Inflation concerns pushed bond yields higher for the month with the US 10-year treasury yield rising 19 basis points to finish at 1.48% with the equivalent Australian bond 28 points higher to finish at the same level. The Australian dollar fell by roughly 1 cent against the US dollar to close at 72 cents, reflecting concerns about Chinese growth that also impacted the iron ore price which finished the month 26% lower. Oil was the standout commodity with production cutbacks producing a global shortage pushing the price up 10.3% to close at $US75 a barrel.
Markets Climb a Wall of Worry
There is no doubt the scourge of inflation is the greatest risk to financial markets. In the US, monthly CPI readings have printed on the high side but the US Federal Reserve believes this is due to transient factors relating to COVID restrictions, especially supply-side bottlenecks affecting manufacturing output and freight costs which anecdotally have risen ten-fold over the course of the pandemic. With demand recovering as economies progressively reopen, there is a short-term price squeeze due to supply limitations. The Fed believes this imbalance should resolve over time and not lead to structurally higher inflation. The risk to this scenario is that elevated inflation expectations become embedded into pricing behaviour, especially wage demands, in which case higher inflation becomes self-fulfilling. Due to the economic dislocation caused by the pandemic, central banks are prepared to be more patient with inflation than would be the case in a normal economic cycle. The announcement by the Fed that they will begin to taper their monthly asset purchases from November this year comes as no surprise but will moderate the tailwind that money creation has provided for asset markets since the pandemic began.
An additional concern in the US is the degree of profligate deficit spending currently before Congress which in total amounts to roughly $US5 trillion adding to the already crippling debt of $US28 trillion (130% of GDP) the US has accumulated. $US1.5 trillion of this relates to upgrading the nation’s infrastructure which has achieved bipartisan support, however $US3.5 trillion relates to factors such as climate change, immigration policy and entitlement measures and has yet to receive unanimous support even within the ruling Democratic Party ranks. From a financial market perspective, the key issue is whether adding further stimulus to the US economy is a wise policy choice at a time when inflation risks are already rising.
Strategy and Outlook
As reported last month, we took some profits from international shares within balanced and growth portfolios following a period of strong performance and in recognition of some developing risk factors. While it is likely that market jitters will continue for the next month or so, the medium-term outlook for equities remains positive. It is expected that central banks will gradually withdraw their emergency support for the financial system as the global economy recovers, however, the driving force for share prices will be corporate profit growth which remains on an upward trajectory. As we move through 2022, the global economy will naturally re-balance as demand recovers and supply bottlenecks are resolved and will begin to resemble a more normal economic cycle rather than one that has been largely contrived by government policy designed to supress COVID 19.
