World stock markets are facing much consternation over key issues including high inflation and the path of interest rates, the Ukraine war, and the Covid pandemic in China, all acting to disrupt supply and global trade.
Against this background, traditional stock market value measures such as price-earnings ratios are still near the high end of historical valuations in many countries, earnings margins are beginning to come under pressure and consumer confidence is decreasing as costs increase. This does not bode well.
Australian inflation is 5.1% per annum, and US inflation was last measured at a rather impressive 8.5%. The US experienced negative real economic growth in the last quarter, suggesting a stagflationary economic environment. It was only last year that you would be laughed at for suggesting stagflation (we did so we know), and the RBA governor was telling the market how foolish they were for even suggesting a rate increase as a possibility in 2022. How times change!
Supply disruptions combined with ridiculously easy fiscal and monetary policy are the reasons for the significant recent lift in inflation globally. Central banks currently have interest rates set near record lows. They believe they have to lift interest rates to try to stop inflation from becoming overly entrenched, despite the supply-side issue. Interest rates tend to move in waves; they historically do not go up and down consecutively, instead tending towards trending. Thus, changes in direction are important and closely followed by markets. This time could be the same, but not necessarily so.
For most markets and their participants, the extent central banks will move rates is currently the most relevant and important factor for investment decision making. The bond market is pricing aggressive rate increases, which to many market participants – us included – appear unrealistic.
US Government Debt to GDP averaged 64.54% from 1940 until 2021, reaching an all-time high of 137.20% of GDP in 2022. US household debt to income is above 77%, while Australian debt to household income is just under 200%; historically, approximately 65% is normal. Many other countries have high debt levels, following further government spending to support economies during Covid or at the consumer end due to higher house prices or credit expansion during a period of record-low interest rates.
How will central banks and markets react to this economic background?
Firstly, economies should prove very sensitive to lifts in interest rates due to high debt levels. We don’t think it will take that many before something meaningful breaks either in markets or the economy or both simultaneously. A recession is a real probability, imminently in Europe but also in other economies in 2022 or failing that in 2023.
Secondly, it will be very tempting for central banks to try and ultimately “under-respond” to high inflation as they need to act to inflate the debt away and will become scared again about deflation and a financial crisis should they overdo rate increases and see markets and economies collapse. This could occur much earlier than most believe.
The unfortunate reality is central banks don’t control everything that goes on in an economy, albeit are loathe to admit it. Monetary policy only has a limited effect on supply-side inflation and ultimately to be effective at addressing this must kill demand i.e., induce a recession. A recession is hence a realistic expectation if central banks are to be taken seriously.
Ultimately, it will be very important how far central banks go. A policy mistake lies beyond every decision they make from here.
The Reserve Bank of Australia recently lifted interest rates slightly, announcing that the cash rate would increase by 0.25% to 0.35%. Incredibly, this was the first interest rate rise in over 10 years. This appears to be a small opening shot against inflation but it is not until rates are closer to “neutral” that we will know how far they are prepared to push it, and neutral cash rates may be lower than ever before.
We would suggest that central banks will continue to lift interest rates, however, to a more limited extent and less than what is priced in. This is because we think something meaningful will break long before they manage to meet the expectations of the bond market, or alternatively, they’ll aim to tolerate higher inflation and raise rates cautiously over a more extended period while talking a tough game and hoping inflation will have some dips.
Investors, many of which have only had limited experience of inflation and how it can have dramatic effects on the purchasing power of cash over a number of years, will need to pay close attention to central bank actions. Macroeconomics matters now like never before.
Market falls could be dramatic because the risks are high and because of the influence of passive investors who don’t know what they own, only that they expect it to go up. Passive investors might wake up one day and decide they’re over-allocated to risky assets due to their backwards-looking models that simply don’t match the times, providing constant selling pressure.
A geopolitical and technological disruptive period
Importantly, it is not only interest rates and inflation that investors need to consider.
Geopolitical risk should be front of mind as the era of (relatively) peaceful prosperity appears over. Power games are occurring on a grand scale and the stakes are big. One wrong step and it is literally kaboom. When people with a history of following through on their threats start threatening the use of nukes, nuclear strikes must be considered a realistic possibility (like it or not).
Investors also need to be aware that we are headed into one of the most technologically disruptive periods in history. The integration of technology into many businesses will see certain companies thrive and many others prove uncompetitive. For example, artificial intelligence, robotics, and the move to the electrification of transportation will have positive benefits for technologically innovative companies over time, while having negative effects on companies unable to implement or use these new technologies productively.
Will the commodity and mining boom continue?
If inflation is permitted to continue to run and demand isn’t destroyed in a recession, commodities and thus mining companies should continue to benefit (albeit not in a straight line). We see electrification, automation and robotics as likely to increase mining company margins, while mine production may continue to lag product demand due to green groups and government slowing mine starts in many countries. Lithium and copper are likely to continue to see market support while nickel could be negatively impacted by a move toward lithium, iron, and phosphate batteries in the electric vehicle space.
The move towards reduced carbon is an ongoing important secular thematic and we are hence allocating towards an active strategy investing in carbon futures to benefit from needed and likely carbon price increases over time.
While technology stocks and disruptors are understandably lagging today as rate increases decrease the value of long duration stocks and some of these stocks are absolutely detested, should the central banks not follow through with the priced rate increases and/or reverse their policy, these stocks may see some respite from their entrenched bear markets later in 2022. Real productivity growth is an important secular need that some technology stocks will provide and benefit from overtime, while many others will fail to reach profitability and hence continue to disappoint or disappear.
Precious metals will also benefit if positive real rates fail to be sustained, which we think is likely in most Western economies in the absence of good policy choices, due to large debts, worsening demographics and mediocre leadership.
Asset allocation and stock selection will hence become a bigger driver of investment returns in this new unstable and dangerous period in world economies and markets. The days of the index approach are hence numbered as broad real returns will likely continue to prove disappointing, and certainly so to anyone with reasonable or high expectations.
Being overly concentrated or convicted may also be highly dangerous in such an uncertain and risky world (many funds are already down 40 or 50% from highs using such an approach!). A humbler and more diversified yet still highly active and selective approach is, in our view, more able to manage the risk and uncertainty, smooth the return path and keep losses to more tolerable levels.
The primary dangers for investment markets are (1) an overly aggressive interest rate stance by central banks, which we would see as an explicit policy error, or (2) an escalation of the war or a new war. Covid policy in China is an x-factor but one would think likely to resolve over time.
If there is one thing we would leave you with, expect to be surprised. We’re in a new dangerous investment era where surprises will prove commonplace, and arrogance and an inability to be flexible may prove deadly. Being humble, cautious and backing good research and prudent risk management might not (yet) be very popular but it will be soon enough. It provides a greater chance of being effective and avoiding the disastrous downdrafts which we expect will afflict many investors in 2022.
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