Market Update – December 2021

Most equity markets have continued to be close to record levels despite concerns about emerging inflation, surging COVID cases and now a new variant.

Even at such elevated levels most developed equity markets are fairly valued versus long term bonds, which continue to trade at yields below inflation.  Apart from China, which has become a special case, there is still momentum in most equity markets, although it is decelerating.

Monetary policy in all major markets is still supporting high equity prices and low bond yields, although this will gradually change over the next year or so, at least in the USA.  The monetary policy status quo was reinforced by the reappointment of Jerome Powell as Chairman of the Federal Reserve Board for another five years. This provides continuity in monetary policy, clarity in the direction of at least one important US institution and reassurance to the bond and equity markets.

All over the world, fiscal policy is still in pandemic fighting mode, with deficits that are massive by historical standards and likely to shrink only very gradually over a long period. The philosophical reluctance of many politicians to preside over deficits and rising debt is trumped by the improvement in their re-election prospects. Fiscal stimulus directly supports many sectors of the equity market, although the consequent level of government debt and bond issuance carries the threat of rising bond yields over the next few years.  The argument in favour of a full allocation to equities appears to remain intact. So does the argument in favour of avoiding long dated bond investments.

It appears that not much has changed, unless we consider what has happened in late November:  a not unexpected wild card, the emergence of Omicron, a new “variant of concern” of SARS-COV2, which may be more effective than Delta in transmission and not as affected by existing vaccines.

No one knows the answers yet, but many are working on it. The effect on the economy and investment markets will be as much determined by the responses of policy makers as by the scientific evidence. Politicians in most places want to keep opening the economy and learning to “live with the virus”, at least for the more than 90% who do not die from it. Depending on the policy makers’ reactions versus the actual virulence of the new variant, the economic outcomes may range from continued acceleration towards prosperity in the midst of a widespread but attenuating virus or a relapse into a deep recession similar to the sharp decline in early 2020. The bottom line is that it is just too early to know whether the situation will develop into a short sharp selloff in equities followed by a rebound or a more serious prolonged recession and downturn in equities.   

All of this reinforces the most likely scenario upon which we have been basing investment strategy for all of this year. This scenario can be summarised as follows: 

A fragile, stop-start recovery where subsequent waves of COVID-19 infections have a partial or severe effect on economic activity. Vaccines are widely available in developed countries, but not in less developed countries where widespread immunity will be delayed until mid-2024 at the earliest. This provides a pool of humanity among which the virus can thrive and spread and mutate, perhaps into more damaging strains. The emergence of the Omicron variant demonstrates the potential risk of disruption. The pandemic may continue until beyond 2025, disrupting many globalised industries and supply chains. Earnings of companies around the world in 2022 are expected to be 10% below the recently reported levels, due to supply and labour force disruptions. Monetary policy is somewhat tighter but not greatly so, due to concerns by central banks that do not want to disrupt the fragile recovery. Short interest rates will rise moderately from their current levels while bond yields will tend to increase as inflation persists around 3% p.a. or slightly higher.

THE OPERATING ENVIRONMENT for investors has become even more uncertain, although some implications are still clear:

1. Inflation will step up to a higher level somewhere between 3% per annum and 5% per annum- a significant but not catastrophic increase.
2. Interest rates will rise over the next three to five years, with long-term bond yields rising by at least 1% p.a. and perhaps by as much as 3% p.a. This will impair the defensive characteristics of fixed interest assets even if credit losses are low.
3. The discount rate for the valuation of equities, real estate and other growth assets will be higher, reducing the value of longer dated cashflows from growth-oriented assets. Among the winners in the post-COVID and higher inflation environment, this effect will be offset by higher and more sustained growth in cash flows. A moderate increase in inflation to between 3% p.a. and 5% p.a. would assist in growing cashflows.

In such circumstances INVESTORS SHOULD, due to the continued support from fiscal deficits and very low interest rates:

• Maximise the asset allocation to equities subject to meeting their perceived need for a reduction in the shorter run volatility of portfolio returns.
• Maintain a portfolio allocation to equities of at least 100% of the neutral or benchmark or long-term strategic weight for the relevant risk profile within the framework that applies to the portfolio.
• Overweight developed market international equities but be careful about so-called emerging markets.
• Underweight Australian equities, due to its concentrated composition and the risk inherent in its reliance on the Chinese economy.
• Invest any defensive assets (cash or fixed interest) with a shorter duration (to avoid losses if bond yields rise)
• Refrain from investing in cash or fixed interest that has significant corporate credit risk, unless it is via a fund managed by managers with proven credit risk assessment skills.
• If a more cautious approach is needed due to the short to medium term risk posed by new COVID variants such as Omicron, then accumulate cash rather than fixed interest or equity investments and deploy into equities later when uncertainty subsides to some degree.

For strategic advice tailored to your personal situation, please reach out: info@genesisfp.com.au.