Free | Global Macro & Strategy

Strategy: under the hood, some caution and defensiveness has entered into the market

If one was only to look at the headline indices, then it would not appear that much is going on. The S&P 500 is back up to its all time high, with volatility (the VIX) breaking below 20 to its low point since the COVID collapse last year. The ASX 200, whilst off a little bit from its recent high, was up last week and looks to be going along OK (albeit sideways for the past 2 months). Volatility on the ASX200 is down to around 12, which is in the bullish by-the-dip range. All up, one would say this is all looking fairly benign.

What is interesting is what is happening underneath the hood, which seems to be sending a somewhat different message. Lets have a look at that, plus some of the other key issues that financial markets are grappling with.

Defensive sector leadership

We’ve just had another week where defensive sectors have been leading the way in the share market, as some short term sentiment indicators struggle and market breadth is a bit weaker. In the US, the defensive sectors of Consumer Staples, REITs and Utilities were the top performers while growth and small caps lagged. In Australia, it’s been a similar story with Healthcare and Utilities leading the way, followed by Consumer Staples and REITs, while Tech and Financials have been the laggards. Defensive leadership is often a leading indicator of some short term bearishness or caution entering the markets. In other words, while the headline indices have not changed much, there has been a rotation under the surface from cyclical to defensive sectors within the market as investors take a more cautious stance.

Bond yields off a bit

Bond yields were singing the same tune last week, with the benchmark US 10 year Treasury stabilizing somewhat to 1.67%, a drop from last weeks mark of  1.73%, with Aussie 10 year yields also falling over 10bps to 1.72%. This could be seen as a move that supports the defensive rotation in the share market mentioned above. Having said that, this sort of counter-trend move or consolidation is also entirely normal (bond yields don’t just go up in a straight line), and does not remove the medium term expectation of higher rates from here off the back of continued optimism on economic growth, the increased supply of debt that will come from the huge US fiscal packages, and the planned large infrastructure spending. So we should not put too much emphasis on one week of bond yields coming off a little.

The US dollar up, the Aussie dollar down, Commodities off their peak

As a group, the US dollar index, the Aussie dollar, and the CRB commodities price index can be used to visually read risk appetite, and in particular, they can give you a visual cue as to when risk sentiment seems to have turned. The US dollar is continuing to creep higher as the US recovery is going well, while over in Europe COVID has spiked again and expectations are for a slower recovery (hence the pressure on the Euro which is a huge part of the US dollar index). The Aussie dollar has been off, down -1.66% last week although it recovered late in the week. The CRB Commodities index is in a crucial spot, where it has come off its recent highs, and is trying to consolidate. The open question here is can it re-establish some upward momentum or will it continue to break down. Collectively, these are a bit of a short term “risk off” signal which is consistent with the defensive positioning in the share market recently.

COVID spikes again

Just when you thought COVID had gone away as an issue for markets given the vaccine rollout, it rises again. Europe has had a spike in cases which have brought with it lockdowns in France and Italy. There is a key narrative permeating markets that Europe have messed this up and their recovery will significantly lag the US. This is affecting the US dollar (rising), which in turn affects other asset classes. It should also be noted that some US states have also seen a flare up where restrictions have been relaxed. And here in Australia, Brisbane has just gone into a snap 3 day lockdown as 10 new cases have emerged. We’ll need to see how that evolves.

End of Jobkeeper

The end of the $90 billion Jobkeeper wage subsidy scheme is ending in Australia. This was a hugely successful scheme that helped many businesses (and indeed entire industries) in Australia to continue to pay employees and remain open, however the end of this scheme is likely to force many marginal businesses to fold. Treasury estimates around 150,000 workers will move from JobKeeper into unemployment. This may prove to be a conservative number. There is no doubt that a number of industries have not recovered anywhere near enough, and may require further assistance to survive. The question is can the Government react in time. For Australia, this is a very live issue and we’ll need to monitor how this affects the data (especially leading indicators) over the coming period.

The counter argument

As can be seen from all of the above, there is a bit of a ‘wall of worry’ developing there for markets to deal with and so its not surprising that positioning has gotten a little defensive. However, its not all bad. There are still plenty of positive forces at work. Firstly, we are about to enter a period (Q2) where the low comps will mean some of the annual data being reported will be ‘off-the-charts’ good. US consumer spending is getting juiced again from those $1,400 stimulus payments that have gone out, and the COVID vaccine continues to be rolled out around the world. Close to 400,000 people have now had it in Australia, and the US continuing to accelerate their rollout with around 15% of the US population having had both shots . And of course Governments are still intent on full throttle fiscal stimulus. Recent statements and testimony from the US Fed and other central bankers have pointed to the fact that they have no intention of winding this back any time soon.

If we look at the economic modelling, we can see that Q2 is still forecast to remain in the reflation regime. Due to the COVID distortions, Q3 is forecast to be quite different and markets may begin to pull this forward at some point, but we are not there yet. In terms of modelling that looks at probable ranges of outcomes in various assets, these have actually been narrowing lately as volatility moves lower, and which is actually a positive sign for equities.

The bottom line

Some caution and defensiveness has entered into the markets. This is evident with some short term technical and sentiment indicators going bearish, bond yields coming off a touch, and the recent outperformance of defensive sectors within the share market. So new investors may want to see this dissipate before taking positions. However the data is still pointing to the overriding medium term theme of reflation still being most likely (at least for now) and the markets are not pricing in a major divergence from that just yet. And of course, there is still massive support from central banks and Governments. If the data changes at the margin, then markets will start to price in a different outlook, and that’s what we’ll be on the lookout for. As always, we remain vigilant to these changes and remain data dependant.


Author: Graham Parkes

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