity surged, with Australian IPO activity reaching its highest level since 2007.

It was a strong year for many stocks with the list of strongest performers dominated by the materials and industrial sectors. Commodity related stocks were boosted by both stronger than expected demand and in many cases supply side shortages with Mineral Resources (MIN, +168%), OZ Minerals (OZL, +108%), ALS (ALQ, +103%) Fortescue Metals Group (FMG, +90%) and Bluescope Steel (BSL, +90%) amongst the best performers. Other key winners through the year included stocks exposed to structural commodity demand, Lynas Rare Earths (LYC, +199%) or housing (Reece (REH, +159%), Boral (94%)).

The list of underperformers was dominated by gold stocks (Northern Star Resources (NST, -25%), Newcrest Mining (NCM, -19%), Evolution Mining (EVN, -18%)), Utilities (AGL Energy (AGL, -49%), Origin Energy (ORG, -19%)) or those affected by China’s ban on Australian coal exports (Aurizon Holdings (AZJ, -19%), Orica (-19%)). A2 Milk (A2M, -68%) underperformed in part due to the rotation out of growth stocks.

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Bonds returns weak as yields rise…

In contrast to equities, it wasn’t a good year for government bonds, with yields rising (hurting the prices of bonds) due to improving economic growth and emerging fears of higher inflation. The US 10-year Treasury yield peaked in March at 1.74%, having started FY21 at 0.65%. However, from March to the end of June bond yields fell as investors re-assessed the inflation risk as ‘transitory’. Global government bonds posted a negative 1.2% US$ return for the year while Australian government bonds’ total return was negative 1.9%.

…but corporate bonds shine as spreads tightens

It was a better year for corporate credit, with global corporate bond and high yield bond indices posting a 5.7% and 14.6% US$ total return respectively. A tightening in spreads was driven by a reduction a much stronger than expected economic backdrop, declining risk aversion and an ongoing thirst for higher returns out of fixed income investments.

Commodities rally

A wide range of commodities rallied through the financial year, propelled by a combination of re-opening of economies (improving demand), monetary and fiscal stimulus and in some instances tight supplies. Broad commodity indices peaked around May-21 before easing back Chinese authorities announced steps to curb what they called ‘unreasonable’ price increases in a number of commodities. A highlight was the price of lumber, which was up 280% at one point before falling back 40% in June. Not surprisingly precious metals (particularly gold) did not participate in the rally, falling victim to falling risk aversion and rising bond yields.

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The US$ weakened…

Major currency news was the decline of the U.S. Dollar. Having risen in the previous financial year as a ‘safe-haven’ during the height of the pandemic, the U.S. Dollar sold off substantially on declining risk aversion.

…while the AUD strengthened

The Australian Dollar rose sharply during the second half of the year, aided in part by a strong iron ore price but also by declining risk aversion as the currency has historically traded in line with the economic cycle.

Macquarie is bullish on the Australian Dollar in the short term: A brief bout of USD weakness over the next few months could trigger a last burst of AUDUSD upside to US$0.79, especially if the RBA back-peddles on its guidance that the policy rate will be kept unchanged until at least 2024. Beyond that, falling commodity prices (Macquarie believes downside risks to iron ore prices are accumulating) and eventual Fed tapering should see the AUDUSD at year-end fall to US$0.74.

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A wild ride for Bitcoin

Bitcoin (and other cryptocurrencies) skyrocketed amid inflation worries, fears of monetary debasement and a growing belief that cryptocurrencies were going ‘mainstream’ as a store of value and/or means of payment. The Bitcoin price rose almost 600% and peaked in April at US$63,000 before falling 43% to finish the year at US$36,000 after central banks and governments began introducing various restrictions on the use of cryptocurrencies.

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The report was finalised on 2 July 2021.
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Outperform – return >3% in excess of benchmark return
Neutral – return within 3% of benchmark return
Underperform – return >3% below benchmark return
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