Themes For November

13 December 2021

Concerns about the emergence of the new Omicron COVID-19 variant caused global equities to retreat late in the month, pushing markets into negative territory for November. The Australian market held up relatively well declining by just 0.5% with the US posting a 0.7% decline. European markets fell by 2.5% with concerns that rising COVID case numbers in countries such as Austria and the Netherlands will lead to a return to lockdowns. China fell by 5.9% amid growing concerns about its economic slowdown and the state of the property market. It’s now confirmed that the large property developer Evergrande will default on its debt obligations and move to a balance sheet restructure in order to save the company.

The “risk-off” sentiment late in the month saw a rally in bond markets with the Australian 10-year bond declining 38 basis points and the US equivalent falling 12 basis points. As is often the case, the Australian dollar behaved as a proxy for risk, falling 5.6% against the US dollar, more than compensating for the decline in overseas share prices for Australian investors.

Market relieved at Powell’s reappointment

Investors breathed a sigh of relief that Federal Reserve Chairperson Powell was reappointed for a further 4-year term late in the month. With the Fed carrying the burden of managing the US inflation outbreak, a steady hand at the wheel is required. Is his testimony to Congress shortly after his re-appointment, Powell signalled that the pace for tapering the quantitative easing program would be accelerated to finish a few months ahead of the previous June 2022 target. Significantly, Powell removed the word “transitory” from his inflation commentary indicating a more decisive adjustment to monetary settings would be required. Inflation for November in the US rose by 0.8% bringing the annual rate to 6.8%, the highest level in 39 years.

The reality is that the new US government has not managed the economy well through its recovery from the 2020 recession. Excess demand from too much stimulus against a backdrop of supply chain bottlenecks, plus constraints on local energy production were always a recipe for higher inflation. The supply issues were not a manufacturing problem, but a distribution issue stemming from labour shortages in waterfront and transportation industries – highlighted by the flotilla of cargo ships anchored off the major port of Long Beach in California. Consequently, the Federal Reserve will have to take centre stage in fighting inflation which will mean firstly discontinuing QE by March next year and secondly increasing interest rates by the middle of 2022, well ahead of previous expectations.

US Inflation

Financial commentary these days tends to read more like “The Lancet” medical journal with detailed analysis of the SARS-CoV-2 virus and its mutations, rather than focusing on the relevance for financial markets. The risk to financial markets is not from the virus itself but from government policies that restrict economic activity such as border closures and lockdowns. As we look out to 2022, it is clear the policy prescription going forward must be very different to the past 2 years. Governments have exhausted their financial capital and the public has exhausted its goodwill to tolerate further draconian measures such as lockdowns. The advent of effective (and evolving) vaccines, new therapeutics plus natural immunity from prior infection means that the policy response going forward should be very different from what we have witnessed thus far in the pandemic.

Strategy and Outlook

The key to managing asset allocation for a multi-asset portfolio is to assess whether the premium available from more volatile assets such as shares is sufficient to compensate for the additional risk they carry.

Source: Macquarie Quantitative Research

The chart above illustrates that the premium for US equities above 10-year bonds is well below historic averages indicating shares are not cheap by this measure. The same is the case for Australia and most other global markets. This is largely the product of very low bond yields suppressed by large QE buying from central banks that have expanded P/E ratios translating to lower earnings yields. While there is not much buffer for uncertainty, we are confident that global economic growth will accelerate in 2022 as governments continue to lift their economically restrictive COVID management policies.

The key questions are whether the current spike in inflation will persist throughout the year and to what extent will this drive government and central bank policy. In the US, inflation has now printed above 5% per annum for 7 months in a row. History tells us that once the inflation genie is out of the bottle it is very hard to put back. This is because inflation expectations are reset at higher levels and become factored into pricing behaviour which perpetuates inflation going forward. The consequences of this are that central banks will curtail their quantitative easing policies sooner than previously thought and the timetable for the first increase in interest rates will also be brought forward. This environment will be very negative for fixed coupon government bonds as higher bond yields will erode their capital value.

In anticipation of this, we sold our positions in these securities several months ago in favour of inflation-linked government bonds and floating rate corporate debt, which offer much better protection against higher inflation. While higher bond yields also present some challenges for equity valuations, the prospect of good earnings growth against the backdrop of an improving global economy will still lead to reasonable returns from shares albeit at lower absolute levels than we have experienced for the past two years.

In addition to this, there is always the possibility of an unforeseen “Black Swan” event – who would have anticipated the COVID pandemic 2 years ago? This is most likely to come from a geopolitical event such as a Russian invasion of Ukraine with potential implications in the energy market, or from military aggression from China towards Taiwan with implications for semi-conductor production. In both instances, severe sanctions from the West would follow, posing a challenge for the global economy.

One final thought for the year, the lead up to Christmas is usually a good one for equity markets, so let’s hope the Santa Claus rally once again delivers a strong close to 2021!