Bond yields a shot across the bow for equities

James Gerrish

Market Matters

Global markets have drifted this week, but the action in local markets remains very pronounced thanks to reporting season. This has delivered more hits than misses and, in aggregate, we’re seeing earnings upgrades across the market - particularly from the two domestic heavyweight sectors of mining and banks, which account for much of the rise.

At MM we are more prepared than most to buy out of favour stocks if we believe their underlying valuation has become deeply compelling. 

Extreme pessimism provides opportunity at times for the brave assuming the risk/reward makes sense. 

However, we won’t take core positions that are structurally opposed to our underlying macro view, which remains bullish on a recovery/reflation. For this reason, we have no interest in bottom-picking the current embattled market areas mentioned above.

This week we heard that Victoria and WA have joined the NSW bandwagon with Royal Commissions into Crown (ASX: CWN). I can't imagine the result will be any worse than that delivered by Patricia Bergen, but it will undoubtedly make a few consultants and lawyers very happy: "fees, fees and more fees!" 

NSW took 12 months and spent $6.5 million to decide CWN couldn’t hold a casino licence at its Barangaroo complex until it cleans up its act. Daniel Andrews and Victoria are spending just six months and around $4 million, but we believe the results will fundamentally be the same:

  1. Crown is not fit to hold a casino licence in its current state and Jamie Packer is eventually going to be forced out of what used to be the jewel in his wealth crown – no pun intended.
  2. An improved board and company will flourish moving forward once all the messy dust has settled, but it won't happen overnight.

Remember the Banks were involved in their own Royal Commission between December 2017 and February 2019. Commonwealth Bank's shares bottomed in October 2018, almost exactly in the middle of the bad news, before rallying 40% plus dividends - a perfect demonstration of how the best buying opportunities often present themselves when the news is awful.

MM remains bullish on the ASX200 through 2021, despite expected volatility.

ASX200 Index Chart

National Australia Bank (ASX: NAB) has almost doubled since its COVID lows last March, while we are bullish on the stock short-term a pullback towards $22 wouldn’t surprise – if this does unfold MM will be looking to increase our banking exposure.

MM is bullish Australian banks through 2021.

National Australia Bank (NAB) Chart

Commodity markets continued their bullish advance this week with Copper a standout. Both Crude Oil and Copper is slowly but surely feeling like an acceleration move to the upside which could surprise many and see a test of $US70/barrel in 2021.

We remain long and overweight commodities

Crude Oil March Futures ($US/barrel) Chart

The recovery/reflation trade is gathering momentum.

Australian 10-year bond yields exploded above 1.5% this week as the yield curve continues to steepen, I’m sure the RBA is watching proceedings very closely with concern around not so much the level as opposed to the acceleration of the move. Notably, local 10-year bond yields are now trading at levels not seen since mid-2019, way before the world had even heard of COVID-19.

The current move in bond yields is polarising the sectors across the stock market. If you benefit from a steeper yield curve, such as banks, it's great news. But it creates a headwind for others, as we've seen with utilities' underperformance flowing through. Overnight the US banks rallied strongly, while the utility sector was the worst on the ground.

MM is bullish Australian longer-dated bond yields

Australian 10-year Bond & 3-year yields Chart

The yield curve steepening is equally as pronounced in the US, which does sow a seed of doubt in my mind over the shorter-term. Aggressive periods of US yield curve steepening often leads to a correction in US stocks.

Remember, MM is looking for 2021 to be a volatile year. 

The current move in yields is a warning that a pullback is on the horizon, and while I can see the S&P500 testing 4,000 in the coming months, I feel the next 10% swing is more likely to be down than up. 

Going back to a point I made earlier when discussing CWN and NAB, things are looking good today on the economic and COVID front, and we're considering moving slightly down the risk curve in the weeks ahead.

US 2 & 10-year Bond Yields Chart

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James Gerrish
Portfolio Manager
Market Matters

James is Portfolio Manager & Primary Author at Market Matters, a daily investment report with over 2500 subscribers that offers real market insight. He is also Senior Portfolio Manager within Shaw and Partners heading up a team that manages...

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