January Market Update
Calendar year 2021 was another good year for diversified portfolio performances, driven by strong equity returns. We note that market strategists’ views for 2022, and beyond, are quite broad. The reality is that global economies continue to face significant uncertainty largely due to COVID, and its impact on economic and social factors. The balance between equity market pricing, interest rates and inflation are arguably quite fragile, while the geopolitical environment continues to provide a further level of uncertainty. We remain supportive of equities based on low interest rates but do recognise the interest rate environment is shifting.
Equity market valuations are high based on historic numbers such as the Schiller PE Ratio, but the historically low interest rates have created a supportive environment. The recent spike in inflation does cause concern and provides for the possibility for interest rates to rise, however, institutions such as the Federal Reserve and the International Monetary Fund forecasts suggest a short-term impact, although they are retreating from the previous ‘transitory’ view. The investment banks have shifted views to the potential for inflation to be higher and longer than recent forecasts, generating further uncertainty for capital markets. While the inflation discussion is front of mind, the actual reality may cause markets to become unsettled as was the case with the ‘taper tantrum’ in Q4 2018. The other obvious factor of concern is the potential for central banks to unwind quantitative easing programs, a task that is likely to create great challenges.
For some time now we have had the view of growing uncertainty potentially causing issues for investment markets. Our view remains the same, although the risk factors have shifted during the last quarter and continues to rise. We can see factors that will continue to support equity markets, albeit they are unlikely to maintain the same growth rate during 2022, and we can also see factors to support a significant correction. We have shifted to the extended inflation camp and see the potential for interest rates to reset to moderately higher levels, which is likely to put pressure on long duration growth equities. While a market correction is possible, they are generally caused by a black swan event, which are hard if not impossible to predict.
We continue to expect risk/growth assets to outperform, however, with the current extended valuations in risk asset classes we prefer to maintain our view to moderate the higher risk exposures, increase exposures to lower volatility risk assets, and maintain a higher quality, low-risk approach to defensive assets.
GDP and economic output
The forecasts and shifts in economic output are a key driver for equity pricing. While there was an impressive recovery during 2020 and 2021, the forward-looking forecasts have been reducing, post the COVID crisis recovery phase and as uncertainty surrounding COVID increases. Note the dotted lines on the chart below, showing reduced growth forecasts.
Source: ASR Ltd, Refinitiv Datastream
The OECD sees global economies in a state of ‘a balancing act’, noting the rebound is expected to slow, returning growth to pre-crisis rates, as shown in the chart below.
As was predicted by those who know best about COVID, the virus developed variants, with Delta and Omicron versions currently circulating. The chart below highlights the medical view that Omicron is more transmissible but less severe, with cases rising significantly in recent months, as the death rate declines.
A European director from the WHO’s recently said, “at this rate, the Institute for Metrics and Evaluation (a research centre at the University of Washington) forecasts more than 50 per of the population of Europe will be infected with Omicron in the next 6 to 8 weeks.”
While Australia was a late vaccination starter, the vaccination ratio would now be one of the highest in the world. Of interest and concern, Australia did have a clear ‘zero COVID’ policy until New South Wales and Victoria lost control and forced all States (except WA at this stage) from a zero COVID containment policy to a let it rip ‘no policy’. We could call it the COVID pivot! Or we could be appalled by the negligent approach.
Source: Johns Hopkins University
Many of us will recall that inflation was the scourge of the 1970’s. Totally uncontrollable at +10% and mortgage rates climbed to 17%. Those rates were painful then and would bring economies to an abrupt recessionary halt now. Clearly the chance of this happening is very low.
We see inflation in the streets. The price of food is going up, the price of fuel is high and as supply constraints prevail, the price of other goods continues to go up. Some prices will retrace, such as lumber, but some may not, such as … have you ever heard of staff giving back a wage increase?
The chart above highlights the massive shift is goods and services consumption, post-pandemic. The lockdowns and stimulus packages drove the supply and demand factors to extreme and dysfunctional levels, causing a transient form of inflation to develop. This is the scenario that led central banks to hold the transient inflation view.
The RBA continues to suggest there is no wage growth push in Australia. The charts below show the unemployment rates falling and wages growth exists in the United States and Europe. A hotel and resort operator in Europe has explained directly that its wage cost is up by 20% across the board. It is almost impossible to remove wage growth without a recession. This factor is a persistent impact on inflation. The difficult question to answer is, whether this continues or not, but inflation can be the cause and effect.
Energy is an uncontrollable cost factor, in a sense that supply and demand cannot be controlled by regulation or central banks. It is northern winter which does provide some reasoning for higher energy prices and lower storage levels; however, the influence of climate factors has served to reduce supply, without a backfill of alternative energy.
On the ESG and climate front, battery cars need to be charged. What will be the source of energy? It appears European farmers are not keen to have wind farms nearby. Many countries are not keen on uranium and the hydrogen experiment is still an experiment. Managing increasing fossil fuel costs, while being phased out, and still not having an effective alternative supply may cause a few issues, including add to inflation.
Input shortages also put pressure on production and inflation.
Supply shortages, energy prices and wage growth could further prolong elevated inflation, according to the OECD.
Central banks and other organisations with direct access to the core data that is required to assess complex issues such as inflation have continually pointed to transitory inflation returning to lower levels after some one-off factors rebalance themselves. The Federal Reserve has now removed the word transitory from FOMC minutes. The inflation factor provides significant uncertainty with regards to future levels and central bank response.
While we have been mindful of inflation possibly being higher and harder to control than has been telegraphed by central banks etc, we have added some inflation hedging investments into our asset allocation and portfolio views. Our concern is that if inflation is persistent for an extended period or becomes uncontrollable, then central banks may be forced to implement policy to restrain it, which in turn could impact equity prices.
Monetary and fiscal policy
The Federal Reserve implemented quantitative easing following the Global Financial Crisis in 2008, and subsequently following the COVID crisis in 2020. The numbers are eye watering, as is the case with government debt related to fiscal policy.
This problem has spread globally, and the markets fondly refer to it as cocaine. Once on it, then it’s hard to get off it.
The charts below show the global pattern that central banks have developed since March 2020.
Note that Japan started the charts above at a high level. From memory, the Central Bank of Japan commenced a form of quantitative easing in the 1980’s, and it has continued from there. It is hard to see how this can be unwound, and if the drug is removed then the reaction would be counter-productive to the original objective. This is a significant conundrum.
Equity markets are at record highs and some valuation metrics would suggest these valuations are extreme, as shown in the Schiller PE chart below. Some might suggest that it is different this time, and in a sense, they are correct, as interest rates have been at record lows which has provided strong support for equities. The low interest rates forced investors out the risk curve and has generated significant wealth for those that took the risk. Some would also suggest that the central bank policy was deliberate and was aimed to push asset prices to add wealth into the system.
Source: ASR Ltd, Schiller, Refinitiv Datastream
It is very interesting to review equity pricing and interest rates. The chart below shows the S&P 500 and US 10-year bond over 20 years. The interest rates predominantly keep falling with equity markets continuing to rise. However, during the last 12 months interest rates have been relatively flat (with some contained volatility) but trending upwards, and the S&P 500 continued with a strong rally. There will be several factors behind these charts, however, the main driver would be attractive dividends compared with bonds providing low nominal and negative real returns.
When we shorten the data to 5 years this phenomenon is more obvious.
There was a rotation from growth to value during Q4 2020/Q1 2021, which occurred in an earlier period than is shown on the chart below. However, the relative underperformance of the NASDAQ during December 2021 and January 2022 highlight the risk-off trade developing. Investors are not deserting equities; they are deserting the longer duration growth/tech stocks.
We would consider this rotation will continue unless higher inflation and interest rates work to generate real rates of return from short and long interest rates. We are also most concerned that as the quantitative easing and government stimulus have driven equity (and other growth asset) prices high, that any withdrawal of such stimulus could potentially cause the reverse for growth assets.
We have discussed inflation above in some detail, which we consider to be the canary in the coal mine. The reaction of central banks to control inflation and, to some extent, unwind quantitative easing (removing the cocaine) is likely to have a significant bearing on equity pricing, as QE influenced asset prices to rise when initially applied.
Most interesting, as seen on the charts above and below, the 30-year US bond has not shifted up in the same way the shorter 2-year and 10-year bonds have. A well understood phenomena – the bond markets think long term, while the equity markets think short term. One might surmise that the bond markets do not consider interest rates will remain high for the longer term.
This is where the longer-term portfolio strategy does become difficult to picture. Will long rates follow the path of short rates or will the monetary and fiscal policy remain in a similar format to the current form, which was the experience in Japan.
China remains an integral part of global and Australian economic fortunes. The geopolitical issues remain in the foreground, while economically China seems more focussed looking inwards. The chart below indicates that the credit impulse has bottomed and is forecast to recover, which should be positive for global growth. Of note, China remains with a zero-COVID policy, which will be interesting to see how that impacts internal growth.
Source: ASR Limited, Refinitiv Datastream
The AUD movement is generally a function of the USD movement. In terms of USD/JPY, the USD is strengthening, which does show up as a weakening AUD. There are other factors affecting the AUD, such as commodity pricing and demand, which is supportive for the AUD. Many of the forecasts have the AUD in the range of 70 to 80 cents, which does line up with the long-term average around 75 cents.
Our views remain similar to 2021. Uncertainties and risks remain at elevated levels which directs us to a more cautious approach. The same was said three years ago and risk assets have significantly outperformed defensive assets over that period. We continue to favour the view of risk assets outperforming defensive assets, but it feels appropriate to aim to control and limit the level of risk exposure.
The degree of monetary and fiscal support in the system, along with the complex circumstances that have been created by COVID, will most likely provide support for risk assets outperforming defensive assets to continue. However, reducing risk in portfolios by adjustment to lower volatility risk assets and being exposed to assets where valuations are less stretched will help with downside risk protection, while capturing much of the upswing of equity markets.
We maintain a view to reduce some equity risk and shift it into lower volatility sectors such as infrastructure and alternatives, while maintaining equity like exposures. We also feel that the inclusion of inflation hedges is prudent while the inflation risk is to the upside. For defensive assets, we aim to lock down the risk and uncertainty in fixed interest by biasing the exposure to predominantly quality short/mid duration fixed interest holdings, with a reduced weighting to long duration government bonds.
Index Returns – 31 December 2021
|Sector Returns (%)||FYTD||1-month||3-month||6-month||1 year||3 years||5 years|
|International Shares (unhedged)||11.46||1.68||7.19||11.46||29.58||20.60||15.10|
|International Shares (hedged)||8.51||3.97||7.90||8.51||23.88||20.20||14.00|
|Australian Listed Property||14.74||4.88||10.10||14.74||26.14||12.80||9.34|
|Global Listed Property (hedged)||9.95||5.89||10.20||9.95||28.60||10.40||6.91|
|Global Listed infrastructure (hedged)||8.11||6.43||7.26||8.11||16.44||10.20||8.67|
|Australian Bank Bills||0.01||0.00||0.01||0.01||0.03||0.63||1.11|
|International Bonds (hedged)||0.08||-0.44||0.03||0.08||-1.53||3.52||3.17|
|CRB Commodity Index USD||8.90||6.02||1.51||8.90||38.48||11.00||3.84|
|Aust CPI (at previous quarter)||1.51||0.25||0.74||1.51||2.89||1.86||1.86|
Source: Lonsec, Bloomberg
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