Inflation management is now the focus of economic policy.
For almost two years now the focus of economic policy has been to stimulate demand to cushion the global economy from the worst effects of the pandemic. This has come at a very high economic cost with most governments now heavily indebted and central bank balance sheets severely bloated. The stimulus strategies were successful, perhaps too successful as excess demand against a backdrop of constrained supply has been the catalyst for the higher inflation we are now experiencing. With headline US inflation now running at 7% per annum (the highest in 40 years), the Fed has accepted that inflation is no longer transitory and requires a decisive policy response.
At his recent testimony before Congress, chairperson Powell indicated that the Fed would commence increasing interest rates as early as March this year, coincident with a run-off in the quantitative easing programme. The forward US interest rate curve is now discounting as many as five 25bp hikes before the end of 2022. Similarly in Australia, inflation for the December quarter printed at a higher than expected 3.5% with the RBA’s preferred underlying measure also above expectation at 2.6% per annum to now be pushing to the upper band of their 2% to 3% target range. The RBA’s stance is a little more dovish than the Fed however, preferring to see higher wages growth before moving to tighten policy. With these sorts of inflation readings, it’s clear that emergency settings for interest rates and liquidity conditions are no longer appropriate. We know from history that once higher inflation expectations become embedded in pricing and wage setting behaviour, it is very difficult to squeeze it out of the system. Because of this, we have seen government bond yields increase to adjust for different monetary policy expectations and a different inflation outlook.
The knock-on effect of this has been to challenge share market valuations, which, in many cases, relied on low bond yields to justify the elevated earnings multiples.
Over the past six months there has been a substantial change to the fundamentals driving financial markets. Interest rates and liquidity conditions have been a strong tailwind for equity markets over the last two years, however, this will no longer be the case as we move through 2022. The arrival of the omicron variant late in 2021 has changed expectations for growth in 2022. Last year, the pandemic’s economic impact was largely the result of government-imposed lockdowns and border restrictions. The omicron variant, however, is much more infectious as it is evading the vaccines’ protection against infection and transmission. This has resulted in labour shortages due to the need to quarantine infected workers and furlough close contacts. This has been a global phenomenon and has seen the OECD revise down their forecast for global growth in 2022.
While economic growth is still likely to be robust, there is no doubt that expectations for earnings growth this year have been revised downwards. The combination of higher interest rates, less money creation, together with negative revisions to earnings growth mean that equity markets offer a much lower risk premium than was the case in the middle of last year. For this reason, we have decided to reduce the exposure to both Australian and international equities as an insurance policy against the possibility of further market declines.
While it is still our expectation it will be a solid year for share market returns, we must recognise that the environment for equities is less compelling than it was last year. The proceeds of the equity sales have been invested in US Treasury inflation protected securities (TIPS) whose capital values are indexed to CPI and therefore insulated from the erosive effects of inflation. The USD exposure provided by these securities will offer additional risk mitigation as the AUD is vulnerable to correction in a risk-off environment.