With rising inflation and the accompanying rising interest rates among the top concerns for S&P/ASX 200 Index (ASX: XJO) investors, we cast our gaze to the latest out of the United States.
Yesterday, overnight Aussie time, US Federal Reserve Chairman Jerome Powell may have blinked first in the central bank's staring contest with inflation.
Addressing the House Financial Services Committee, Powell said that with very low inflation figures last year and plenty of pent up consumer demand, the Fed does expect inflation to tick up.
He calmed the markets by reiterating that, "Our best view is that the effect on inflation will be neither particularly large nor persistent… We have been living in a world of strong disinflationary pressures, around the world really, for a quarter of a century. We don't think a one-time surge in spending leading to temporary price increases would disrupt that."
However, the blink in question came when Powell stated, "We do expect that inflation will move up over the course of this year."
One of the leading gauges of investors' inflation expectations is the US 10-year Treasury yield. And following on US President Joe Biden's US$1.9 trillion (AU$2.5 trillion) COVID relief package, yields spiked to 1.69%, the highest since before the pandemic struck.
Of potential concern now is the pending US Federal budget. Estimated at a whopping US$3 trillion or more, Biden's spending plans could see bond yields spike far higher.
Here's why that's important for ASX 200 investors.
What happens in the US doesn't stay in the US
Unlike the old adage, "What happens in Vegas stays in Vegas", what happens in the US doesn't stay in the US.
If inflation begins to run higher in the United States, it's a good bet inflation in Australia will too.
The world today is more deeply economically connected than ever before. And the world's leading central banks and developed nations have taken similar approaches to combatting the economic slowdown brought on by the global pandemic.
Namely huge fiscal spending packages on the government side. And record levels of quantitative easing (QE) along with record low interest rates from the central banks.
Australia's government economic support packages and the Reserve Bank of Australia's response certainly fall in line with that approach.
And as an added inflation concern Down Under, the flooding in New South Wales and Queensland may well put significant upward pressure on food prices over the coming months.
How do Australian government bond yields impact share prices?
Mark Draper is a financial adviser with GEM Capital Financial Advice. Writing in the Australian Financial Review, Draper said:
Since 1994, investors have enjoyed the tailwind of falling bond rates. But the tide has turned since the last quarter of 2020, when Australian 10-year rates rose from about 0.7 per cent to around 1.7 per cent. That is a 140 per cent increase…
In valuation terms, Arvid Streimann, head of macro at fund manager Magellan Financial Group, says that a 1 per cent increase in the 10-year bond interest rate generally results in a 9 per cent decrease in the capital value of 10-year bonds and about 15 per cent for equities.
Have another read of Streimann's figures. A mere 1% hike in the 10-year bond yield could see the ASX 200 fall by 15%.
Now not all shares are created equally.
Growth shares have done exceptionally well since the lows of last March, propelled higher by a tide of easy money. Value shares, until more recently, have trailed.
So how should share investors position themselves if inflation and bond yields indeed keep heading higher this year?
JPMorgan Asset Management on the reflation trade
While some analysts point to commodity shares as a good inflation hedge, Thushka Maharaj, global multi-asset strategist at JPMorgan Asset Management, has a different view.
Maharaj says (as quoted by Bloomberg):
Commodities tend to be volatile and do not necessarily offer good inflation protection. As for index-linked bonds, our study showed their long duration outweighs the pure inflation compensation this asset offers. It's not the top asset on our list of inflation hedging.
If inflation were to rise and continue rising – and we think that's a low probability event – equity sectors that are geared toward the recovery provide a good investment profile. We also like real assets and the dollar.
We are expecting volatility in inflation, especially at the headline level over the next few months, mostly over 2Q, driven by base effects, excess demand in the short term, and disruption in supply chains caused by a long period of lockdown. We see this as transitory and expect the central banks to look through the near-term volatility.
ASX 200 shares geared toward the recovery
The ASX 200 shares that were most beaten down by the onset of COVID-19 and the ensuing lockdowns and social distancing are largely still trading well below their pre-pandemic share prices.
There are a number of these to cover, but for the purposes of this article we'll stick to 2 leading ASX 200 travel shares.
The Qantas Airways Ltd (ASX: QAN) share price was absolutely ravaged by the virtual shutdown of international and interstate travel. Shares fell 68% over a period of 3 months, bottoming out in on 20 March. Qantas shares have soared 118% since that low, but are still 30% below their 20 December 2019 levels. At the current share price Qantas has a market cap of $9.8 billion and pays a dividend yield of 3.1%, fully franked.
The Sydney Airport Holdings Pty Ltd (ASX: SYD) share price was another ASX 200 member to get smashed when travellers were forced to stay home. Shares in the iconic airport fell 47% in less than 3 months. While the Sydney Airport share price has gained 25% from the 20 March lows, it's still 37% below its 27 December 2019 levels. Sydney Airport has a market cap of $16.3 billion and pays a dividend yield of 3.4%, unfranked.
