Monthly Musings - February: Reflation trade overshadows an impressive reporting season
Why the reflation trade, as it’s being referred to, matters for both your portfolios and the broader market in general is that bond markets – the market that sovereign governments raise capital in – have seen the yields they offer move from 1.12 per cent for the Australian 10-year bond at the start of February to 1.85 per cent by the end of it.
What this suggests is that over the next 10 years, interest rates in Australia (and the world for that matter) will rise, and rise significantly, as central banks try to rein in inflation. This will mean interest-rate sensitive markets such as equities and property will see higher borrowing costs and lower returns, which means lower values – hence the sell offs.
Now we should point out very clearly that central banks are telling everyone that rates won’t move anytime soon. The Reserve Bank of Australia (RBA) is stating in all publications and speeches that rates won’t move until 2024. But the market believes rapid inflation will force their hand. So, February unfortunately saw this ‘push-pull’ tug of war over which view is right, leading to a strong sell-off in fixed income which spread to other asset classes in the final week of the month.
The reflation issue did overshadow what was a very impressive half year earnings season, which should be taken as not just good news for equities but more broadly about the state of the country’s bounce back after last year’s COVID-led shutdowns.
Australian stocks rose 1.5 per cent in February on a total returns basis, underperforming the 2.9 per cent rise in the S&P 500 on the same measure which explains the International Equity Portfolio’s outperformance once again.
The driving feature of the equity markets was the performance of material stocks due to the surging commodity prices of copper, iron ore and other infrastructure-exposed minerals. This feeds back into the reflation issues as the global economy is rapidly expanding and the need for raw materials will continue as the globe continues to pull itself out of the pandemic but it will also lead to increased prices – inflation.
However, the counterpoint to materials were the sectors sensitive to rising yields. Utilities, gold, and technology lost some 9 per cent in February. The last two sectors in particular, thrive in low interest rate environments so any sign that rates could rise will be a headwind for these sectors. Real estate also fell, but not by the same amount as the three above, as demand returned due to the population going back into the office instead of working from home.]
What is also interesting from February is for the fifth month in a row, value stocks have outperformed growth stocks, in fact, total outperformance in that time now sits at 31 per cent. With Australia entering into the next stage of the pandemic – vaccinating – expect value to continue to outperform as normalisation in the economy begins to return and rising yields put pressure on those that are overvalued. It should also be expected that domestic-facing sectors will outperform as Australia has generally done better than its international peers and thus the recovery here will likely be faster.
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