For my technical clients.
This technical commentary has been prepared for Network Financial Planning clients with investments held under the MDA Investment Program. It provides an update on the quarterly portfolio performance and some perspective on the economy and the current outlook for investment markets.
MARCH QUARTER - 2022
What Happened During the Period
We said in January that markets expected around 3 rate rises in the US in 2022 which at the time was a major shift in expectations from a few months previously. Fast forward to April and the US Fed is even further behind the curve in fighting inflation with around 9 rate hikes expected during 2022. Even the most dovish members of the Fed have now become hawkish as US consumer inflation hits multi decade highs of 8.5%. The Fed completed its QE program or buying of bonds in March. Shrinking the US Fed balance sheet from its current level of around $8.9 trillion is now expected to begin in June at a rate of $95 billion a month. This quantitative tightening (QT) is another headwind that equity and bond markets will have to face.
Most equity markets were down in the first quarter but bond prices also experienced major falls as yields rose in the face of decades high inflation and a much more aggressive US Fed. Both the US and Australian 10 year bond yields have risen by over 1.3% year to date to trade at around 2.9% and 3.0% respectively. This equates to price falls of around 5% to 6% just in the first quarter for the common fixed interest benchmarks. It is now very likely that bond prices will fall for two years in a row, which is not a common occurrence.
The other major event has obviously been the Russian invasion of Ukraine. Quite apart from the humanitarian disaster, this has led to elevated oil prices and higher commodity prices, which has also added to inflation pressure. In addition, this has resulted in global growth estimates being wound back.
Australian large cap equities returned 2.24% for the 3 months to 31 March 2022. This was well ahead of Australian small cap equities which returned -4.21%. Equities had a good bounce in March, with the ASX200 jumping 6.9% which offset the losses earlier in the year.
Resources massively outperformed Industrials over the period, (by 22.9%) or 20.36% versus -2.58%. With resources outperforming, it should not surprise that domestic equities handily beat Developed Market Global equities which returned -8.37%. Emerging Market equities were the laggard with a return of -9.89%. Australian fixed interest had a terrible quarter with the benchmark returning -5.88%. Australian listed Property could not overcome the rising bond yields and had a return of -7.1% for the period. Cash continues to essentially produce zero returns but we expect that to change soon as rate hikes start to kick in.
The common theme over the last few months has been that Global GDP estimates have been revised down, with both the IMF and World Bank doing so very recently.
The World Bank cut its forecast for global GDP growth this year to 3.2% from a January prediction of 4.1%. They cited the war in Ukraine, supply chain disruptions and inflation (energy) as major factors. They are expecting a sharp contraction in Russia and Ukraine and negative impacts particularly in Europe and Central Asia. The global forecast for 2022 compares with 5.7% growth in 2021.
The International Monetary Fund (IMF) downgraded the outlook for the world economy for both 2022 and 2023. This was attributed to the war in Ukraine for disrupting global commerce and pushing up oil prices amongst other factors, as well as increasing uncertainty. It cut its forecast for global growth to 3.6% in 2022, a steep fall from the 6.1% last year and from the 4.4% growth it had expected for 2022 in January of this year. It expects the world economy to grow by 3.6% in 2023, slightly slower than the 3.8% it forecast in January. China’s growth forecast was downgraded to just 4.4%, well down on the 8.1% it recorded in 2021.
The Chinese economy grew by 4.8% in the first 3 months of the year, compared with a year earlier. However much of this growth occurred in January and February, and that figure obscured the economic slowdown that took place last month as much of China locked down for Covid. The Caixin Manufacturing PMI in China recorded 48.14 in March, below expectations of 49.9, as manufacturing was dragged down by the COVID wave that has shut down cities such as Shanghai. The US Fed recently also cut its US GDP estimate for 2022. It now sees the economy expanding by 2.8% this year, down from the 4% it had predicted in December of 2021 and the 5.7% recorded in 2021.
Australia is an exception to IMF downgrades as higher commodity prices will provide a boost to income and it actually received a small upgrade to its growth outlook. Australian GDP is forecast to grow by 4.2% in 2022, up from 4.1% forecast in January. They estimated Australian inflation to average 3.9% in 2022, well above the RBA target band, due to rising petrol prices and the low 4% unemployment rate. The RBA estimate for inflation in 2022 is 3.25%, however, the RBA is expected to upgrade its forecasts in early May. Australian economists are also slightly more bullish than the IMF with the Australian economy forecast to grow at 4.3% this year.
Markets and Outlook
The US Fed has been actively talking up interest rates in the US as it has attempted to get markets to do the tightening ahead of it raising rates (one hike so far). The formerly dovish governor Brainard has done much of the jawboning.
“Currently, inflation is much too high and is subject to upside risks,” ... “The committee is prepared to take stronger action if indicators of inflation and inflation expectations indicate that such action is warranted.” . The Fed “will continue tightening monetary policy methodically through a series of interest rate increases and by starting to reduce the balance sheet at a rapid pace as soon as our May meeting”.
We believe the Fed would like to rapidly get the cash rate (short rate) to a neutral level which is thought to be about 2.4% before possibly pausing. Market expectations change from day to day but there are roughly 10 quarter point rate hikes built in to markets. Fed projections are for the cash rate to be at 2.8% in both 2023 and 2024. Also, the expectation is that the next two hikes at least, will be 0.5%. The most hawkish Fed member, St. Louis Federal Reserve president James Bullard said the Fed’s Cash rate should reach 3.5% later this year, a level that implies 0.5% rate increases at each of the bank’s 6 remaining meetings in 2022.
The Fed is so far behind the curve with CPI inflation of 8.5% and PPI (or wholesale inflation) of 11.2% that it is an open question if projected rate hikes will be enough to tame inflation. Historically, the Fed has had to raise rates to a level matching wages growth or the level of inflation, that is over 5% or 8% respectively. However, it is very hard to see that happening given the enormous levels of debt post the pandemic.
So, the issue is we do not know how far interest rates will rise which makes it very difficult to value markets. There is also the question of how much inflation is due to supply chain issues which will gradually dissipate over time. Another major complicating factor is we will also have to deal with QT at rate of $US95 billion a month. This is a reversal of QE which some estimates say has depressed the US 10 year bond yield by around 1.5%.
Finally, there is also the possibility of a recession as it historically has been difficult for the Fed to engineer a soft landing when inflation has become out of control. This is not our base case for the next 12 months but the probability of a recession has been rising according to various models. According to a Wall Street Journal poll, the probability of a recession in the next 12 months was 13% in April 2021, 18% in January 2022, and a 28% chance in April 2022. According to JP Morgan, historically the Fed has tended to stop hiking when the one year out probability of a recession reached 30% to 40% (JPM, 31 March, Bond Bulletin).
We also expect the RBA will begin hiking rates in June. In the April minutes it acknowledged a significant pick-up in inflation, noting that “a further increase was expected”, with measures of underlying inflation in the March quarter expected to be above 3%. This is probably an understatement with NAB economists predicting core inflation at 1.2% for the first quarter and 3.4% over the year. If this comes true, the 6-month annualised rate of core inflation would be 4.4%. And this is before most of the inflation pressures from the war in Ukraine conflict have been reflected. With Australian inflation roughly half that in the US, we expect the RBA to be less aggressive but should point out the neutral rate here is considered to be a little above 2.0%
This is probably the most complex investing environment we can remember, but what we can say is that we would expect equity PE multiples to fall as interest rates rise. The 20 year average PE for the ASX 200 is 14.7x (currently ~17x), the 25 year average PE for S&P 500 is 16.8x (Currently ~20x, JPM). We do not know where PEs will end up but just note that if the US PE went from 20x to 17x for example, this is a multiple contraction of -15%. This would require a combination of +15% in EPS growth and Dividends just for an investor to break even, disregarding the time period involved. On the plus side, Europe, Japan and China are now all trading below their long term PE averages, something we have not seen for a while. The World PE is still above this average but this is mainly due to the US market.
Australia is a special case for the moment. The war in Ukraine has boosted the price of many commodities such as oil, nickel and wheat and given a boost to the Australian dollar. The S&P GSCI Commodity Total Return Index for example increased by 5.9% in March, while the Australian Dollar Trade Weighted Index rose by 5.0% in the same month. Our market is seen as a hedge against inflation so has been one of the best performing markets this year. If the war in Ukraine ended, then we would expect a knee jerk hit to the AUD and our share market but it would still find support as long as inflation is a major issue.
We continue to believe you should hold a mixture of equity styles such as Value/Cyclicals and Growth. In the US for example, year to date, Value style equities are roughly flat while Growth style equities are down well over 10% with a large proportion of Nasdaq stocks in a bear market (i.e. down more than 20% from their recent high). We believe it is too early to start increasing the Duration in fixed interest portfolios as we think there is a risk that central banks may need to raise rates by more than current expectations to tame inflation.
While negative real interest rates currently favour Growth assets over the long term, it seems a good idea to hold higher Cash levels than usual to take advantage of likely higher than average volatility in markets. However, we expect that long interest rates (at least) will have positive real yields over time, i.e. after inflation, providing some competition for equities. Our strategy for growth assets continues to be one of patience, we would wait for pullbacks in markets or for individual opportunities to arise given the uncertainty around the fight to tame inflation.
DECEMBER QUARTER - 2021
Portfolio Performance Summary
The performance of risk assets was mostly positive in the 3 months to the end of December 2021. However, fixed interest produced negative returns as bond yields rose over the period. Cash continues to deliver returns that are close to zero.
The returns of the Strategic portfolios ranged from 0.4% for the Conservative Portfolio to 2.0% for the High Growth Portfolio. These returns were all below the Mercer Wholesale Averages for similar funds over the period.
Some of the factors impacting returns were:
The level of hedging had little influence on returns during this quarter, with the Australian dollar moving less than 1% versus the US dollar. Developed Market Global equities performed much better than Australian equities which should have benefited our portfolios since we are overweight global equities relative to domestic equities. However, our Global Equity mix substantially underperformed the benchmark. The level of underperformance was large enough that our Global equities mix actually returned less than our Australian equities managers.
Our Australian Equity managers as a whole did quite well and finished a little above the return of the large cap benchmark. The best performing large cap manager was Ausbil Active Equity which returned 2.93% for the quarter, or 0.8% above the benchmark. Our best performers though were our mid and small cap managers. Aberdeen Ex-20 Australian Equities (Quality Growth) returned 3.69%, while our small cap manager in Fairview Emerging Companies returned 5.14%. The latter result was 3.1% ahead of the Small Cap benchmark which returned 2.03%. The laggards were T Rowe Australian Equity (Quality Growth) which returned 1.60% and Tyndall Australian Share (formerly Nikko, Value style) which returned -0.99%.
Our Global Equity managers as a whole had a very disappointing quarter. As a group they returned less than 2% versus the Developed Market Global equity benchmark which returned over 7%. In addition, none of them managed to beat their benchmark. Our best performing manager was MFS Fully Hedged Global Equity (which we regard as a Growth at a reasonable Price Manager) returned 6.01%. This was followed by WCM Quality Global Growth which returned 5.64%. All the other managers had relatively bad quarters. Our other Quality Growth manager in T Rowe Price Global Equity actually had a negative quarter, returning -0.83%. Despite this setback, this has been our best performing global fund over 5 years.
Platinum International which has a high exposure to Asia including China/HK returned 0.2%. Asia and particularly Emerging markets have significantly underperformed Developed Market Global equities over the last 12 months. Our specialist Emerging markets manager in Aberdeen Emerging Opportunities returned -4.36% which was almost 2.5% below its benchmark.
As a group, our fixed interest managers did relatively well and finished ahead of the Australian fixed interest benchmark return of -1.46% in what was a tough quarter for fixed interest. We benefited by having somewhat less than benchmark duration during a period of rising bond yields. Our best performing manager was Janus Henderson Tactical Income which returned 0.18%. This fund also handily beat its benchmark which is 50% Cash and 50% Australian fixed Interest. All the other managers had negative returns which ranged from -0.28% for PIMCO Global Bond to -1.86% for Schroder Fixed Income Professional.
What Happened During the Period
Equity markets did very well in 2021 but volatility picked up during the last quarter as bond yields rose on the expectation of more and faster rate hikes than had been factored in. The other feature of equity markets late in the year was a rotation away from high PE Growth stocks to cheaper, more Value style stocks, this has continued into the early part of 2022.
The main concern of markets in the early part of 2021 was the effects of the various waves of Covid on economies and investment markets. In the last quarter of 2021, markets came to the realization that inflation is not transitory, the US Fed was behind the curve, and it would have to bring forward its tightening of monetary policy. The US Fed finally announced tapering of its QE program in November with bond buying originally set to end by mid 2022. Given persistently high inflation in the US and the various statements by Fed members, we now expect QE to be wound up my March of this year. Markets now expect 3 rate rises in the US this year which is a major shift in expectations from a few months ago. Also, the Fed chair, Jerome Powell, was recommended for another 4 year term.
The dominant Omicron strain of Covid is a game changer in that it is much more infectious than Delta and it appears to be impossible to contain since it also bypasses current vaccines. According to Dr. Hoyen (University Hospitals and Cleveland Clinic) “Omicron is the second most contagious virus on the planet,” ... “The most contagious virus we think of is measles, which has a factor of about 18.” The “factor” is the basic reproduction number or the average number of people who someone with the virus would infect. “This new variant of COVID-19 has a factor of 15.”
Currently Australia has the fourth highest per capita infection rate among wealthy nations. It is also very likely that reported numbers here are being massively undercounted due to the difficulty in actually getting tested and the number of asymptomatic cases. China remains the major holdout country in trying to eliminate the virus rather than learning to live with it. This is adding to global supply chain disruptions as cities of 10 million plus are locked down on the basis of just a few cases.
A positive outcome for markets (in our opinion) was the stalling of the latest US Democrat spending bill in congress. This plan was estimated to cost USD $5 trillion and would have added $3 trillion to the US deficit (over 10 years). Leaving aside the social aspects of the plan, it would certainly have added to inflation concerns and resulted in an even more aggressive US Fed. On the commodity front, China appears to have eased up on steel production quotas and that has resulted in a rally in iron ore prices and Australian resource stocks.
Australian large cap equities returned 2.09% for the 3 months to 30 December 2021, essentially in line with Australian small cap equities which returned 2.03%. Resources outperformed Industrials by over 9% over the period (9.71% vs 0.45%), which was the reverse of the previous quarter. Developed Market Global equities did quite a bit better than domestic equities, returning 7.07% for the quarter. A lot of this was due to the S&P 500 which returned 11.0% (in USD) for the quarter. Emerging Market equities were the laggard with a return of -1.95% as Asian markets continued to struggle. Australian listed Property also had a great quarter returning 10.7% despite rising bond yields. Australian fixed interest returns were negative with the benchmark returning -1.46% for the quarter and -2.87% for the year. Cash continues to essentially produce zero returns with the benchmark returning 0.01% for the period.
The Australian economy was expected to rebound strongly in 2022 post the pandemic lockdowns of 2021. In fact, post the lockdown retail sales boomed in Australia with November retail sales up 7.3%, following a rise of 4.9% in October. However, the exploding Omicron wave will slow the economic recovery in the early part of this year at least. While we do not have mandatory lockdowns, consumers have pulled back their activity levels and spending. This has been compounded by crippling worker shortages as they are forced into isolation post infection or exposure. Two examples are airlines cutting flights due to staff shortages and lack of consumer demand and sparse supermarket shelves as upwards of 20% of distribution workers are unavailable.
While the economy is expected to continue growing (unlike the 2020 and 2021 shutdowns), it is expected to take a hit in the first quarter. For example, the Goldman Sachs base case estimate is that roughly 38 million hours of work will be lost in January. As a result of this, Goldman has trimmed its economic growth forecast from 2.6% to 2.0% for the March quarter, before a rebound in spending fuels some “catch-up” from the second quarter of this year. Similarly, Citigroup has cut its quarterly economic growth forecast to 1.3%, from 2.3% (AFR, 11 Jan, 2022).
It is obviously difficult to forecast GDP growth rates with all the covid slowdowns. For example, the US economy grew at an annualized 2.3% rate in Q3 of 2021, following a 6.7% expansion rate in the previous 3 month period. The (US) Conference Board forecasts that US GDP growth for 2021 will come in at 5.6% and the economy will grow by 3.5% in 2022. While the 2022 number has been revised down, growth is still forecast to be above trend this year.
The annual inflation rate (CPI) in the US climbed to 7.0% in December of 2021 from 6.8% in November. This was the largest 12-month gain since June 1982. Also, inflation rose 0.5% from November, exceeding forecasts. Excluding the volatile food and energy components, so-called core prices jumped 5.5% from a year earlier, the biggest advance since 1991. Inflationary pressures are likely to last well into the middle of 2022 and will put pressure on the Fed to bring forward its tightening of monetary policy.
The World Bank recently downgraded China’s GDP growth estimate for 2022 from 5.4% to 5.1%. On the plus side, inflation pressures moderated in December. The producer price index (PPI) rose 10.3% from a year earlier, down from November’s 12.9% rise, while the CPI rose 1.5% compared with 2.3% in November. Both came in lower than market expectations. Lower than expected inflation gives the central bank scope to possibly cut interest rates just as most major nations look to tighten policy.
Markets and Outlook
We would expect that the majority of Australians will be exposed to Omicron in the next few months given how infectious it is. The good news is that it seems to be milder than Delta and is largely an upper respiratory infection. This is considered to be the text book way a virus evolves, i.e. it becomes more infectious but less deadly. We are not calling the end of the pandemic but we certainly dodged a bullet in that Omicron is less harmful than Delta. We believe Omicron is well over 90% of cases in NSW for instance. The hope is that infection (and recovery) by Omicron will confer a broader immunity to future variants since people should develop some level of immunity to the other 20+ proteins of the virus, not just the spike protein targeted in current vaccines. Also, the current boosters are probably not a long term solution as efficacy against symptomatic disease appears to fall into the 30% range after 10 weeks or so.
We said in our last newsletter, “We believe that the taper, or the unwinding of QE by $15bn a month may be speeded up so that it finishes earlier than June next year (2022) for a number of reasons. Firstly, there is no justification for QE in this economy…”For example, the US unemployment rate fell to 3.9% in December, not far off the 3.5% pre-pandemic low. We expect asset purchases (QE) to end in March and interest rates to start rising very soon after that. Cleveland Fed president Loretta Mester said recently she believes that it’s “a compelling case” for the central bank to raise the federal funds rate at its March 15-16 meeting or “as soon as asset purchases are terminated”. Also, (Fed chair) Powell, asked about plans to shrink the Fed’s $US8.7 trillion balance sheet, said at some point this year he and his colleagues will allow the balance sheet to run off.
So, we are now entering a US Fed tightening cycle with current expectations of between 3 and 4, quarter point rate rises in 2022. The Fed is now obviously behind the curve with annual CPI inflation of 7.0% and wholesale inflation of just under 10%. Inflation has now broadened out beyond the early culprits which were used cars and issues related to disrupted supply chains. The danger is that inflation will become entrenched and the Fed will need to become much more aggressive in order to tame it. The Fed will want to be cautious in hiking rates though given the massive levels of debt but circumstances may force its hand. We should also point out that the neutral cash rate in the US is considered to be around 2.5% with rates now at zero. Similarly in Australia it is probably around 2%.
Current settings still favour growth assets over bonds over the long term given real interest rates (after inflation) are strongly negative. The US 10 year government bond yield is around 1.8% (having touched 1.9%) while estimated 10 year inflation is 2.5% to 2.6% (inflation break-even).
However, we would expect equity PE multiples to contract somewhat from current levels as rates rise. The S&P 500 forward PE was 21.2 times at the end of 2021. The 25 year average S&P 500 forward PE is 16.8x (JP Morgan, 31 Dec 2021) reflecting higher rates over most of that period, For example, if the PE multiple were to contract 10%, in order to maintain current index levels, earnings would need to rise 10%. The Australian PE (ASX 200) was 18.1x at 31 December 2021, versus a long term average of 14.7x (JP Morgan, 31 Dec 2021).
We would also expect higher PE stocks, particularly those with no earnings to underperform in the period ahead. Certainly, the tech heavy Nasdaq has struggled relative to the broader indices lately, being down around 11% from its November peak and around 4% in 2022. This is also an environment where more cyclical, Value style stocks should do well. That is, provided that economic growth is maintained at a reasonable level and we do not have an economic downturn as a result of multiple rate hikes.
We think this is going to be a much tougher year than last year for equities and likely the second ordinary year in a row for bonds. It is hard to predict what equities will do this year but certainly do not expect the returns we got in 2021. With returns likely to be much lower in 2022 we expect dividends to increase in importance and to be a larger proportion of total returns.
Our strategy for new money would be one of patience, we would wait for pullbacks in markets or for individual opportunities to arise. The upside is that we think you will get more volatility (or opportunity) this year than we got in 2021. This is obviously a juggling act since we expect inflation to be above central bank targets for the next year or two, and hence expect negative real returns for holding cash.
SEPTEMBER QUARTER - 2021
Portfolio Performance Summary
The performance of risk assets was moderately positive in the 3 months to the end of September 2021. It is normal for risk markets to become more volatile towards the end of an economic cycle. Fixed interest returns were only slightly positive while Cash returns were close to zero over the period.
The returns of the Strategic portfolios ranged from 0.8% for the Conservative Portfolio to 1.9% for the High Growth Portfolio. These returns were quite close to the returns the Mercer Wholesale (and Retail) Averages for similar funds over the period.
Some of the factors impacting returns were:
Our Australian Equity managers as a whole did well and as a group, they beat the Australian large-cap equity benchmark return of 1.7% by over 1.5%. The best performing manager was Ausbil Active Equity which returned 4.49% for the quarter, this was more than 2.7% above its benchmark. All our large-cap managers beat this benchmark during this quarter with no style dominating in terms of returns. All of the other large-cap managers were fairly tightly bunched return wise over the quarter. Tyndall (former Nikko Australian Equity, a Value manager) returned 3.31% while T Rowe Australian Equity (Quality Growth) returned 3.21%. Note that the Ausbil fund is style neutral and can tilt towards Growth or Value when opportunities arise. Aberdeen Standard Ex-20 Australian Equities (Quality Growth) also did well, returning 3.92%. Our small-cap manager in Fairview Emerging Companies returned 3.67% which was also above the Small Australian cap benchmark which returned 3.44%.
The Australian dollar fell over the period (helping Global equity returns). However, our Global Equity managers as a group finished around 1.5% below the Developed Market Global equity benchmark. One of the major issues here was that Emerging markets and Asia, in particular, underperformed Developed Market equities. From the 1st of January to 18 October this year, Emerging Market equities have returned just 3.4% compared to 19.1% for Developed Markets. Funds that had significant exposure to this sector were not surprisingly laggards. Our worst performer over the period was Aberdeen Emerging Opportunities which returned -4.11%, although this was 0.2% above its benchmark. Platinum International which also has high exposure to Asia (and around 20% in China/HK) had a negative return of -0.69%. Our best performing manager was WCM Quality Global Growth which returned 4.03%. MFS Global Equity (which we regard as a Growth at a Reasonable Price Manager) returned 3.07% while T Rowe Price Global Equity (Quality Growth) returned 2.27%. While we continue to see opportunities in emerging markets, we monitor our international equity regional allocations closely.
This was quite a subdued quarter for fixed interest returns. Our fixed interest managers as a group returned fractionally less than the Australian fixed interest benchmark which returned 0.31%. Global fixed Interest returns were even lower than this with the benchmark returning just 0.05%. Returns were dragged down by rising bond yields in September with the Australian benchmark falling by 1.5% in that month. Our two best performing managers were JCB Active Bond and Janus Henderson Tactical Income which both returned 0.23%. The latter fund also beat its benchmark which is 50% Cash and 50% Australian fixed Interest. Not surprisingly. the laggard was PIMCO Global Bond which returned 0.07%.
Our interest rate sensitive sector managers both produced positive returns, despite the end of quarter sell-off sell-off in fixed interest. The APN AREIT Fund returned 4.65% while Lazard Global Listed Infrastructure returned 0.9%
What Happened During the Period
Global stock markets recorded new highs in August and early September before giving back most of the quarter’s gains in late September. Partly this can be attributed to economic data pointing to slowing rates of growth in the US and China. There were also concerns about the Delta variant which thankfully now shows signs of having peaked in many countries. China was also affected by energy shortages which shut down some factory production as well as financial trouble with Evergrande (China’s largest property developer), which owes over US$300 billion to creditors. Markets were initially spooked by risks to the financial systems in China and elsewhere but we believe have now concluded that the financial risks can be managed. Nevertheless, we believe that the situation in China deserves to be watched closely.
Property has been a big driver of Chinese growth and is particularly relevant to Australian companies such as BHP and RIO, as almost 30% of iron ore in China is used by the property sector. The Iron ore price has now fallen by over US$100 from the peak of US$230 per tonne. This fall is not all property-related though, China has been cutting steel production quotas (to 2020 levels) to lower carbon emissions.
In Australia, Delta has resulted in growth forecast being slashed for this year but markets have largely looked through this as NSW, and soon Victoria exit lockdowns in the next month. The major shift has been that the policy of eliminating Covid is over and moving forward we will have to learn to live with it. This has been made possible by vaccination rates now approaching 80% in most of the states after the initially slow vaccine rollout.
There is an expectation the US Fed will announce tapering before the end of this year. This, as well as persistently high inflation in the US, has caused global bond yields to rise lately. All the concerns set out here finally lead to the US equity market had its first 5% pullback this year although markets have since partially bounced back.
The other major development was Australia being on a path to acquiring nuclear submarines due to the deteriorating security situation in the region. Not only is this an expensive exercise but it may have knock-on effects for relations with China and trade relations.
Australian large-cap equities returned 1.71% for the 3 months to 30 September 2021 while Australian small-cap equities did considerably better with a return of 3.44%. Industrials outperformed resources by a massive 14.05% over the period (4.48% vs -9.25%). Developed Market Global equities did quite a bit better than domestic equities, returning 3.92% for the quarter. They were also assisted by a fall in the value of the Australian dollar. Emerging Market equities were the laggard with a return of -4.36% as Asian markets struggled. Australian listed Property also had a good quarter returning 4.24%. Australian fixed income returns were muted with the benchmark returning 0.31%. Cash continues to essentially produce zero returns with the benchmark returning 0.01% for the period.
Markets feared that there was a possibility Australia could have a technical recession if the economy shrank in the 3 months to 30 June, and the September quarter was negative (as we expected). However, the GDP data for June showed the economy grew by 0.7% which was ahead of expectations. We anticipate that the Australian economy will have begun to grow again in the final quarter of this year as lockdowns end with the associated gains in employment, consumer spending and sentiment.
The annual inflation rate (CPI) in Australia rose to 3.8% in the second quarter of 2021 from 1.1% in the first quarter. This was the highest reading since Q3 of 2008. However, this was influenced by some base effects following the introduction of free child care and a record fall in fuel prices in Q2 of 2020. The underlying inflation rate, which the RBA focuses on, was just 1.6% and this remains below the RBA’s target range of between 2% and 3%. While inflation seems well contained in Australia, markets are still concerned about elevated inflation in the US which is running at 5.4% and the recent surges in global energy prices.
China’s economy has continued to slow with GDP rising 4.9% in the third quarter of 2021 compared with last year. This was below expectations of 5.0% and the 7.9% increase in the previous quarter. Chinese industrial output in September rose by just 3.1% compared with a year prior, this was also below expectations of a 3.8% increase. Some of the major issues here were energy shortages that disrupted industry and caused shutdowns. China has built its economic prosperity on the back of significant debt levels which creates financial risk. Also, China still has zero-tolerance for Covid and is quick to lockdown regions just as the rest of the globe is learning to live with Covid. This action exacerbates supply chain disruptions.
The IMF (October) forecasted a slowing of economic growth. The global economy will grow by 5.9% in 2021 and 4.9% in 2022. The US is projected to grow by 6.0% in 2021 while China is forecast to grow by 8.0% in 2021 and 5.6% in 2022. Certainly, for China, we believe those numbers are on the high side and probably need to come down. China itself is only saying they will do at least 6.0% this year.
Markets and Outlook
The RBA has stated for a while now that there will be no rate hike before 2024 at the earliest. However, futures markets are betting that this will occur sometime around the middle of 2022. We are not sure there is much predictive value in this though. An early lift-off in rates here would be based on elevated inflation in economies like the US rather than on the strength of an Australian economy emerging from lockdowns. Also, while the unemployment rate at under 5% appears low, if you factor in under-employment, it is close to 10%.
The RBA’s October minutes reveal the bank remains dovish in its outlook. From the minutes - members concluded their discussion of domestic economic developments by observing that underlying inflation pressures in Australia were more moderate than in other advanced economies. This reflected a range of factors, including the relatively slow rate of wages growth in Australia. The RBA has also said that it will not begin to normalise interest rates until inflation is sustainably within its 2% to 3% inflation target, which it believes will require wages growth above 3% for several quarters. Wages growth in the June quarter was just 1.7%.
We do expect that the US Fed will announce tapering to its $120 Billion per month bond-buying program before the end of this year and that tapering will be completed by the middle of next year. However, the US Fed chairman has made it clear that there is no connection between tapering (which is almost certain) and possible rate rises, that is a separate decision.
The biggest risk to markets right now is that inflation, particularly in the US, remains elevated for some time, The most common explanation for high inflation there is that it is the result of supply chain issues due to Covid and reopening. For example, there are not enough truck drivers to ship containers in the port of LA and ships are backed up as far as the eye can see. Shortages in goods are driving up prices. There are also issues around underinvestment in fossil fuels driving up oil and gas prices which feed into inflation numbers.
Inflation certainly bears watching, as at some stage the stickiness of this number may become an issue that disrupts financial markets and causes PEs to rest lower. However, the elephant in the room is that if inflation is mainly due to supply issues, then raising interest rates will do nothing to address this problem. Worries about inflation and tapering have caused global bond yields to rise although they are mostly below levels we saw earlier in the year.
Another concern is the Biden administration’s spending proposals which amount to over $5 Trillion (properly cost over 10 years). It is not just the magnitude of this number, but that it seeks to introduce several new entitlements and taxes that would take the United States to its highest sustained levels of federal spending since World War II. The history of new programs is that once enacted, they are forever. There are currently only two senators standing in the way of its passage. If passed, the risk is that it will result in slower growth for the US economy.
Equity valuations are a risk, but that has been the case for a while now. PE’s have been drifting down slowly with the Global equity PE at 18.5x as of 30 September 2021. The forward PE for the S&P 500 was 20.3x (S&P 500 at 4,308), while the ASX 200 was 17.9x (ASX 200 at 7,332). The global PE is now down around 10% from its recent peak. This is what we would expect as bond yields rise as the world returns to some normality. The US PE is still around one standard deviation above its 25-year average level, but bond yields were much higher than today over most of that period. Providing rates rise slowly (assuming we have steady growth), then they do not have to cause major disruptions in markets. We will just have to wait and see how inflation tracks in the US particularly and how the current reporting season there pans out.
In terms of allocations, negative real interest rates continue to favour Growth assets over fixed interest. Currently, the US 10-year bond yield is around 1.6% while 10-year inflation expectations are at 2.5% (Oct 18). Many stocks have corrected which should provide opportunities for managers. Most resource stocks for example are down by over 15% in the last month. We would not aggressively add to positions right now but suggest investors maintain a mix of Growth and Value styles, the wild swings of the last year showed that that is very hard to time these moves.