It’s time to think beyond the reopening and examine factors that could drive the post-COVID-19 global economy. Now that the global macro environment is in the last innings of the reopen/reflation narrative, what comes next?
All things considered, there are important factors that remain supportive of risk assets: Global growth is likely to be running at historically high levels throughout 2021 (and into 2022), and monetary and fiscal policy will continue to be extraordinarily accommodative. In absolute terms, most global macro indicators appear very strong; however, we believe these supportive factors will begin to diminish on a relative basis going forward, implying that we’re currently at peak macro—and the road ahead could be bumpy.
In my view, the somewhat more challenging macro environment should be able to mitigate the gradual rise in market rates, and I expect it to be less damaging to equities. Crucially, I believe sector selection, country selection, and regional focus will play a very important role in asset allocation decisions in the coming months—the ability to distinguish which elements in the macro narrative have reached peak (versus those that haven’t) could be critical to outcomes in the fourth quarter of 2021. I have discussed inflation at length in the last month, and my view remains that inflation is likely to stay elevated throughout Q4, followed by structurally higher inflation—possibly closer to the 2.5% mark—in 2022 and beyond.
I would expect the reflation narrative to move from being framed as a positive development to being seen as a warning about higher input costs across a select set of industries that have been beset by supply chain disruptions. In other words, certain areas may continue to face margin squeezes while others experience relief, thereby increasing the value of solid active management in the equities space. Importantly, there’s little central banks can do to mitigate the situation.
Central banks should avoid prematurely tightening policies when faced with transitory inflation pressures but should be prepared to move quickly if inflation expectations show signs of de-anchoring. Emerging markets should also prepare for possibly tighter external financial conditions by lengthening debt maturities where possible and limiting the build-up of unhedged foreign currency debt.
A supercycle bull market in bonds, which saw 10-year yields fall from around 16% to lows last year of around zero (and lower still in some countries) has been a key feature of investment markets for the past four decades. This protracted period of decline helped propel a global “search for yield” by investors that has pushed down yields and pushed up prices of most other assets. Underpinning it has been a collapse in inflation globally.
Inflation is as much a psychological process as an economic one. And a key indicator of inflation expectations has risen in recent days, which could ultimately lead to higher interest rates. Despite some of the fastest price increases in decades, investors in the Treasury bond market who are keenly attuned to inflation have been steadfast in their belief that it was a temporary phenomenon.
A key measure of the bond market’s expectations for inflation over the next five years — known as a breakeven — rose to a new high last month, briefly topping 3 percent. That meant investors expected inflation to average about 3 percent a year for the next five years, far higher than any time in the decade before the pandemic hit. Measures of inflation expectations over longer periods, such as over the next 10 years, also rose to multiyear highs.
While the Fed chair, Jerome H. Powell, and other central bank officials have spent months saying higher inflation was a “transitory” result of pandemic-driven supply chain problems, there has lately been good reason to believe that price rises could be a more lasting concern. The US Consumer Price Index reading for September, released last month, showed prices climbing 5.4 percent from the previous year — and slightly faster than they grew in August. But analysts say the crucial concern for bond market investors was that prices seemingly unrelated to the pandemic were also beginning to move higher. Foremost among them was monthly rents, which tend to rise for long stretches once they start moving upward. Rents jumped 0.5 percent from August to September, the quickest rise in about 20 years
Energy prices also jumped 25 percent last month, driven by sharp increases in gasoline and fuel oil costs. Rising crude oil prices are behind the surge, and there is little sign that those pressures are going away any time soon. Benchmark American crude oil prices continue to push higher, rising 12.5 percent in October alone and over 70 percent for the year. And at the same time, Covid-related production snags, such as the stop-and-go recovery of auto manufacturing, continue to keep other prices elevated. A report on wholesale used car prices, which has become a closely watched indicator of inflation on Wall Street, showed the prices that dealers pay to stock their lots were surging once again. Those prices will filter through to consumers, most likely keeping used car prices high for months.
All those factors have prompted investors invest into inflation-protected Treasury bonds, whose payments increase to keep pace with inflation, and sell off plain vanilla Treasuries. Investors are watching the Fed’s moves closely. The bond-buying programs and low interest rates have been a huge boon to the stock market.
I have a view that if you move away from emergency conditions in a deliberate manner, the markets will like that, and growth can continue. Markets are likely to recalibrate, with shorter-term Treasury bond yields easing and the 10-year yield inching up, causing the yield curve to re-steepen. Equities will need to catch up to the reality of tightening financial conditions ahead. the Fed opted to taper bond purchases from this month and intends to end the program by June. The Fed will reduce its bond purchases by $15 billion for November and by a further $15 billion in December.
In the aftermath of the GFC, AREIT managers cleaned up their act, making the sector more resilient through lower debt levels, increased sources of financing, and less speculative activity.
Record government stimulus, monetary policy easing and the roll-out of vaccination programs are now intersecting with the gradual lifting of lockdown restrictions. These forces are feeding rising inflation expectations, expressed through a sharp increase in nominal bond yields. It’s easy to consider rises in bond yields and deduce that “bond proxies” like AREITs will underperform as inflation expectations rise but it’s not that simple. Even if higher inflationary expectations become a reality, in our view the prospects for future AREIT returns remain positive.
There are two reasons for this. First, a sustainable rise in general pricing levels and economic growth should be welcomed. Governments and central banks the world over have been working to engineer this for over a decade. It is odd that this imminent prospect is now a source of concern. Weak wages and economic growth have bedevilled the world for years. If the return of inflation heralds the end of these two things, income investors should be relieved rather than worried.
Second, the best protection against actual inflation (not just the expectation of it) is to invest in real assets. Commercial property leases typically include annual rent escalations equivalent to or above the consumer price index, or a fixed percentage of annual rent, often above the prevailing rate of inflation. Commercial property rents have in-built inflation protection. A similar argument applies to capital values. Because asset revaluations incorporate consideration of replacement costs, rising inputs costs through higher material and labour charges are ultimately incorporated into asset revaluations.
During eight periods when bond yields increased over the last 20 years, AREITs underperformed. However, when bond yields ultimately settle after a period of increases, AREITs have historically outperformed. In six of the last eight cycles, AREITs outperformed by an average of 8% against broader equities. This analysis leads to one conclusion. AREIT investors focused on relatively high, sustainable levels of income while maintaining the purchasing power of their underlying investment should not be too concerned by short-term market reactions to increasing nominal bond yields. Investors generally don’t cope well with risk and uncertainty. Yet that is all they have seen in the last 18 months. While AREIT prices have been a rollercoaster, operationally they have shown a level of resilience far beyond what doomsayers expected and gave investors the opportunity to snap up some bargains
Strong GDP growth this year is already priced into Australian share prices. For 2022, our expectation is that local and global growth will likely begin to fade as fiscal stimulus begins to unwind, after being heavily front-loaded into the first half of this year. As a result, consensus earnings growth estimates will likely be trimmed, and earnings momentum (upgrades less downgrades) may turn negative. Under this scenario, value is unlikely to continue to outperform growth. We expect the value rotation trade to first fade and later reverse. Unlike some market strategists, we see limited scope for interest rates to move much higher given the historically high post-COVID levels of domestic household debt.
In my view, it is not too soon to think of taking profit on some of the value positions that have done well, and to begin positioning Australian equity portfolios for the return to favour of quality growth in 2022. We note that stimulus as measured by the fiscal impulse (the change in the cyclically adjusted primary budget balance as a % of GDP) is much less in 2021 than it was in 2020. In 2022 it is set to turn negative (the ‘fiscal cliff’ effect), subtracting from GDP growth in that year. Under these conditions – a return to slower growth and sustained low interest rates – we believe growth stocks should return to favour. In portfolio positioning, focus is on ‘Quality Growth’, increasing active bets in the areas of higher quality businesses and cyclical growth. The price of raw materials often remains stable or declines when rates rise. The companies using these materials to produce a finished good — or simply in their day-to-day operations — will see a corresponding increase in their profit margins as their costs drop. For this reason, these companies are generally seen as a hedge against inflation.
Rising interest rates are also good news for the real estate sector, so companies that profit from home-building and construction may be good plays as well. Poultry and beef producers may also see an increase in demand when rates rise, due to increased consumer spending and lower costs.
Becoming more defensive
You may want to consider sectors that tend to perform best (or fall in price the least) when the market takes a downward turn. These can be considered defensive investment types:
- Consumer staples (non-cyclicals)
- Consumer discretionary (cyclical)
Stocks will typically perform best during the peak times of the economic cycle and during the early stages of rising interest rates. But non-cyclical or defensive stocks are more suitable before a recession hits, which is difficult to forecast. People still need housing, food, heating, cooling, education, and other products for daily living, even during a recession.
- Healthcare: Just like staples, people still need to buy their medicine and go to the doctor in both good times and bad. Health sector mutual funds and ETFs can be smart holdings when rates are rising.
- Gold: When traders expect an economic slowdown, they tend to move into funds that invest in real, physical asset types. These may include assets such as gold funds and ETFs. Gold is not a sector, but it is an asset that can do well in uncertain times and falling markets.
Despite a positive view on economic growth, we expect interest rates to continue to remain low in support of the recovery. While we see the RBA remaining dovish, long-term interest rates may rise to reflect the strong economic momentum. This is a scenario we believe should be positive for the stock market, as a steep recovery in earnings should outweigh any feasible rise in long-term rates.
The broadening global expansion faced numerous crosswinds, leading to mixed asset-market results. Global vaccination progress continued, but supply disruptions due to virus outbreaks, labour-market constraints, and severe weather restrained growth and sustained inflationary pressures. The cyclical backdrop is still favourable, but a move to a less accommodative stance by policymakers likely would present a challenge to asset returns.
While global growth has recovered at a record pace in the year following the 2020 pandemic-led recession, the world economy is likely to be passing peak growth in 4th quarter 2021. A few challenges lie ahead. With tapering on the way, will the global economy be able to transition without upsetting the recovery?
Near market tops. Market tops don’t happen with bad economic data. They happen when employment is good and GDP growth is high. The downturn begins when the economy goes from being good to being not so good. Fortunately, leading economic indicators turn down before employment deteriorates and industrial production sags. Therefore, leading economic indicators are so important.
Persistently high inflation would muddy the monetary-policy outlook and cast a long shadow over financial markets. As things stand, though, monetary stimulus is likely to be rolled back only very slowly in coming years.
- Inflation has been top of mind for policymakers for the past few months. This is not surprising as inflation, measured with the consumer price index (CPI), is currently at multi-year highs. Specifically, based on the latest data, inflation stands at more than 5% in the US and around 3% in the Eurozone which are both higher than the respective central bank inflation targets.
- GDP growth and manufacturing numbers that have be revised lower Global GDP is projected to grow by 5.7% in 2021 and 4.5% in 2022. A strong rebound in Europe, the likelihood of additional fiscal support in the United States next year, and lower household saving will boost growth prospects in the advanced economies.
- Global Consumer confidence improved in October, reversing a three-month downward trend as concerns about the spread of the Delta variant eased. While short-term inflation concerns rose to a 13-year high, the impact on confidence was muted. The proportion of consumers planning to purchase homes, automobiles, and major appliances all increased in October—a sign that consumer spending will continue to support economic growth through the final months of 2021.
When I look at all these together, they’re all converging around this similar theme of ‘at peak’ or ‘near peak’ or ‘passing the peak’ in terms of growth.
Earnings have been trumping any negative economic news to lift the stock market higher for most of this year, but can the stock market rally continue given rising inflation and slowing growth? Even after the government reported a sharp drop in economic growth for the third quarter (a 2% annualised rate) compared with the first half (over 6%), the U.S. stock market continued to advance. The fourth quarter is historically a strong period of the year for the equities market, and this year that seasonal advantage appears on track. Earnings are coming in better than expected, consumer demand is robust, and GDP is on track to finish the year at 6%-7% growth. Earlier this month, all six of the largest U.S. banks beat earnings expectations for the first time in years,
Persistent supply chain issues and resurgent demand are stoking inflation. The September consumer price index (CPI) rose 5.4% compared with September 2020. Some prices are rising rapidly and are clearly not transitory. The indexes for food and shelter rose in September and together contributed more than half of the monthly all-items seasonally adjusted increase. Rent rose 0.5% versus August — an enormous number, and suggests the Fed is behind the curve in monetary policy initiatives. September retail sales confirmed strong demand, up a huge 20.6% compared with September 2019, pre-pandemic. U.S. third-quarter credit card billings were up 25.2% versus the same period in 2020, according to an analysis from Merion Capital — showing that consumer spending is roaring ahead.
Researchers cited “a longer-lasting virus drag on virus-sensitive consumer services spending” and expectations that the global supply of semiconductors will not improve until next year, along with a likely decrease in fiscal stimulus.
Since the consumer constitutes 70% of the economy, it will be necessary to watch the surge in spending closely. Note that we still have pent-up demand, which bodes well for the overall economy. The consumer savings rate, according to the St. Louis Fed, was at 9.4% in its latest reading in August, still well above the historical average of 5%, amounting to $2 trillion in consumer excess savings, according to Merion Capital and Cornerstone Macro.
The Federal Reserve is set to start cutting back on its asset purchases soon, but even with the taper, it will still be injecting significant liquidity into the system through mid-2022, to the tune of roughly $105 billion per month. And the new infrastructure spending, which will likely amount to $1 trillion to $2 trillion, will eventually come and continue to stimulate economic activity.
Higher inflation has at least two consequences for stocks. First, some companies will find it more difficult than others to pass through cost increases to their customers, putting more pressure on their margins. Second, higher inflation should lead to higher interest rates and a higher discount rate applied to future cash flows, implying a lower valuation multiple for stocks in general.
At its meeting in September, the ECB revised upward its projections for inflation in the euro zone for this year from 1.9% to 2.2% as well as for 2022 to 1.7% and 2023 to 1.5%.
The ECB expects the euro zone economy to grow by 5.0% this year. Previously, it had expected a growth of 4.6%. In view of the rapid recovery of the economy, the success of the vaccination program, as well as the recent sharp rise in inflation in the euro area, the ECB Governing Council decided at its meeting to moderately reduce net purchases under the Pandemic Emergency Purchase Programme (PEPP). ECB head Lagarde did not initially name an exact sum of reduction.
Just like the US, the degree to which skills in the workforce match the skills in demand will determine how long high rates of underemployment persist. Consumer and business confidence levels have had a bumpy ride, following the ups and downs of the Covid-19 pandemic. Right now, growth is on a downward trend. Overall, the recovery isn’t going as well as it should be. Europe’s post-Covid momentum is fading fast, which is bad news for the US because of the close relationship between the two trading blocs.
The European and global economies are experiencing significant price increases across an array of commodities and input components. Particularly notable has been an enormous rise in natural gas prices, which have been affected by many factors including most recently hurricanes disrupting the natural gas supply chain.
This has the knock-on effect of significantly increasing the cost of electricity. The rise in electricity prices will likely create a significant supply side shock to some companies and consumers. Some European governments have already begun to respond to the political pressure this is causing. Spain has effectively implemented a tax on the profits of utility operators to keep prices down. Italy, on the other hand has offered to subsidise electricity prices for consumers.
In Germany, the headline inflation figure climbed to 4.0% year on year—the highest level in almost 28 years. In the euro zone, the headline inflation rate rose to 3.0%, while core inflation rose to 1.6%. Experts expect inflation rates to rise further in the coming months. However, since wages have not risen accordingly so far, this is a temporary phenomenon.
According to ECB chief Christine Lagarde, there is no sign that the current rise in inflation is of a long-term nature. Overall, the outlook for Europe is positive: a successful vaccination program, good macroeconomic data, a rapid recovery. Even though the rise in inflation is assumed to be transitory, there is a real chance that inflation will be more pronounced than expected. Investors should be prepared for possible equity market pull back.
The Bank of Japan has trimmed its economic growth and inflation forecasts for the year through March 2022, keeping its ultraloose monetary policy intact to support it weak economic recovery.
Rising commodity costs have pushed Japan’s wholesale inflation to a 13-year high in September. But the pass-through to households has been remarkably slow due to sluggish domestic demand, keeping consumer inflation stuck around zero. That leaves Japan as an outlier, especially as intensifying global inflation pressure is prompting more central banks to consider withdrawing their massive stimulus.
The BOJ gave the bleaker economic outlook after a two-day policy meeting, as parts shortages have hit automakers such as Toyota Motor Corp. that have been forced to cut output. COVID-19 restrictions that were in place until recently have delayed a recovery in the services sector.
The economy will likely grow 3.4%, rather than the 3.8% projected earlier. The bank also projected inflation at well below its 2% target for at least two more years, reinforcing market bets it will lag other central banks in dialling back crisis-mode policies.
The projections highlight the policy gap between Japan and other economies. While other countries are gradually moving towards reducing monetary stimulus, the BOJ is living in a totally different world as an outlier from the global trend. Given tepid inflation expectations, the BOJ will stick to easing policy under yield curve control at least until 2023.
Japan’s economy emerged from last year’s pandemic-induced doldrums as robust overseas demand propped up exports, offsetting some of the weakness in consumption. But supply bottlenecks and chip shortages have hit manufacturers, clouding the outlook for the export-reliant economy.
The BOJ will continue to buy exchange-traded funds with an upper purchase limit set at ¥12 trillion ($106 billion) a year. The policy board also decided to keep funding support for struggling firms amid the pandemic.
Over the last several months, Chinese government authorities have unleashed a highly aggressive, “socialist smackdown” upon businesses. Chinese Communist Party (CCP) actions range from anti-trust probes and cyberspace crackdowns, to targeted prevention of the “disorderly expansion of capital”.
Although Evergrande doesn’t look exactly like a Lehman moment, the sharp drop in housing activity and prices are not good for Chinese consumers, who have approximately 60% of their savings wrapped up in their homes. What’s more, sweeping power outages and rising commodity prices are stirring a sense of social unrest and point to the potential for more problems. With the government’s willingness to intervene in the private sector markets makes a debt crisis and global market collapse improbable, and valuations have become substantially cheaper.
Beijing’s focus to address wealth inequality has had far‑sweeping impacts on sectors such as technology, education, real estate, and health care. At the same time, authorities have started to pursue more aggressively its five‑year plan to reduce carbon emissions by limiting coal supply, resulting in power outages, and shuttering factory activity leading to supply shortages. The degree of recent actions taken by the Chinese government combined with declining growth estimates is causing investors angst. Although unlikely to allow economic growth to fall significantly, China’s actions may force foreign investors and trading partners to reassess the risks of investing in a place that has become more predictably unpredictable
Gold’s correlation with most major asset classes is low and is one of the principal arguments for considering a strategic allocation. Within a strategically designed portfolio, this supports the potential ability of a dedicated, long-term gold exposure to provide meaningful diversification benefits on an ongoing basis. Gold’s correlation can vary and potentially provide a hedge in various market environments. Two examples of environments where gold can provide diversification benefits are when equity markets decline materially, such as 2008-2009, and investors seek safety in gold exposures, and situations where real interest rates (as measured by Treasury Inflation-Protected Securities, or (“TIPS”) are declining and investors consider the opportunity cost of holding gold in a low real rate environment. From the investment performance standpoint, gold has performed as might be expected over time. Over the last 30 years, gold has returned roughly 3.3% per annum, lagging the performance of riskier assets like equities but outperforming inflation. I view an allocation to gold as a strategic position in a world with persistently low real interest rates. Gold’s independence from any central bank makes it attractive as an asset (or currency) that cannot be easily devalued. Importantly, gold serves as an asset class with its own unique characteristics that provide potential benefits to a diversified portfolio.
Like many other assets and strategies that diversify growth/equity risk, expected rates of return are modest, at best, but shine when growth assets are in crisis. With beneficial correlation dynamics and a historical return profile, an allocation to gold may support the portfolio’s risk and return objectives over the longer-term horizon.
Energy prices soared in the third quarter of 2021 and are expected to remain elevated in 2022, adding to global inflationary pressures and potentially shifting economic growth to energy-exporting countries from energy-importing ones. In 2021, some commodity prices rose to or exceeded levels not seen since the spike of 2011. For example, natural gas and coal prices reached record highs amid supply constraints and rebounding demand for electricity, although they are expected to decline in 2022 as demand eases and supply improves. However, additional price spikes may occur in the near-term amid very low inventories and persistent supply bottlenecks. The use of crude oil as a substitute for natural gas presents a major upside risk to the demand outlook, although higher energy prices may start to weigh on global growth.
Fertilizer production has been curtailed by higher natural gas and coal prices, and higher fertilizer prices have been pushing up input costs for key food crops. The production of some metals such as aluminium and zinc has been reduced due to high energy costs. As global growth softens and supply disruptions are resolved, metal prices are forecast to fall 5 percent in 2022.
|Sector||12 Month Forecast||Economic and Political Predictions|
|AUD||75c – 80c||Governments are committed to strong support, particularly given the sharp improvements in the underlying fiscal position. Momentum outside NSW is strong while there is ample evidence that economies bounce back from snap lockdowns on government support and pent-up demand. Nevertheless, that is likely to mean significant volatility. With high levels of vaccination expected by end November I expect that governments will be much more cautious in resorting to lock downs, laying the foundations for a lifting AUD by year’s end.|
|Gold||Gold remains attractively valued, even at these levels.
In the short term, prices are supported by a recovery in demand for gold jewellery and the potential for the dollar to weaken as emerging markets rebound. A weaker greenback makes dollar-priced bullion more affordable.
|Despite the recent run-up in gold prices, we believe gold remains attractively valued – one might even say cheap – in the context of historically low real interest rates. The key risk is that real interest rates rise, making gold relatively less attractive.|
|Commodities||There is a compelling investment case for those natural resources companies that are positioning themselves on the right side of decarbonisation investment trends and broader ESG themes.||In 2021, some commodity prices rose to or exceeded levels not seen since the spike of 2011. For example, natural gas and coal prices reached record highs amid supply constraints and rebounding demand for electricity, although they are expected to decline in 2022 as demand eases and supply improves. However, additional price spikes may occur in the near-term amid very low inventories and persistent supply bottlenecks.|
|Property||Prefer Retail and Office sectors.
The underlying economic fundamentals for commercial real estate are gaining more momentum with a higher level of vaccine coverage, which is likely to boost REIT earnings growth over the remainder of this year.
|REITs are well positioned to take advantage of a growing economy because they entered the crisis with historically strong balance sheets and access to credit and liquidity.
REITs outperform in periods of moderate and high inflation, while providing competitive returns in periods of low inflation.
|Australian Equities||Consumer staples (non-cyclicals) and consumer discretionary (cyclical) stocks will typically perform best during the peak times of the economic cycle and during the early stages of rising interest rates.||Australian valuations are not as favourable as they used to be. Earnings momentum in Australia is weak with more downgrades to come, reflecting the impact of current lockdowns and the Chinese slowdown.
However, Australian labour market and sentiment indicators have proved to be more resilient than expected. Regulatory overhang in China has likely peak, high vaccination rates in Australia bode well for a strong economic reopening before the end of the year.
|Bonds||Pair short-term bonds with other instruments, including floating-rate debt, bank loans, and Treasury Inflation-Protected Securities (TIPS), whose adjustable interest rate is less sensitive to rising interest rates than other fixed-rate instruments||Rates will generally begin to rise as an economy rebounds. For this reason, now is the time to begin preparing for this shift in the interest rate environment.|
Elevated stock and bond valuations, elevated corporate and government debt levels
Fed accommodation has peaked, fiscal stimulus has peaked, corporate taxes likely to rise.
|Healthy consumer balance sheets and high savings rate. Exceptionally strong earnings growth. Infrastructure spending likely to increase. Delta variant spread appears to have peaked.|
Limited long‑term catalysts for growth. Limited scope for ECB to stimulate further demand from China fading Microchip shortage impacting auto production rebound
|Higher exposure to more cyclically oriented sectors that should benefit from economic recovery. Monetary policy remains accommodative. Fiscal stimulus likely to increase. Equity valuations remain attractive relative to the US.|
Local stock markets look attractive due to favourable relative valuation, and positive earnings trends Policy setting remains extremely accommodative, with further boost coming from fiscal spending
|Economic activity should benefit from a rebound in capex, inventory build-up and improvement in business confidence. The slowdown in global economic data, especially in China, presents a headwind for Japanese companies. Stagnant productivity remains a structural issue for margins in the face of a tight labour market.|
|Emerging markets||Prefer Asia Markets
Global trade likely to improve as bottlenecks are worked through and vaccine levels continue to improve.
|Equity valuations attractive relative to developed markets. Exposure to cyclical areas of economy should benefit from broad global recovery. Chinese regulatory actions likely to have peaked. Vaccination rates are improving.|
|China||Preferred International exposure
The slowdown in Chinese economic activity may have increased the chances of policy easing to come
|Chinese consumer spending is still lagging the recovery and below expectations, with consumers acting cautiously in the face of uncertainties. There is a contagion risk from the Chinese property sector, while power cuts add further uncertainty.|