April Market Update
Financial markets have become more complex as investors adjust to the reality of inflation and interest rates heading to higher levels than central banks were initially forecasting. The views of key market forecasters of the magnitude have split into two camps, while central banks have firmly switched the preference of price stability and controlling inflation over supporting asset prices. This is a significant shift of policy from the excessive fiscal and monetary stimulus and support that originated following to GFC and further to support the COVID pandemic crisis which was aimed at asset price support to support consumer demand. This situation is further complicated by interest rates now transitioning after 40 years of declining rates towards a period of increasing rates.
Key for central banks will be achieving the fine balancing point of controlling inflation without tipping global economies into recession, a ‘soft landing’. Arguably, although significant support was a necessity, the central banks over-stimulated and now seem to be behind the curve of controlling inflation. The most recent print of US inflation is 8.5% and the expectation is for it to shift higher in the near term, before retracement. The Federal Reserve have stated they want inflation back to 2%. When questioned, the Fed Chair stated, “not 3%”. While supply constraints may soften which helps to reduce inflationary pressures, there is clear evidence of rising input costs which will be hard to control. Not to be under-stated, this is the most important factor financial markets have faced in years! The last time the markets witnessed these conditions was in the early 1980’s.
To further complicate the macro perspective, global debt is at historic highs, as shown in the chart above. Clearly most of the global economies, corporates and consumers have limited capacity to meet increased borrowing costs, although higher rates will be attractive for income earners. At the same time central banks want to reduce inflation and normalise (reduce) their balance sheets (quantitative tightening), which is most likely also supportive of rates moving higher. This is where the tipping point becomes important and market forecasters views separate into two camps.
During Q1 2022 equity markets suffered two sell-off periods. Initially equity markets shifted to risk off and reduced valuations for high growth companies as the reality of higher interest rates affecting PE valuations. The Russian invasion of Ukraine induced the second wave. While the oil price was already adjusting upwards as a form of ‘green inflation’ due to pressure from climate change and carbon policy, this upward adjustment was magnified by the invasion of Ukraine highlighting the significance of Russian oil and gas providing essential power to much of Europe, and therefore putting further upward pressure on inflation.
Of considerable concern, is that the central banks initially denied inflation was anything other than transitory and subsequently pivoted from spending trillions on unrealistically pumping-up asset values to now focus on hiking interest rates to tackle what is now anything but transitory inflation, which has the potential to reverse price movement for asset prices. We are currently experiencing a significant period of transition between extreme liquidity in the system, falling interest rates to ultra-low levels, causing expanded valuations and high equity and fixed interest asset prices. However, as we noted earlier, there are two camps of thought. One camp one thinks inflation and interest rates will be higher for longer, and the other camp thinks not as high or long.
While monetary and fiscal stimulus was important to maintain economic stability following the outbreak of Covid-19, in retrospect it now looks to have been excessive. While the stimulus helped to initially fuel inflation, the post-pandemic supply side constraints and rising energy prices brought on by carbon policy and later the Ukraine war, have further inflamed the level and persistence of inflation and is now causing central bankers to adjust policy in a manner that is likely to impact asset values.
Global economic growth is forecast to slow, as shown in the chart below from the IMF. The outlook trend is consistent with previous forecasts; however, the levels have been further reduced. Growth forecasts remain at positive levels in the range of long-term averages and reduced growth will support reducing inflationary pressures.
While there are two camps of thought, we consider the Federal Reserve’s focus pivot away from stimulus pumping asset prices, to reducing inflation back to 2% as a major transition in policy direction that could have a significant impact on growth assets. Factors such as energy pricing and wages are the major ingredients of inflation and are not easily controlled, providing a degree of uncertainty to how the Federal Reserve policy plays out. Australia has not had the same level of inflation print at this stage, and in that sense, we are running behind the United States. The intention to reduce central bank balance sheets (quantitative tightening) will drain the abnormal liquidity from the system, also putting asset prices and bond funding under pressure. On the positive side, forecast growth deceleration and unwinding of supply constraints will provide support for Federal Reserve policy, which underlies the view of inflation being contained.
While our view is that risk levels are elevated, markets do adjust to adverse conditions rather quickly. The key with asset allocation is to adjust exposures to limit downside risk while maintaining appropriate exposures to risk and growth assets. While the level of uncertainty continues to remain elevated, it is important to remember that adversity provides opportunity, and a review of equity index charts highlights that economic growth and equity price growth has outpaced the periods of adversity over a very long period.
Inflation is expected to be the most important factor for financial markets during 2022. Having said that, inflation is an outcome not an input, and the inputs causing inflation are not always easy to control. Over the last 25 years inflation has been benign and more disinflationary than anything else, as globalisation and technology developed. However, the economic regime has shifted since the pandemic following significant policy support, pandemic related supply constraints and now the Ukraine war has magnified issues including hiking energy, food prices and further supply constraints.
The US and Europe are subject to high inflationary pressures, with the most recent US CPI print at 8.5%. During 2021 the general central bank guideline was that inflation was transitory and would subside. This guidance made little sense at the time and late 2021 and following the Ukraine war inflation has taken a solid path upwards (see the chart below). Federal Reserve Chair, Jerome Powell, gave a speech on 21 March 2022 to the (US) National Association for Business Economics. When asked if the long-term inflation target might be lifted to 3% (from 2%) to assist with a soft landing the answer was a definitive ‘no’. During the speech he also noted several times, the Federal Reserve is committed to restoring price stability (controlling inflation), which is a significant shift of monetary policy of providing stimulus and abnormally low interest rates, aimed at generating wealth and consumer confidence supporting the wheels of industry. Some are now talking about a ‘reverse wealth affect’ being a policy tool.
Source: Yarra Capital
Logic would suggest if low rates and abnormal system liquidity drove equity markets up, then maybe reversing the policy will have the reverse outcome. The key will be whether central banks are able to orchestrate a soft landing while normalising interest rates and reducing government and central bank balance sheets (quantitative tightening).
There is a lot more theory relating to inflation sources and impacts, however, this note is aimed at capturing key issues, not expanding on theory on an economic influence not seen for 40 years.
Policy interest rates
Central bank policy has shifted significantly over the last year. During 2021 the Federal Reserve expected no interest rate increases in 2022, and now they foresee the federal funds rate closer to 2.5% by the end of 2022 and over 3.0% in 2023. Here in Australia the RBA held their policy rate at 0.10% until October 2021 after stating many times this rate would remain in place until 2024. The CBA sees the Australian terminal policy rate around 1.5% while others see it closer to the US rate. If our cash rate is significantly lower than the US, we would assume the currency will adjust lower. While many input factors will affect the ultimate outcome, the level of uncertainty with regards to central bank policy will likely cause the volatility of markets to remain elevated during 2022.
The Federal Reserve introduced quantitative easing in 2008 to provide USD 4.5 trillion support following the GFC and then took it to USD 9 trillion post-pandemic (see the chart below). Other central banks followed in various formats, including our RBA. Financial markets reacted badly when the Federal Reserve began to reduce the post-GFC stimulus in Q4 2018. Financial markets are quite aware of the intention of the Federal Reserve to commence quantitative tightening (balance sheet reduction) so it will be interesting to see what happens when this commences in the next few months.
Referring to the Global debt to GDP (1st chart above) and the US debt to GDP chart below, the numbers continue to grow and are quite concerning. It is interesting to note the tail reducing from early 2020, which is why maintaining GDP growth is so important.
GDP and economic output
As we note from the IMF world growth projections (2nd chart above) and the chart below, GDP growth peaked during 2021 and has now commenced falling and forecast to fall over the next couple of years. GDP growth is a big driver of equity pricing. The 2021 peak was abnormally high due to the post-pandemic catch up, and further reduction bring GDP growth forecasts back to around long-term averages, and therefore the reduction would not be a concern under normal circumstances. The issue for financial markets is if constraints aimed at curbing inflation drive GDP growth lower such that a recession emerges. The reality is that no one knows the answer to that question, although some are pointing to an inverse yield curve which is also not a certainty at this stage.
As the chart shows Global GDP growth has not recovered to pre-pandemic forecasts.
It is hard to believe that in 2022 we are faced with an issue such as the Ukraine War and its unbelievable atrocities’. From one angle this is a territorial war, and the West has not interfered. Partially due to the threat of nuclear escalation and partially the social impact of losing lives on foreign territory such as has been experienced in Iraq and Afghanistan. But we must understand that we are all paying for this war, in an economic way. The price and supply of food and energy, and the future deceleration of global synchronisation. The price of this war paid by the global citizen will be significant.
The OECD has provided some interesting data in the charts below.
Russia and Ukraine supply 30% of the world’s wheat demand and Russia supply 23% of the fertiliser requirements. Russia is also a major gas supplier for much of Europe. The impact on pricing and supply on factors such as inflation are quite significant. With the most basic food pricing under upward pressure, this is sure to have a serious effect on the poorer nations.
The economic consequences measured by GDP and inflation shown below.
We are all paying the price. As uncertain as the outcome for Ukraine, so is the uncertainty for how it plays out for global economies.
As we have previously discussed, Energy is an uncontrollable cost factor and inflation input. The Ukraine War is having an impact on energy prices (see chart below), but prices were rising before the outbreak due to what is being referred to as green inflation. The decarbonisation and global warming movement has caused a drop off in exploration and production expenditure, which is having the obvious effect of a price push as supplies are gradually restricted.
The positive that comes out of this situation is that the search and development for renewable and alternative energy sources will be brought forward significantly. While this doesn’t provide a near-term solution, it will assist to shorten time frames. An interesting discussion is also starting to evolve around nuclear energy, which appears to have many benefits, while technology has advanced significantly from the days when the nuclear plants such as Fukushima and Chernobyl were designed and built. Australia holds significant uranium reserves.
The central bank’s determination to raise interest rates moderately aggressively, along with the Ukraine War have put pressure on equity pricing. Weaker global growth and higher inflation are reducing EPS growth forecasts. Stocks with higher earnings growth forecasts have been re-rated lower as higher interest rates impacted earnings multiples and price/earnings ratios. In essence, the long duration equities (high growth forecasts) and lower quality growth stocks (earnings and balance sheets) have been re-rated to lower valuation levels. The chart below shows the equity index movements over the last six months for the large cap S&P 500, the tech heavy Nasdaq and the smaller cap Russell 2000. Interestingly, the small cap space has been more heavily affected and shown less recovery during the last six-month period.
As we mentioned earlier in this note, the market forecasters have shifted into two camps for interest rates and inflation, and this should lead directly into views on equities as well. While interest rates and inflation are showing signs of being higher than previously expected and for longer, the equity market has shown resilience and modest recovery from the lows experienced during February and March.
The sell-off was less severe for large cap and mid-cap Australian equities (see the chart above). In a sense, Australian equities are better placed compared to global equities, to benefit relatively from the inflation and the interest rate story from resources and financials.
We are concerned that global equity markets do not properly reflect the impact of central bank policy rates hikes, quantitative tightening, and potential pressure on margins from rising costs.
Central banks are behind the curve with plans control inflation with rate hikes. It was only a few months ago the Federal Reserve was talking transitory inflation and the RBA fixed and solid with the policy of holding the policy rate at 0.1% until 2024. Seriously, credibility has taken a hit with that sort of guidance from the central banks that are privy to more inside data than any other collective economic group.
So now reality is that policy rates are heading towards 3.0% in the US and probably similar in Australia, although the latter currently has less inflationary pressure showing up in the data. The reference earlier in this note to Jerome Powell’s talk at the National Association for Business Economics in March highlights the desire to control inflation back to the policy objective of 2.0%. That is a lot lower than the current 8.5%, but to be fair there are obvious pressure points that could fold lower quickly, but there are also pressure points that will be very difficult to control, such as energy, food and supply issues that emanate from the Ukraine War. This creates a large degree of uncertainty.
‘Bond yields soar’ back to levels that existed only three years ago. This has generated negative valuation returns for investors holding long duration bonds. Interest rates have been steadily falling for 40 years and the low point for the long bond rates became obvious at the time, and now it would be just as obvious that long bond rates do not track higher for the next 40 years. We have been underweight long duration bonds in our portfolio allocations, reducing the overall negative impact of rising rates. Given there is a high degree of uncertainty, we feel there will be a time, probably in the latter half of 2022, where the increasing yield for long duration bonds provides a good opportunity to increase exposure. We do not forecast; however, our observation would be that there is a possibility the yield curve will flatten around the 3.0% range. Rate hikes are designed to slow economic growth and its anyone’s guess when that will be achieved, however, when economic growth stalls then policy rates are generally reduced to induce growth. If central banks were in front of the ‘curve’ then maybe this gyration could be avoided. Interesting times, and the factors to watch in the future are inflation and growth.
The chart above shows the interest rate volatility compared to the S&P 500 and Nasdaq. There are two interesting factors, firstly, interest rate volatility is increasing at a faster rate than equities over recent months, and more so, the nominal level of volatility for interest rates is currently significantly higher than equities.
The currency is at interesting crossroads. The Federal Reserve’s rate hike policy should be supportive of the USD, while the commodity price rises is supportive of the AUD. There are some forecasts (including the CBA) that suggest the Australian policy interest rate will peak around 1.5%, which does make some sense when considering our inflation rates are likely to be lower than being experienced in the US. However, the unanswered conundrum is the what the level of the AUD might be if US policy rates are 3.0% and ours are only 1.5%. This would put significant downward pressure on the AUD. But most of the Australian banks have recently marked up their forecasts on the AUD closer to 80 cents by the end of 2022 and into early 2023. We favour the view that terminal policy rates in the US and Australia will be at similar levels, and the AUD will remain supported by commodities in the near term.
As we have previously noted, uncertainties and risks remain at elevated levels which directs us to a more cautious approach, and as time has passed the reality has become more evident for equity and bond markets. The over-valuation of big tech and high multiple stocks, and the extended fall in interest rates have been accentuated by loose global fiscal and monetary policy. Inflation in the US has kicked in and likely to surface in other key centres of economic influence, including Australia, has caused global central banks to adjust policy from pumping asset values to restricting inflation. If not managed correctly this could lead to a reversing of asset values, which ultimately is more than likely to correct valuations and provide opportunity.
Over the past year we have structured portfolios to reduce equity risk and shift it into lower volatility sectors such as infrastructure and absolute return 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 reduce the risk of rising rates and uncertainty in fixed interest by biasing the exposure to be underweight long duration bonds across portfolios.
We also acknowledge timing is difficult and there is likely to be a time to extend risk and duration. It should be noted that the degree of uncertainty defies strong views on pricing levels and timing, and our view is to tilt asset allocation along a path rather than adjust to specific terminal levels.
Index Returns – 31 March 2022
|Sector Returns (%)||FYTD||1-month||3-month||6-month||1 year||3 years||5 years|
|International Shares (unhedged)||2.08||-0.89||-8.42||-1.84||11.6||12.9||12.9|
|International Shares (hedged)||3.06||2.88||-5.02||2.48||10.85||13.6||11.6|
|Australian Listed Property||6.59||1.24||-7.1||2.26||17.74||5.15||7.8|
|Global Listed Property (hedged)||6.07||4.72||-3.53||6.28||15.65||4.22||5.89|
|Global Listed infrastructure (hedged)||15.7||5.53||7.49||12.46||18.04||6.59||7|
|Australian Bank Bills||0.03||0||0.01||0.02||0.04||0.46||1.02|
|International Bonds (hedged)||-4.9||-2.13||-4.98||-4.95||-4.01||0.84||1.99|
|CRB Commodity Index USD||38.33||9.7||27.03||28.94||59.59||17.1||9.69|
|Aust CPI (at previous quarter)||2.99||0.29||0.86||2.21||3.77||2.35||2.06|
Source: Lonsec, Bloomberg
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