Monthly Investment Update — February 2022
In our first newsletter for 2022, we look at some of the key issues facing investors and how they may impact financial markets this year.
The main points are as follows:
The US economy is currently experiencing price inflation last seen in the 1980s.
The US Central Bank has clearly indicated the need to remove emergency stimulus measures to slow the rate of inflation.
Imminently higher US interest rates are expected to slow demand-driven inflation.
Supply chain pressures (a by-product of pandemic economic scarring) are also stoking inflation and are expected to persist. This will complicate matters.
Higher interest rates will weigh on asset prices moderating upside return potential.
Markets and businesses need to adjust for this which is evident in the market volatility of late.
Now is a good time to consider the appropriate risk tolerance and cash levels in portfolios.
Since the 1980’s individuals and businesses have faced many challenges—but inflation has not been one of them. Much of the credit can be given to Central Banks who have delivered on their mandate for stable prices.
The art of price stability is achieved by adjusting interest rates. Should growth be weak and unemployment high, central banks would lower interest rates putting more money in the pockets of consumers and businesses. They would increase their spend thereby spurring economic growth. Once unemployment levels recovered and prices started to rise (inflation) central banks would slow the economy by raising interest rates.
Low inflation has allowed interest rates to remain low for many years. This has been supportive of economic growth and business profits resulting in higher share markets. The challenge we face today is prices are rising at levels last seen in the 1980s.
This is not good for individuals or businesses. Higher prices mean consumers can buy fewer goods with the same amount of dollars. If businesses don’t raise prices, they are not able to maintain the same level of profits which impacts what they are worth. Not a great environment for the economy or asset prices.
Jerome Powell, the Chairman of the US Federal Reserve has recently indicated that they need to change their policies to slow inflation. That means interest rates will need to move higher. Investors are nervous. How high will interest rates go? How fast will central banks hike interest rates?
What makes this time different is the pandemic has le† economic scarring. A disrupted supply chain is at the top of mind and remains a challenge as we enter 2022. The all-important Chinese manufacturing sector is still being interrupted by zero-covid policies and is likely to see a bumpy recovery and inflation remain higher for longer.
This is going to create serious challenges for central bankers which make us question whether their tools will be effective. Raising interest rates to curb inflation will work if inflation is because of strong demand. It will not curb inflation if the inflation pressures are due to supply disruptions. In fact, raising interest rates may make supply bottlenecks worse by increasing the cost to repair them.
Striking the right balance will be important. We would expect a combination of profit headwinds, higher rates and lower valuations to pressure markets and contribute to higher volatility throughout 2022. We continue to lean into our 3 pillars of Quality, Diversification and Liquidity when investing in this environment. We also believe a higher cash weighting may be of benefit to best capitalise on any opportunities that may arise.
The investment landscape has changed
Low inflation has allowed interest rates to remain low for many years.
This has been supportive of economic growth and business profits resulting in higher share markets.
We believe persistently higher inflation changes this narrative.
This is a situation that markets have not had to contend with for 40 years when US inflation peaked at almost 15% in early 1980.
Central Banks use higher interest rates to defend against inflation. If they don’t, they risk inflation destroying the value of money and undermining economic stability.
In the early 1980s interest rates were hiked to 20% which halted inflation but also triggered a recession.
The current stock market volatility reflects uncertainty about the durability of the current US inflation spike (7% in 2021) and just how aggressive the US Fed will be at reining it in.
With high levels of debt in the system, we do not expect rates to reach 20% this time. As rates quickly rise from rock bottom levels there is however always the potential for a growth scare.
We believe the combination of higher upcoming rates, lower valuations and earnings pressures are headwinds for equity market returns in 2022 and a recipe for higher volatility.
The facts have changed! "Much stronger...Far stronger...Much higher"
Share markets delivered stellar returns for calendar year 2021 delivering +27.1% as measured by the MSCI World ex-Australia Index in AUD.
The gains can be attributed to strong corporate profits. Fuelling these impressive gains has been continued emergency support measures, most notably record low-interest rates.
Signs started to emerge early in 2021 that the economy had recovered, and emergency support was no longer needed.
These signs included higher inflation and a strong labour market.
Central Bankers (the US Fed) however viewed elevated inflation as being temporary/“transitory”.
This view saw interest rates remain low whilst the US Fed continued to print US$120B in new money each month.
On 15Dec21 US Fed Chair Jerome Powell conceded that “Inflation is running well above target…” signalling an end to the “transitory” view.
The final nail in the “transitory” coffin was when we learned on 12Jan22 that US consumer prices rose by 7% in 2021.
US inflation is now at a 40 year high sending a clear message emergency stimulus measures need to be removed.
US Fed Chair Jerome Powell agrees, and now they are going to take away the “punchbowl”. How fast? We think much faster than expected.
On 26Jan22 he said – “We know that the economy is in a very different place than it was when we began raising rates in 2015. Specifically, the economy is now much stronger. The labour market is far stronger. Inflation is running well above our 2 per cent target, much higher than it was at that time. And these differences are likely to have important implications for the appropriate pace of policy adjustments.”
The facts have changed, support measures are being removed, interest rates are moving higher, and the US Fed is going to be less patient.
Paul Samuelson who was awarded the 1970 Nobel Prize in economics once said, “Well when events change, I change my mind. What do you do?”
At the minimum, we would not expect a repeat of the +27.1% appreciation in global share markets in 2022.
What do you do?
As the facts have changed, we know we need to be increasingly flexible in our investment approach.
No longer should cash be viewed as “Only returning 0.10%”. Cash is most valuable when everybody wants it.
We know central banks will be withdrawing cash from the system so it should become more valuable.
Raising portfolio cash levels will provide greater defence and entry opportunities should asset prices fall.
Bear markets generally occur when the economy enters a recession. Whilst possible, a global recession remains unlikely in 2022. The possibility for a recession into 2023 remains unclear.
As discussed before, we expect improved performance from companies with greater inflation protection. These include the energy and material sectors.
Cheaper value style companies are likely to perform better as interest rates move higher.
More expensive growth style sectors are likely to face greater valuation challenges as interest rates move higher. These include the technology and communication sectors.
This rotation in market leadership has been one observation over the past month:
Global Energy Companies ETF (ASX: FUEL) +12.58%
ASX 200 Resources ETF (ASX: OZR) +2.85%
Global Value Equity Active ETF (ASX: VVLU) +2.17%
Nasdaq 100 ETF (ASX: NDQ) -8.70%
Climate Change Innovation ETF (ASX: ERTH) -16.10%
This is quite the opposite of the winners and losers of the past decade. So, a balanced approach is sensible.
Australian Equities
The S&P/ASX200 Index posted a -6.35% return for the month of January and +9.44% over the last 12-months.
The top-performing sector for the month was the Energy sector which gained +7.81% as the oil price reached a 7-year high. Sector heavyweight Woodside gained +14.30%.
The weaker part of the Australian market was the Technology (-18.40%) and Healthcare (-12.11%) sectors. Afterpay/Square declined -19.93% and CSL declined -10.52%.
The rotation away from expensive stocks into cheaper stocks is clear and this trend may continue as interest rate expectations move higher.
International equities
The MSCI All-World Index gave back -6.95% over the month. Despite this correction, international equities remain a strong performing asset class over a 12-month period.
Regional relative strength over the last month favoured the cheaper S&P Europe350 Index which declined. Slightly weaker was the S&P Japan500 Index which declined -5.05% and the US S&P500 Index which declined -5.17%.-4.41%.
The S&P Dow Jones Emerging Market Index gave back -0.95%, once again being spared during a global equity market selloff. This is partly due to cheaper valuations relative to Developed Markets.
Property and Infrastructure
Australian Property Index followed the broad equity market lower, declining -9.52% over the month. The rich valuation of index heavyweight Goodman Group contributed to the overall index weakness.
Global Listed Property (Hedged) outperformed its ASX listed peers (-6.60%). Global Listed Infrastructure (Hedged) ended the month flat (-0.08%) providing great diversification benefits.
Fixed income
The Bloomberg Australian Bond Index slipped -1.02% lower as investors digested higher interest rates from central banks globally.
The 10-year Australian government bond yield reached +1.91% by month-end. This is significantly higher than the +0.84% low reached in October 2020. Interestingly also higher than the +1.84% high reached during the March 2021 inflation tantrum.
This is significant and confirms our view that interest rates are moving higher despite the RBA keeping official cash rates at emergency low levels at this stage.
GENERAL ADVICE WARNING
The advice contained within this document does not consider any person’s particular objectives, needs or financial situation. Before making a decision regarding the acquisition or disposal of a Financial Product, persons should assess whether the advice is appropriate to their objectives, needs or financial situation. Persons may wish to make their assessment themselves or seek the help of an adviser. No responsibility is taken for persons acting on the information within this document. Persons doing so, do so at their own risk. Before acquiring a financial product, a person should obtain a Product Disclosure Statement (PDS) relating to that product and consider the contents of the PDS before making a decision about whether to acquire the product.