It’s fair to say it’s been quite an unbelievable period since our last update.
Ups and downs in virus numbers, declining hospitalisation and death rates in most jurisdictions, particularly those with heightened vaccination rates, some of the largest quarterly economic growth numbers on record, surging inflation in the USA and concerns regarding inflation in other countries, all whilst central banks attempt to reassure investors regarding their plans, and geopolitical risks rumble in the background.
Markets have largely sailed through most of above with the strongest returns coming from equities, and more recently, property & infrastructure which have benefited from faster than expected reopening. Bonds, which struggled earlier in the year, have come roaring back (well as much as bonds can roar) as government bond prices have risen even considering the rising inflation risks.
In our day-to-day research, there are four key areas we’re currently focused on which are impacting markets and hence likely to impact portfolios over the coming months, quarters, years, and possibly even decades.
The reopening path is generally moving along at a reasonable pace, faster in some countries but slower than others.
It’s generally faster in those countries with higher vaccination rates, those countries that had managed the virus well in the initial phases, and some emerging market countries where they don’t have the ability to lockdown due to population density and/or higher levels of poverty.
Interestingly there are some countries where the pace of reopening is slower than expected even with their high vaccination rates (e.g. UK) and lower case/death rates (e.g. Australia).
The reopening path is critically important as it allows for:
We’re watching the path closely as it can also dictate some very different market and portfolio outcomes including the Value (i.e.. reopening/inflation) vs Growth (i.e.. lockdown/deflation) equity style dynamic, the amount of additional (or less) government stimulus needed in the period ahead which has a direct impact on the government bond market and specific stocks / sectors / countries / regions which are more sensitive to more or less reopening (e.g. property & infrastructure).
Right now, we believe the reopening path is sustainable and likely to improve from here given the pace of vaccinations and the general acceptance that life can’t return to normal without a large proportion of the population vaccinated. That means higher economic growth and likely higher inflation in the short term.
However, we think the pent-up demand story is likely a one-hit wonder in that once the money is spent / invested (if in fact it is, versus paying down more debt) the coffers won’t be replenished. That means we expect economic growth and inflation to settle back down over the short-to-medium term as the levels of government and central bank stimulus subside.
Can that be traded?
It can, but the timing is almost impossible to get right. We profess no skill here, except for a balanced and well diversified approach.
It still feels strange talking about the prospects for higher inflation given central banks have failed in their efforts to generate inflation anywhere near their targets over many decades. The lack of inflation has been due to the combination of too much debt, poor and declining demographics, and the rapid pace of technological advancement (i.e. technology being a substitute and/or replacement for labour).
That hasn’t gone away.
If anything, the structural tailwind for each of these three areas is now even stronger – i.e. we have significantly more debt than we did pre-Covid, demographics will continue to worsen as health concerns and economic hardship impact fertility rates, and we’ve seen a rapid acceleration in technological advancement since Covid began which has likely brought forward at least five years of progress, possibly more.
Over the last couple of months, we have seen higher inflation in many countries around the world, which was always going to be the case given you generally get demand and supply imbalances in a recovery, especially in a recovery where the movement of goods, services, and labour are in some cases severely restricted by government virus polices.
Usually, these are temporary issues which are solved by demand and supply imbalances correcting as supply either catches up (more investment) and/or demand starts to wane (consumption slows) as the recovery is complete.
However, this time around we have inflationary concerns that are more heightened than they might otherwise be, off the back of substantial government fiscal stimulus which continues to be provided, and supply being constrained by virus health policies. This combination can lead to extraordinary amounts of short-term inflation, enough to cause pain to businesses and consumers, whilst unsettling investors. We’re seeing this right now in the USA where inflation is running at an annualised pace well above 5%, and data shows that some inflationary pressures are sneaking into other regions as well.
We don’t believe these levels of inflation can be maintained given demand will settle down once the government stimulus reduces and supply will increase once virus restrictions are removed. However, we do have to deal with the degree of uncertainty around the length of time these conditions may last and the market’s reaction to such conditions which can be extreme as seen in the February/March government bond market sell-off.
Whilst central banks have done their best to douse any medium and long-term inflationary concerns (more on this below), the longer and higher inflation keeps running, the more volatility we’re likely to see in asset markets.
Hopefully, it subsides soon enough.
Whilst the short-term issues in financial markets centre around inflation caused by government fiscal policy and virus induced supply constraints, central bank policy is the key as it pertains to market support levels and continued asset price growth.
Central banks will at some stage need to get us off the zero percent rates and will also need to slow the growth in their balance sheet expansions (i.e. money printing). They have vowed to be slow and very measured, thus allowing for higher interim inflation, learning from their mistakes since the Global Financial Crisis (GFC) where every time they tried to normalise rates and their balance sheet, it sent investors into a panic-induced market sell-off.
This then resulted in central banks having to retrace their steps back to very easy policy settings, using more even more stimulus, thus making it a very circular exercise and putting them further behind the inflation objective each and every single time.
As such, it’s now a game of trust.
How much do we trust central bankers to remain calm, settled, and slow in relation to their policy tightening efforts? They’ve told us on numerous occasions that they will be slow and continue to reinforce that point. If so, then market conditions remain ripe for some time.
Our base case does align with this in that we don’t think the extraordinary levels of government debt (and private sector debt) allow for significantly higher rates without higher defaults and it’s also fairly well understood that whilst central banks don’t have equity market stability as one of their explicit objectives, it has somewhat become implicit in their operations since the GFC. i.e. no central banker wants to have on their resume that they were responsible for causing a debt crisis or an equity market collapse.
As mentioned above, we also think the recent sharp increases in inflation are likely to be transitory. For inflation to be sustainably at or above central bank inflation targets, we need to see persistently and considerably higher wage growth (unlikely given technology) and/or velocity of money (i.e. the pace at which money moves around the economy). Both of which are very low right now, especially the latter as central bank money printing has failed on the velocity of money front due to too much debt globally.
However, we do have to account for the fact that higher short-term inflation can and will test a central banker’s nerves, and the market itself (particularly the bond market) can and will test the courage of central bankers through the buying and selling of government bonds and currencies.
This may create some short-term volatility which we would see as a buying opportunity, assuming you can trade it quickly enough.
If you have an interest in politics, then geopolitics is a natural and significantly more complicated extension. There are always geopolitical risks present and there is always a way of connecting these risks even when they seem totally disparate from each other.
Our world is very much an interconnected game of chicken which makes it all the more interesting, and dangerous. Whilst there is plenty going on right now, we are focused on US-China, Australia-China, the Middle-East, and the European Union (elections in Germany and France). The Australia-China conflict is obviously closest to home and the most problematic in that they are our biggest trading partner with no easy solution to the problem (we trust that they will strike a balance).
We remain conducive on the forward period in relation to the economic recovery, the market environment, and geopolitical tensions, but we remain cautious in our trust given the events of the last 12-15 months.
At this stage, there is nothing we’re advertently avoiding, but we do currently favour less government bond exposure, a healthy Aussie small company allocation, a preference for unhedged global equities over Aussie equities, a healthy Asian / emerging market equity allocation, a healthy allocation to global listed property & infrastructure (with preference for the latter), whilst running cash at pretty low levels. We continue to favour active over passive investment management in light of potentially higher volatility ahead and a very healthy opportunity set within markets; versus the rich valuations on market indices which passive investing tracks. Value style investments are likely to benefit in light of near-term inflation concerns, but we favour valuation-aware Growth (or GARP) style investments over the medium to longer term. Binary portfolio decisions/allocations, along with too much concentration, will likely prove to be dangerous in the period ahead, hence sensible and impactful diversification is key.
The Australian equity market (as measured by the S&P/ASX 200) started the December quarter the same way the September quarter ended, with a sea of red as stubbornly high inflation and rising bond yields placed pressure on current and forward-looking company earnings. November and December came roaring back as positive inflation data (i.e. lower inflation numbers) and sudden falls in bond yields created an air of optimism and the potential end of central bank tightening. The share market closed at near record highs.
2023 made for another very interesting year in investment markets as macro / regime driven events resulted in extreme shifts in investor sentiment on an almost monthly basis. Investors chose to shoot first and ask questions later in what can best be described as a year of maximum noise.
The Australian equity market (as measured by the S&P/ASX 200) started the September quarter with a flurry but ended up in the red as the global “higher-for-longer” narrative (interest rates) coupled with the ever-increasing cost of living concerns caused consumer confidence to wane.