Mountains are sometimes referred to as sleeping giants. Sleeping because from a distance, they are majestic and have a certain stillness. Giants because of their sheer size. But as anyone who has tried to climb a mountain knows, they can be extremely unpredictable, violent and deadly. More than 300 people have died trying to reach the summit of Mount Everest alone.
Financial markets can be thought of in similar terms – from a distance they can appear magical to a novice investor; a place where it is easy to make quick money. A seasoned investor, however, knows better; they understand that markets can turn violent in a heartbeat. So just as climbers do, it pays to watch the weather signs.
Applying this mountain metaphor further, the four mountain peaks we are grappling with currently are the Pandemic, Policy, Growth and Inflation peaks. Some of these peaks appear clearer and therefore easier to identify and yet others are shrouded in a fine mist.
Let’s take a guided tour of each of these and try and ascertain if there are storm clouds brewing.
Up until a few weeks ago, we thought we had seen the peak of the pandemic, with the seven-day rate of new cases of COVID-19 globally declining from around 5.8 million per week in mid-April to 2.9 million in early June. Unfortunately, a new Delta variant of Covid-19 means that there are more clouds brewing.
Just as England celebrated its ‘Freedom Day’ and threw caution to wind, they are now seeing over 50,000 new cases of infection per day. It is also apparent the US is experiencing a fourth wave of infections with case numbers rising quickly throughout the country. And this is despite having large numbers of the populations vaccinated.
Thankfully, it appears that the current vaccines continue to provide some protection against the new Delta variant. The increase in case numbers seem to be taking hold in those segments of the population who remain unvaccinated. As more and more people get vaccinated, the chances of the Delta variant taking hold grow smaller.
If we do peak in infections, we believe that the global recovery will continue to gather momentum and more economies will begin to reopen. As in most cases in life, there will be some laggards in the race to reopen and unfortunately, it looks like Australia will be one of those.
Our troubles with the vaccination program are well documented and the percentage of the population vaccinated remains very low. This will continue to have an economic drag on our economy as we continue to see further lockdowns.
Policy support has played a tremendous role in sustaining global economies. There is little doubt that without such support we would have entered a severe economic winter which would have resulted in disastrous financial impacts for everyone.
While such support was required, critics will point to the financing of government budgets, inflation of asset prices and the boosting of inequality, so the question remains is it still required? If infection rates have started to decline, as we suspect, then so too has the need for fiscal support.
Developed market fiscal policy support.
Some central banks have already begun to scale back their asset purchases (fiscal support). The Bank of Canada reduced the pace of its bond buying in April, the Bank of England announced that it would be slowing its asset purchases, the Reserve Bank of New Zealand has advised that it will not make all of its proposed purchases and even our own Reserve Bank of Australia announced on the 6 July that it would begin tapering its purchases in September.
In contrast, the US Federal Reserve has only indicated that it has started “talking about talking about” tapering. Why the hesitation from the US central bank? It has vivid memories of 2013 when then Chairman Ben Bernanke hinted that the Federal Reserve would slow the pace of quantitative easing, only to see the 10-year Treasury yield jump from 1.7% to 3.0% very quickly.
Such a dramatic lift in interest rates again would be catastrophic for financial markets. The impact would not only be felt in financial markets but also on businesses and employees hip pockets. Given the large volumes of business and consumer debt, such a rise at a time of volatile economic growth could well push us back into a recession.
For this reason, we believe it is highly unlikely that we will see any aggressive tapering measures from the US Federal Reserve and that they will allow rates to only rise gradually. Such an environment should stay conducive to economic growth and corporate earnings which in turn will be supportive for investment markets.
At the moment, markets are pricing in about five 25 basis point rate increases by the Reserve Bank of Australia before the end of 2024. Should these increases come to fruition, there should be minimal impact upon the bond markets. Such a gradual increase will be a positive for most sectors in the Australian equity market however, some will feel the strain more than others.
As already mentioned, the dramatic stimulus measures to date have benefited economic growth as highlighted in the chart below.
You can also see in the chart above the expectations for growth in 2022 are declining and that is tied to the Peak Policy expectations that more central banks will begin a gradual reduction in their stimulus support.
A slowing of global growth is not necessarily a bad outcome if growth reduces to a more sustainable rate. Growth sustainability means that central banks are not forced to raise interest rates aggressively to stamp out inflation.
You will be able to see that between 2012 and 2018, global growth remained reasonably stable while over that same time the MSCI World Index rose by 58.8%.
Perhaps the largest and most frightening mountain looming in our view is the inflation peak. There is constant debate amongst economists and investors about whether we are seeing a temporary spike in inflation or whether we are entering a new inflationary period.
The following chart highlights the relationship between developed market GDP growth and developed market core inflation for the past 18 years. Inflation generally lags economic growth and the chart below has been altered to highlight that relationship.
If, as we believe, that global GDP growth will slow in the coming 12 months, we think inflation will also peak in the next 6 months. This is certainly the line that the US Federal Reserve is currently adopting and hence its conservative nature in relation to its stimulus support and interest rate forecasts.
There is no doubt that we are currently seeing spikes in inflation, especially in the US as highlighted in the following chart comparing developed market core inflation (including the US) in the blue line versus the same measure excluding the US in the green line.
The bulk of this inflationary spike should prove transitory as it is more akin to a reflationary period following the global shutdowns than a true inflationary / stagflation period.
There are a number of reasons why we believe it should prove transitory. The primary reason is due to the base effect whereupon the inflation numbers dropped dramatically 12 months ago as the world entered rolling shutdowns. Now that growth is re-emerging from these shutdowns, we are seeing significantly higher inflation numbers compared to those lows, hence the base effect is over dramatizing the results.
Another factor at play is the current shortage of some production goods. Just as we witnessed a spike in second-hand car prices last year, the US has seen a 45% increase in the same period due to supply shortages of new cars and hire companies being forced to buy back cars that they sold in the middle of the shutdowns. Timber prices have also recently spiked dramatically higher impacting housing construction prices due to global shortages of finished goods.
A lot of these supply constraints are temporary and include shortage of staff willing to return to the workforce and an avoidance of some staff to travel on public transport. In time, these bottlenecks will clear and supply will return to normal.
The other reason we remain confident it is temporary, is that the deflationary forces which have driven down prices for an extended period have not disappeared. High debt levels, ageing populations, automation of workforces, technological advances and globalisation are still with us and will remain so for years to come. Yes, supply chains are questioning their over reliance on China and making changes, but those changes often see supply shifted to other emerging countries.
We should note that this is a widely held consensus view and therefore not without some risk. Should we be wrong in our assumptions and inflation proves to be entrenched and continues to grow, the impacts on markets will be dramatic.
In this situation, central banks will need to shift quickly and interest rates will potentially rise at a fast pace. As we highlighted above, such a move would be reminiscent of the 2013 period and would impact bond and equity markets alike.
The key economic indicators we continue to watch are unemployment rates and wage rates. We expect unemployment rates to fall below 4% in Australia before any sustained wage increases emerge and therefore any inflationary period becomes the norm. Until then, we continue to hold the view that inflation will prove to be transitory.
In short there are a lot of moving parts however, we still believe that we are likely to see very low interest rates until at least the second half of 2023. As such, cash will remain a drag on portfolio returns. We continue to tilt our defensive portion of portfolios towards bond investments, both corporate and government, to generate returns over the cash rate.
Given our views on the investment outlook, we continue to prefer an overweight towards growth assets over defensive assets. Our preference remains holding some additional exposure to European and Emerging Market equities purely on valuation grounds.
We are seeing fewer high conviction opportunities and believe valuations in a number of markets are becoming expensive. In this environment it remains prudent to be watchful and to take some profits while redirecting capital to other areas that have further scope to advance.
Andrew Aylward is Chief Investment Officer at Keep Wealth Partners.
Keep Wealth Partners Pty Ltd (AFSL 494858). This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from a financial planner who can consider if the strategies and products are right for you.