Oct 2021 15 Minutes
Economic Update – October 2021
Economic and Asset Performance Comment – October 2021
While global financial markets have remained strong since May 2020, supported by fiscal and monetary stimulus, low interest rates as well as the development and rollout of the COVID vaccine, key factors such as new COVID variants affecting the opening of economies and the inflation outlook remain significant uncertainties that could have significant impact on financial markets. Equity valuations are stretched at current levels, but ultra-low interest rates continue to be supportive for equities. The withdrawal of stimulus, higher interest rates and/or inflation could negatively impact equity markets.
There are many factors that influence equity markets such as earnings growth, the difference between equity and interest rate returns, and sentiment, to name a few. We note how stretched the valuations are for the broad indexes, which has been largely driven by US big tech equity pricing. Valuations for other sectors and regions are far less stretched. We must also consider how new technology has created the disruptive companies and how the older style business has benefited from embedding new technology. We are living in a most peculiar environment socially, and the level of government stimulus and money printing is at a level that has never been seen before, and technology has generated efficiencies and new business in a similar manner to the Industrial Revolution. Hindsight is wonderful and it is difficult to know if there was far too much printed money and support provided. However, better to look forward and try to understand the scenarios that we currently face.
Investment markets are confronted with a complex set of issues and the traditional safer interest rate markets not only provide low returns, but the risks are also elevated. This is forcing investors out the risk curve into equities, property, higher yielding credit and even private equity and debt, with the latter not exposed to the rigor of transparent market pricing. It is all about balancing the degree of risk appetite against the likely rewards, subject to liquidity requirements.
The degree of uncertainty remains high for investment markets, with high equity and fixed interest valuations as the world transitions through this most abnormal period. The OECD considers that a strong global recovery is underway, albeit uneven across countries. They also consider cost pressures will be temporary, although market views on the latter vary considerably. Factors such as investor sentiment and complacency should also be considered.
We continue to expect risk 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 adjustment is a key factor for equity and bond markets. The OECD GDP growth forecasts released in September 2021 remain relatively stable. The charts below highlight the uneven recovery pattern between developed and emerging markets. According to the OECD, employment remains below pre-pandemic levels in most countries; inflation is projected to moderate, but less in some EM countries; uneven vaccination progress is putting global recovery at risk; and supply chain blockages are causing problems.
The OECD has reduced GDP growth projections for Australia in 2021 from 5.1% to 4.0% and maintained the 2022 forecast at 3.3%.
There is clearly inflation in the system, but the experts have a wide range of views whether it will be transitory or persistent. We feel that inflation, along with COVID issues, will be the key for the financial markets outlook for the next couple of years. During February and March this year the bond market became extremely nervous about the spike of US CPI data and was aggressively sold off. The proportionate increase of longer-term bond yields was possibly at record levels, albeit the actual 2% rate for 10-year US bonds is incredibly low. The chart below is a reputable forecast suggesting US inflation will be sub-2% by 2023.
Inflation is difficult to calculate. It is all about the allocation and purchasing power of earned income. For example, our food prices are rising, while China has been exporting deflation. The chart below shows the price changes over the last 20 years.
Shipping costs (see below) would be considered transitory and likely to return to historical levels over time.
Likewise global gas prices (see below) are rising due to UK gas shortages, again this would appear to be transitory.
United Kingdom Natural Gas Futures
However transitory, the consumers dollar purchasing power is currently under pressure. Will this force central banks or bond markets to react? Rising inflation and/or interest rates is not good for equities, and hence we have maintained our risk tolerances at slightly lower levels than neutral.
The rate that vaccines were developed was amazing. 45% of the world population and 80% of Australians have received at least one dose. These figures are positive but do highlight how uneven the rollout is (as shown in the chart below), and therefore the global recovery will have competing issues for some time to come.
While setbacks relating to COVID, such as new variants, pose a huge risk to economic growth and financial markets (and health), the recent news from Merck regarding the development of an antiviral treatment pill could be a game changer, reducing extreme health issues, similarly as Tamiflu did for influenza. For Australia, who have sheltered behind the deep-water moat from COVID, are now planning to open international borders since New South Wales and Victoria have failed to contain the Delta strain, which puts a lot of pressure for the smaller States to vaccinate quickly. The real issue in Australia seems to be the lack of planning and funding of the health and hospital facilities in most States over the last eighteen months to cope with borders opening – hard to fathom!
China has been central to the Australian economy for over two decades, as was Japan in the 1980’s, and the ultimate outcome is uncertain. Western views regarding China’s policies range from global domination at any cost, to autocracy clinging to Communist ideology.
China has always worked with long term plans. Shifting 250 million people from subsistence farming to far better lifestyles in cities obviously develops support by the people of the central policy and is not possible to reverse. Integration into global economies would appear important but the underlying plan is unclear. Rhetoric of trade wars creates front page news, however, the chart below showing China’s trade balance highlights the real picture. China is also carrying a large debt load that needs to be funded. China is working through a period of transition from socio-economic development, manufacturer, and exporter but the future is more focussed on consumption and remains as complex as it is unclear.
Tariffs imposed on Australian exports was an unfortunate speed hump for Australian product, however, this has caused lazy marketing departments to look elsewhere and employ Risk Management 101 process, that is, diversify income streams. Treasury Wines have pivoted to markets including the US, while barley has also found alternative buyers. High quality product will generally find a home.
Of more interest recently is China’s policy shift to ‘common prosperity’. The key objective is to create a fairer and more equal ‘social welfare society’ which is a long-term policy goal, and will create macro implications over the longer term, accelerating the rebalance from investment to consumption in China. It looks like the CCP will take out a few entrepreneurs along the way, for the greater good.
The implosion of Evergrande is a re-write of the old and common glutenous property development excesses that have existed across the world, but this one is on steroids, and no doubt a few more to come. Evergrande originally grew from a housing requirement that needed to be filled and was consistent with the government objectives. Excesses of product and debt followed, supported by government plans, and when the government cracked down on the same leverage and speculation it encouraged for years, Evergrande and other developer’s problems emerged. The general view is that the ‘common prosperity’ theme is likely to see projects for homebuyers completed at the expense of bond and equity holders.
Monetary and fiscal policy
Unconventional monetary policy first emerged following the GFC in 2008 via ‘quantitative easing’, The RBA avoided this policy until the COVID crisis when it adopted its own Term Funding Facility (TFF) (see the charts below). The policy is aimed at boosting bank reserves and deposits, and therefore providing liquidity for the banks to create debt and support the economy. Interestingly, business debt remains subdued while household debt has expanded significantly. The printed money is shifted into the system as bank deposits and/or for asset purchases. With interest rates close to zero, the printed money is trending towards equity or hard assets, hence the stock market and housing markets are very strong and boosting economic growth. Investors have shifted out the risk curve to earn a margin above cash rates.
As was noted after the GFC calamity had subsided, the central banks involved with quantitative easing struggled to unwind these facilities. We had the taper tantrum late 2018 when the Federal Reserve began to unwind. The reality is that unwinding of quantitative easing or the Australian TFF will create a significant drag within the financial system. Ok, a problem for another day.
There is no doubt that equity markets have marched aggressively upwards since the COVID crisis. Equity markets are heavily influenced by earnings growth, which is fuelled by GDP growth, both coming from significant lows caused by the COVID crisis, as has sentiment. The stimulus and ultra-low interest rates have created a most unusual set of circumstances which might suggest we throw away our old textbooks, except for the chapter about comparing earnings from dividends and interest rates, which currently supports equities.
We are no fans of quoting Warren Buffet, however, there has been talk recently about his ‘favourite indicator’. This is the combined market capitalisation of the total of publicly traded shares, divided by the global GDP. Well apparently, it is currently sitting at 142% and by his measure when the indicator is greater than 100% the global stock market is overvalued and prone for a correction. The charts below highlight the rate of growth of equities since the COVID crisis began in March 2020.
The VIX generally responds to actuals rather than providing an insight to the future. We do note the VIX has started to rise recently, which may suggest others are concerned about future equity market levels.
Volatility Index (VIX) - 5 year
We are concerned about equity markets in the near term because of the steep climb of prices over the last year, however, there are also factors such as the rate of fall of interest rates, the rate of economic and earnings recovery from 2020 lows. These are most unusual times, and we are facing most unusual living conditions and economic circumstances. Another factor to remember is that much of the equity growth has been driven by the efficiencies created by the infusion of technology by way of disrupters and embedding into older style business, which is a long term positive. We would be more of the view that equity and interest rate markets have adjusted for these unusual times but need a rest and/or consolidation. Over the medium term we would expect equity markets to continue to be supported by low interest rates and stimulus which is difficult to unwind. However, if inflation were ultimately considered to be persistent, then this could result in rising interest rates and a significant equity market correction. These are key factors to monitor.
Capital markets forecasts for emerging markets (EM) continue to be at the higher levels compared to most other asset classes. Also, EM equity markets have been relatively flat in recent years compared to developed markets. The level of risk that could impact emerging markets, as we broadly discuss above, are at very high levels. We are cautious on EM and consider the risk reward does not justify investment at this stage. Further, Australian equities provide a useful proxy for emerging markets, with less underlying risk.
The bond markets are more aware of macro issues than equity markets, and they are also much larger, therefore probably the key market to watch while valuations are at extreme levels.
The 10-year Australian bond rate graph below highlights the extent of the interest rate spike during February/March this year, which remains top of mind in the bond market. This spike was a result of aware people becoming very nervous of several macro and inflationary issues, many discussed in this paper.
There is much uncertainty in investment markets and views of the interest rate outlook vary. In reality, they can also fall further from here. Probably the biggest influence will be inflation. We are unlikely to know the answers to the inflation question until later in 2022. The Federal Reserve policy and actions will also be a significant influence. There is another aspect that is not discussed by central banks. Question: How do global governments fund the currently extreme borrowings at, say, twice the current cost? The cynical view would be that governments may prefer rates to remain lower for longer for their own budget benefit.
In the chase for yield, credit spreads remain at extremely low levels (see below). Support packages have provided corporates a lifeline which has saved many during the post-COVID period. Although this is a positive factor for corporate credit, we do remain cautious for the medium term and question the risk reward factor of lower quality credit.
Domestic house prices and debt
Domestic house prices have risen circa 20% over the last year. Initially, house price rises were driven by owner-occupiers, however, over the last 3 months investors have driven the recent push, as can be seen when comparing the two charts below. Like equities in the post-COVID stimulus supported environment, how far is too far? Finally, APRA have recently announced the requirement for banks to lift the interest rate buffer used for home loan approvals. This alleviates the requirement for the RBA to increase rates. Our regulators are serially slow reactors, and it would be preferred if they were more proactive.
The Australian dollar has been trading either side of the long-term average (USD 0.76) for some time, and forecasts have been in the range of 0.70 to 0.80. The AUD is heavily affected by the USD. The bigger picture is that the expanded level of US money supply is not supportive for the USD and rising commodity prices is supportive of AUD, although the recent fall of the iron ore price should also be considered. The AUD seems to be range bound.
Our views remain similar to earlier in the year. 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.
Index Returns – 30 September 2021
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