Lull Before The Big Cyclical Swells Return

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By

Paul Ashworth


Posted 09 August 21

The cyclical upturn, accompanying inflation and bond market fears a few months ago have evaporated over recent months. What waits after the lull?

Interview with ausbiz, 9 August 2021

During an interview with business news broadcaster, ausbiz TV, our CIO Paul Ashworth shared his analysis on how the Delta strain has been a catalyst for the pullback in the reflation trade and in growth expectations since mid May. Going into 2022 however, we expect reflation should re-emerge strongly. As a guiding point, Paul sees that the UK provides an optimistic path to economic rebound which could illuminate a path for Australia. Specifically, he highlights promising prospects in the 'smart' industrial sector in the US, UK and here in Australia. 

The cyclical upturn, accompanying inflation and bond market fears a few months ago have evaporated over recent months. The Delta strain has been the catalyst for the pullback in growth expectations over the last two months, seeing a sizeable (and largely unforeseen) rally in bonds. The reflation trade rolled in, and just as quickly, its swell disappeared. That said, equity valuations have remained buoyed and inflationary expectations have not declined in sympathy with the “slow growth for longer”. We view the current lull in bond markets is not a reflection of the outlook for 2022 and beyond, and that the reflation trade is merely paused and that the UK shows a post vaccination path (albeit imperfect) to economic rebound and a renewed reflation trade.

The core foundations for rebounding growth remain firmly in place:
— Stimulatory monetary policy (retained QE + probable delay in increased cash rates)
— Developed economy enthusiasm, really reckless abandon for abundant government support (fiscal)

As matters stand, the UK provides the most optimistic path for the developed world. The adult population is approximately 70% first dose vaccinated and 1-in-5 of the population estimated to have contracted COVID, the UK is arguably closing-in on herd immunity. Suffice as to say, it is early days, but the key observations are:
— Infection rates are declining, but this is to be expected from a recent wave of infection.
— Full dose vaccination provides excellent protection against serious infection requiring hospitalisation, let alone ICU treatment and of course, ultimately death.

Should these condition hold, policy makers have a sound basis to continue opening their economies and potentially opening their economies to similarly full vaccinated inbound movements. The developed world is divided into various levels of possible opening from:
— UK which seeks to liberally allow inbound/outbound full vaccinated travellers, both with high vaccination and natural antibody rates.
— US which seeks to support relatively free internal movement, but not offshore or inbound travel – again, good vaccination and natural antibody rates exist.
— Australia who has both lower vaccination and natural antibody rates, is hostage to suppression to zero infection policy.

In Australia, we have both lower vaccination and natural antibodies, but by the end of September we can expect full adult vaccination rates to be in the low 50%’s and if added to single dose recipients, will be in the low 60%’s.  It is the pathway illuminated by the UK’s example that gives us some confidence that growth and reflation will rebound in early 2022. There is of course no straight line, and the political culture in the UK and US is somewhat in contrast to the somewhat more timid political structure and leadership in Australia. That aside, the data in the UK does appear to illuminate a reopening path. In Australia, the political will may just take that bit longer, complicated by election cycles Federally and in Victoria in 2022.

Markets, particularly for inflation expectations, are giving us a strong indication that the reflation environment is merely lulled not stopped. This can be seen with Figure 1, below, which shows breakeven inflation remaining at elevated levels. Combined with suppressed interest rates resulting in a negative yield outlook, this is potent for growth moving forward.

Diagram showing

As we can see at Figure 2 below, the reflation trade to mid-May was the big game in town with energy, financials, materials, industrials and communication streaking ahead. Since mid May this has halted, particularly for cyclical reflation bell-weathers in energy and materials. The big rebound has been information technology, supported by very good earnings reports. It is in the industrial segment, and what we call the ‘smart’ industrial sector that we see very good prospects. The clearest demonstration of this can be seen in the UK equity market where we have operated and held significant equity exposure for over 15 years. Our UK holdings have generated 45% performance over the last 12 months as part of our International Equity Strategy. Since May, 'smart' industrials in the UK have advancing strongly such as Croda International (+35%), Howden Joinery (+19%), Genuit (+20%), Cranswick (+ 12%).

Diagram showing

Beyond the Delta COVID lull, there is much to support the reflation rotation swells returning, and with it, solid returns through 2022 from high quality ‘smart’ industrial and service businesses.

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