The ABC’s hit of the pandemic much less painful than expected
While an economic recovery is clearly developing here and elsewhere, it is not without risk. More virus outbreaks, new more dangerous mutations and questions about the effectiveness of certain vaccines are obvious risks, as well as the rate and possible coverage of vaccinations.
Markets anticipate a rapid recovery and are downplaying risk, with equity markets reaching or near record highs and bond market yield curves steepening. The US key yield curve, which plots bond yields with maturities as short as three months to as long as 30 years, is now at its highest level in more than five years.
This implies growth and, for the first time since the financial crisis of more than a decade ago, a significant increase in inflation.
The buzzword in the markets, however, is not inflation but “stimulus”, which is a different concept.
Essentially, markets anticipate a rapid return to global economic growth, whether or not accompanied by inflation in consumer prices and firm input costs, and seek “stimulus trade” or sectors. and stocks that would benefit the most from a rebound in activity.
They are not looking at the bond market, where yields are already rising (and therefore bond prices are falling) in anticipation of accelerating growth, but sectors like banks, oil producers and commodity producers in general and smaller cap stocks which generally perform well in times of economic growth.
At some point, depending largely on the effectiveness of vaccines and some return from international travel, airlines, cruise lines, travel agencies and other sectors most affected by the pandemic will also make a move. return.
Bankers and insurers (and offshore defined benefit pension funds) will examine the shift in interest rates in recent weeks and steepening yield curves and hope, some desperately, that it continues.
Banks borrow short term and lend long term and generate income from their share capital. Insurers also depend on fixed interest income on their capital and reserves and are also exposed to the discount rate of their claim liabilities, which changes according to the risk-free rates.
The steady decline in central bank policy rates since the financial crisis has been exacerbated by the pandemic to the point that most of them are at or below zero. This squeezes the net interest margins that drive banks’ core profitability and undermines the solvency of insurers.
The CBA, for example, has the largest margins of any Australian bank. It had a net interest margin of around 2.11% in the run-up to the pandemic (it was around 2.2% before the 2008 financial crisis), but in the latter half it fell 10 basis points to 2.01%.
This is a substantial amount of potential profitability that has evaporated as rates have fallen – and a substantial amount that could be recouped if yield curves continue to steepen.
Producers of commodities are particularly exposed to economic growth, and among commodities, petroleum and copper are perhaps the greatest lever for growth.
Oil prices, which were trading below US $ 20 a barrel when the pandemic hit last year, have risen sharply. Over the past three months, they have gone from less than US $ 40 a barrel to over US $ 60. The price of copper has risen 22 percent in the past three months. They both signal a strong recovery.
Australia, having contained the virus as well or better than any other major economy, with a starting position where the balance sheets of governments and businesses, especially the balance sheets of big banks, were strong relative to the rest of the world and more Exposed that most stimulus trade is in a reasonably good position to benefit from a global recovery as long as there are no new threatening outbreaks of the virus.
And, if they are, with public finances that are nowhere near as tight as those of other major economies and a banking system that remains, as the CBA result shows, highly profitable and capitalized, we are better placed than most to respond to them.
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