Omicron variant and a more hawkish tone from various Central Banks. By the end of December, investors largely brushed off these concerns with markets in Australia and the United States at or near all-time highs to end the year. However, further hawkish commentary from central banks led to rising yields and an associated selloff of equities and bonds. The ASX200 fell 3.4% between the start of December and the end of January, while the US S&P500 fell by 1.8% over the same period. The technology-heavy NASDAQ 100 index was hit particularly hard, with the highly valued innovation stocks falling by 9% over the two months.
US Q4 2021 reporting season is underway, and the number of companies beating analyst estimates is equal to the 5-year average. However, companies who miss earnings expectations or who provide poor forward guidance, often based on supply chain impacts or labour concerns, tend to get punished, as demonstrated by Meta Platforms (formerly Facebook), which fell over 20% on weak guidance. US 10-year bond yields finished January at approximately 1.78%, whilst Australian 10-year yields sit about 1.90%, up 0.35% and 0.17%, respectively, since the start of December.
Iron ore recovered to approximately USD$130 (China futures pricing), rising from the low 100’s in December. It rebounded as moves in China to support its embattled real estate sector bolstered the demand outlook. Copper ends January relatively steady at USD$4.32. Oil and natural gas prices were boosted by supply shortages and political tensions in Eastern Europe. Brent crude rose from US$68 to US$90 over the two months. Gold was steady at ~USD$1800.
The Australian Dollar weakened slightly against the US Dollar to 70.6 cents by the end of January, impacted by expected rate hikes in the US.
The Australian economy remains strong, with Omicron related impacts expected to be a blip on the path to recovery. Businesses and consumers are becoming more adept at coping with outbreaks and restrictions, resulting in a reduced hit to economic activity. While retail sales were impacted in December, this was likely due to sales brought forward in November with shoppers concerned about warnings for long lead times. Australian employment figures continued to improve, and Australian inflation came in at 3.5% for 2021, above the RBA target range and consensus expectations. This raised the likelihood of interest rate hikes in 2022, with Governor Lowe conceding such action was “plausible”, relaxing from his hard stance a few months earlier. The RBA is likely to remain patient and wait for more data to confirm that inflation will be sustained in the target range and that wages are rising before making any decision.
In the US, inflation rose to 7% year-on-year in December, with core inflation that removes the most volatile sectors, including food and energy, rising by 5.5%, the largest advance since 1991. In the face of such high readings, the US Federal Reserve turned more hawkish, laying the ground for an interest rate increase in March with more expected to follow. Bond market investors now see five interest rate hikes in 2022. Still, it is crucial to remember that interest rates are at historic lows and will remain low by historical standards even with these expected increases. Economic data has primarily been positive, with consumer confidence proving more resilient than anticipated though retail sales disappointed. US employment data stunned and was well above top-end expectations and wages also rose, signifying a tight labour market.
The European Central Bank (ECB) also took a more hawkish turn in response to inflation rising to 5.1% year-on-year. ECB President Lagarde dropped communication that there would be no interest rate hikes this year acknowledging “the situation has indeed changed”. The Bank of England raised interest rates for a second time by 0.25% as the central bank seeks to contain soaring inflation as higher energy costs, supply chain issues, and strong demand continue to pressure consumer prices.
China’s economy continues to show mixed signals. Chinese GDP, fixed asset investment, and industrial production figures were better than expected. Chinese exports growth also remains strong. However,
retail sales disappointed, indicating that consumer demand continues to slow. Purchasing Manager Index readings also moderated as Omicron caused another wave of lockdowns. Consistent with this slowing down, the People’s Bank of China has signalled a shift towards boosting growth and supporting the property sector. It reduced banks’ reserve requirement ratio, which helps to free up liquidity and cut prime loan rates marginally for the first time in over 18 months, which provides markets with a signal that more support may be on the way. China’s regulators have instructed state owned asset management companies to support cash-strapped real estate developers by acquiring stalled property projects and purchasing distressed loans. This is a tangible sign of support to help prevent further financial losses and social disruption that may arise from property settlement failures . Further assistance may be necessary for the coming months as China deals with their worst virus outbreaks since the early days of the pandemic while still adhering to a Covid-Zero philosophy, meaning continued broad lockdowns are a risk.
Market Outlook and Positioning
The economic outlook would appear robust at first glance given strong GDP, low unemployment and a waning Omicron wave. While initial market adjustments to the Federal Reserve’s more hawkish (ie a steeper rate hike) outlook from the Fed minutes and Federal Open Market Committee statement, there have been positive signs for a recovery. The most recent US inflation release and interest rate adjustments have caused a recalibration of expectations once more. We consider the underlying economic and market regime setup and look at positive and negative scenarios for the year ahead.
Considering the underlying economic situation, even though GDP growth is strong, there is a reasonable expectation that growth will fade after a short term post Omicron bounce. Sticky inflation pressures are a part of this story as persistent goods shortages, low inventories of houses and cars, and energy prices combine with wage pressure on the upside in the US. Delays in opening up Australia’s borders are also creating shortages in labour in many industries. While wage pressures in Australia aren’t exhibiting themselves yet, given the wage shortages we would expect more upside pressure. Input costs are growing from a combination of under investment in key commodities, China’s reduced output capacity, and energy costs. Company margins are under pressure and despite a decent earnings season so far in the US and Australia, these are backward looking and we would expect forward guidance to be more conservative. Companies will be forced to pass on price rises that have to date been mostly held back, and consumers will have to absorb the costs. While we do see very high levels of household savings compared to history, this is concentrated in middle and upper income households. Lower income houses spend almost all they receive including the pandemic support payments. The net effect on consumption will be a decline given household spending will have to absorb multiple pressures from essential spending from energy costs, rising food prices, interest rates on housing and rents rising as migrants come back and absorb rental housing.
We see the Federal Reserve having to hike more than markets are pricing as inflation pressures linger, while the hikes occur into a slowing economy and a pressured consumer. The risk of policy error is high, with the chance of overtightening causing the economy in the US to slow into a recession in 12 months.
On the positive side, company earnings have been robust and are still holding up. There appears pent up demand from consumers and businesses given shortages of goods and services. High household savings and strong corporate balance sheets would seem to be able to withstand some of the inflationary pressures and add to demand. Technology has enabled more efficient deployment of resources and flexibility in some of the workforce. Equity markets have traditionally recovered from an initial change of direction and the last Federal Reserve rate hiking cycle reached a 2.5% cash rates before equity markets corrected materially. Surely we can withstand what some observers expect to be a short and sharp hiking cycle?
However, we think that the underlying and persistent inflation pressures highlighted in the January inflation number of 7.5% released in early February are highlighted in the broad rises in all inflation basket components. This makes it more likely that this hiking cycle can go further than either bond or equity markets are pricing in. Given equity market portfolio managers were only expecting three rate hikes this year, we expect a recalibration of expectations as the bond market pricing filters through to equity investors. As such we expect a higher discount rate to be factored into valuations sooner rather than later, which impacts high growth stocks more than value and stable earnings companies. There is more extreme valuation in the US and offshore markets, hence we are expecting to trim growth-oriented managers at an opportune time shortly, while increasing value manager positions. A reduction in equity allocation is justified and we will source this from international equities. Our Australian equity positioning is leaning more towards value, therefore we are happy with our current allocation. In a rising interest rate environment, long maturity and broad market fixed income strategies will lose the most value. Fortunately we are positioned in shorter maturity bonds and a mix of credit quality so we are more defensively positioned. In this environment of public market volatility in listed equities and traded bonds, there is a haven in selected private assets such as property, private debt and private equity. These can withstand market volatility if a portion of client portfolios are able to tolerate their relative illiquidity.
Overall, this will be a volatile year given the setup is quite different to any experienced in the last 40 years for inflation, with a pandemic adding further to complexity. We see this as an opportunity for careful risk management and preparedness for investor portfolios.
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