CONSUMER PRICE INFLATION is accelerating in the USA, Europe, and Australia, due mainly to factors beyond the influence of central bank monetary policies. Nevertheless, central banks are responding by rapidly increasing short-term cash rates.
Central banks are saying they can get inflation back to the 2-3% pa range they have been targeting for the last thirty years. Based on historical evidence, they will need to escalate interest rates significantly above the rate of inflation to break down inflationary expectations and succeed in their aim. This would cause a major recession, which in turn would lead to cuts in interest rates sooner than previously expected.
The equity and bond markets have responded to this possibility by pushing up prices in recent weeks. Long-term bond yields have already fallen from their most recent inflation-fuelled peaks. The most significant outcome of this is that the US two-year bond yield is higher than the ten-year bond yield (an inversion of the yield curve). This is a signal of a recession in the USA within 18 months.
In China, the GDP growth rate fell to 0.4%, the second worst quarter in 30 years. The government of the PRC will not meet its target of 5.5% pa GDP growth in 2022. The Chinese economy is slowing rapidly due to the combined effects of its zero COVID policy leading to extensive shutdowns, and the reduction of leverage in the property development sector. Much slower growth in China has led to lower commodity prices. Both oil and copper have fallen over 14% in the last six weeks. Iron ore, an important export from Australia, has also been adversely affected.
Beyond commodities, slower Chinese economic growth also affects the import of manufactured goods from the European Union and the USA, so it will contribute to slower growth worldwide. The IMF, the OECD and the World Bank have all scaled back their forecasts of global GDP growth in 2022 (World Bank from 4.1% pa to 2.9% pa and the OECD from 4.5% pa to 3.0% pa).
In Australia, shifts in monetary and fiscal policy will have limited effects on the outlook for bond yields, equity earnings or pricing. The Australian bond market will be most affected by conditions in the US bond market. The Australian equity market is more likely to be influenced by economic conditions in China or equity market conditions in the USA.
The key focus of bond markets is the level and shape of the yield curve in the future. An upward sloping yield curve with a ten-year bond yield of between 3% pa and 4% pa would feel ‘normal’ to bond market participants. The US equity market could also live with such yields, although PE ratios may need to average closer to 15 times rather than the current 20 times earnings. This would imply a stock market re-pricing in the USA of minus 25% from the current levels in the absence of growth in earnings. In a world where inflation is stabilising at around 3% pa or more, earnings per share growth would be faster than it would otherwise be for some companies and may offset much of the re-pricing pressure.
In summary, our assessment of the major factors affecting the attractiveness of equities are as follows:
Policy and political factors – In most places, monetary and fiscal policy are still supportive of equity earnings and equity prices but monetary policy support will reduce sharply over the next two years. The policies of China and Russia will continue to be disruptive.
Valuation factors – From a longer-term perspective, all major equity markets have become more attractively priced following the scaling back of bond yields from recent peaks.
Momentum factors – Equity market momentum is now neutral except for India where it is moderately positive and China where it is negative.
Overall, the outlook for equity investment in the longer term (3 to 10 years) is still positive relative to bonds but less so relative to cash returns which are rising. In the shorter term, over the next one to three years, a major downturn in equity markets, of 30% or more below the current level is a significant possibility because of the intersecting problems of the continuing COVID pandemic, war and inflation which are beyond the capacity of governments and central banks to fix quickly.
Investors who are concerned about the capital stability of part or all of their assets over the next three years should significantly reduce the allocation to equities in that part of their portfolio that relates to the next three years. They should then hold short-term fixed interest or cash rather than long-term bonds as defensive assets for that part of the portfolio, because bonds may well have low or even negative total returns.
Portfolio holdings that relate to the longer term, beyond five years, should continue to hold a benchmark weighting in equities, but only if there is a tolerance for a significant downturn in value over the next few years, before an eventual recovery, which may take up to five years. There is scope, from a long-term valuation perspective, to consider a careful and gradual move to an overweight position in equities if the equity markets do indeed experience a significant further fall from the current level.
This information is general advice only and does not take into account your personal circumstances, goals and objectives. Therefore, you should consider its appropriateness for your circumstances before acting on this information.