The Reserve Bank (RBA) has just raised its economic forecasts, projecting unemployment to drop from 4.2% to 3.75% this year, a level last seen 50 years ago. Annual core inflation rose to 2.6% in December, years ahead of the RBA’s previous forecasts. Underlying inflation is projected to rise to around 3.25% by June this year. Most importantly, wage growth is expected to reach 3% in 2023. This is the level considered necessary by the RBA to lift inflation to its 2% to 3% target range, and to keep it there sustainably. All of this prompted Dr. Lowe (RBA head), to say that it was a “plausible scenario” that the Australian cash rate could rise in 2022, or it could occur next year or later. This is a long way from previous statements from the RBA that the next rate hike was unlikely to happen until 2024.
The biggest change in market expectations has been the realisation that inflation in most countries will be both higher and much less transitory than previously thought. In the US for example, 40-year high annual inflation of 7.5% has led to a much more hawkish stance by the Fed. As a result, the US has sped up its taper (the unwinding of bond buying of $120bn a month), and we now expect that this quantitative easing will end in March this year.
We are now entering a US Federal Reserve (the Fed) tightening cycle. Markets are now factoring a rise of 0.5% in March and possibly 6 rises in 2022 compared to 3-4 quarter point rate rises just a few months ago. The Fed is now obviously behind the curve with annual CPI inflation of 7.5% and wholesale inflation of around 10%. Inflation has now broadened out to affect “stickier” areas such as wages and shelter costs.
The danger is that inflation will become entrenched, and the Fed will need to become much more aggressive to tame it. Given the massive levels of debt, the Fed will want to be somewhat cautious in hiking rates, but circumstances may force its hand. We should also point out that the neutral cash rate in the US is around 2.5%, with rates now at zero. Similarly in Australia, the neutral cash rate is around 2%. The wild card is the Fed’s $US8.8 trillion balance sheet. Fed chair Powell when asked about plans to shrink the Fed’s $US8.8 trillion balance sheet, said at some point this year he and his colleagues will allow the balance sheet to run off by selling the bonds that it holds back to the market.
The volatility we experienced in January was partly due to rising bond yields and the expectation of more and faster rate hikes than had been previously factored in. The other feature of equity markets has been a rotation away from high PE (price-to-earnings) Growth stocks to cheaper, more Value style stocks. The Fed’s current priority is to try to get inflation under control, which makes coming to the rescue of the stock market by loosening monetary policy and/or reinstating QE very unlikely, as this would exacerbate the issue of rising inflation.
Furthermore, real interest rates (after inflation) are negative with the US 10-year government bond yield at around 2.0% while estimated 5-year and 10-year inflation is 2.81% and 2.45% respectively (inflation break-evens). The markets are thus hostage to the inflation data, and we would expect quite a bit more volatility in 2022. We would expect equity PE multiples to contract from current levels as interest rates rise. The S&P 500 forward PE was 21.2 times at the end of 2021 (down from a recent high of 23x). The 25-year average S&P 500 forward PE is 16.8 times (JP Morgan, 31 Dec 2021) reflecting higher interest rates. 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 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. This is also an environment where more cyclical, Value style stocks should do well, provided economic growth is maintained at a reasonable level and we do not have an economic downturn as a result of multiple rate hikes. We do expect growth to slow as rates move higher and yield curves flatten.
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. With returns likely to be much lower in 2022 compared to 2021, 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 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.
There are also several geopolitical risks apparent at present. The recent Russian invasion of Ukraine has led to restrictions on a Russian gas pipeline that will likely keep energy (oil and gas) prices high and add to inflation. The other two potential flashpoints are China invading Taiwan and an Iranian nuclear breakout, likely to lead to other middle eastern states also going nuclear. We are not predictingboth of these, but obviously any more of these outcomes will add to the disruption of equity markets.
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