THE WORLD is now an even more dangerous place for investors than it was a month ago.
We have reached a tipping point.
The outbreak of war in Europe, which may escalate further, could well lead to a protracted recession in growth and increase in inflation. Meanwhile, the continued evolution and spread of COVID will lead to other supply chain disruptions, limiting growth and boosting inflation.
In the shorter term (over the next year) the prospect of a major downturn in equity markets of the order of 30% to 40%, is real. There is much less prospect of a rapid recovery such as occurred in 2020 following the short Covid induced recession. Now is the time to significantly reduce the portfolio allocation to equities in favour of cash rather than long term bonds.
In the longer run (over the next ten years), notwithstanding the level of uncertainty, some elements of the investment environment are still discernible:
- Inflation in the USA and Australia, and in other developed economies, will step up to a higher level, averaging somewhere between 3% per annum and 5% per annum. This is significant, but not catastrophic.
- 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. Investing in floating rate rather than fixed rate securities will be more defensive.
- 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. There will be some companies whose cash flows will grow fast enough to offset this effect on their value, especially in a higher inflation environment.
- The longer the war in central and eastern Europe lasts, or if it keeps escalating, the more it will damage economic growth and lead to much higher inflation such as that seen after World Wars 1 and 2. Once the war is over, or at least stops escalating, the long-term valuation of equities will be fair relative to bonds and cash and will offer an equity risk premium of between 3% p.a. and 6% p.a. in developed markets. It will then be time to reallocate to equities.
WHERE WE ARE NOW – Table 1: Financial markets 4 March 2022
Over the course of the last month:
- Short term interest rates on cash worldwide have been unchanged and may now be on hold or at least rise more slowly than previously expected. Long-term bond yields, in major markets other than Australia, fell as investors started a flight to safety from equities as the risk of a global recession rose.
- Major equity markets stalled (Australia) or fell (every other market) as the onset of war in Europe and the effect of wide-ranging sanctions on Russia started to sink into investors’ consciousness. There is probably much further to go as the war continues and sanctions escalate.
- Equity market momentum has now largely disappeared, despite continued support from very low interest rates and massive fiscal deficits.
- Commodity prices are up strongly with oil up 32.9% as a direct result of the imminent risk of a major interruption to a significant part of world exports. Copper is up 8.5% and gold is up 8.9% as part of investors’ flight to safety. Many other commodities such as wheat, aluminium and titanium are also more expensive as a result of supply interruptions from Russia and Ukraine, which are major exporters.
- The Australian dollar rose 3.4%, boosted by stronger commodity prices and the relatively higher Australian ten-year bond yield. This exacerbated the downturn in returns on international equities for Australian based investors.
Table 2: Summary of factors affecting investment markets over the next one to three years
Fiscal and other public policy
Politics and Geopolitics
Overall effect on the outlook for investment returns
Positive but reducing over the next two years as short interest rates rise due to rises in the Fed Funds rate, and long bond yields are pressured as quantitative easing is withdrawn, albeit slowly.
Positive for equities but will decrease sharply in 2022, especially as major new spending legislation is stalled.
Negative for bonds as the deficit is still large at 7.8% of GDP
Negative due to the Russia- Ukraine war, the disruption of trade due to sanctions and the rising oil price. And that’s the good news. It could get worse.
Negative for bonds in the medium and long term but could be positive in the short term as bond yields fall as a global recession takes hold. This would be a good time to sell bonds and hold cash. Negative for equities in the short to medium term (out to two years). Slightly more positive for cash over the next five years.
Slightly positive for bonds and equities as policy settings are still being loosened to avoid too serious a slowdown.
Overall negative impacts on corporate governance and strategy outweigh the effect of fiscal stimulus with the deficit at 5.0% of GDP.
Negative in the run-up to the 2023 National Peoples’ Congress, especially as it appears to have made a major policy maker mistake in backing Russia.
Negative for bonds and equities.
Positive with long bond yields anchored close to zero, although the anchor is being shaken loose.
Positive. The fiscal deficit is 7.0% of GDP.
Negative given its potential exposure to aggression in East Asia.
Negative for equities. Neutral for Japanese government bonds.
Positive with a retreat from QE which is slower than in the USA.
Positive. The Euro area fiscal deficit is 4% of GDP, a very high level for the conservative northern countries. Likely to get worse as government need to spend more on refugees and weapons.
Negative due to the Russian invasion of Ukraine which could proliferate into a wider and more persistent war in Europe.
Negative for bonds due to the high deficit and the prospect of higher inflation driven by rising oil and gas prices. Negative to very negative for equities depending how bad the war gets.
Positive for equities but less so for bonds as QE is cut back.
Positive for equities.
Net negative for bonds given that the deficit is still 5.4% of GDP.
Negative as the war adds to the government’s self-destruction of its credibility.
Negative for bonds in the medium to long term and negative in the short to medium term (3 years) for equities.
Positive but reducing as buying bonds under QE has ended but with an increase in the official cash rate dependent on wage inflation exceeding 3% p.a. which is not expected until 2023 at the earliest.
Positive but weakening for equities with the fiscal deficit at 4.6% of GDP, which is negative for bonds.
Negative due to the war, as for other countries, made worse by the impact of Covid and floods, in the run-up to the election that needs to take place before the end of May 2022.
Neutral to positive for bonds in the short term but turning negative in the medium term as bond yields rise in line with inflation and the withdrawal of QE. Negative for equities out to three years, and eventually in 2023 slightly more positive for cash.
SUMMARY OUTLOOK FOR EQUITY MARKETS
In summary, our assessment of the major factors affecting the attractiveness of equities are as follows:
> Policy and political factors (Monetary, Fiscal and public policy, Politics and Geopolitics)
In most places, monetary and fiscal policy are still very supportive of equity earnings and equity prices. They are expected to remain supportive but progressively lessen over the first half of the next ten years. There are major negative policy factors arising from the autocracies such as China and Russia, which offset the positive effects of fiscal and monetary stimulus in those countries. More importantly the effects of their aggressive policies are sufficient to also offset the effects of supportive monetary and fiscal policies on a global basis.
> Valuation factors
From a longer-term perspective, all major equity markets have become less attractive following the outbreak of war which will slow economic growth and disrupt many industries. The UK and European markets have fallen in price by enough for them to still retain a fairly priced status from a longer-term (ten-year) perspective. For other markets, the expected fall in bond yields in a Global Recession would be sufficient to make some of them fairly priced in such a scenario.
> Momentum factors
Equity market momentum has now largely disappeared, despite continued support from very low interest rates and massive fiscal deficits.
Overall, the outlook for equity investment in the longer term (3 to 10 years) is still positive relative to bonds and cash. In the shorter to medium, out to three years, investment in equities needs to be carefully and selectively managed by investing through a diversified group of active equity managers with proven stock selection skills that are exercised within a sound investment process and is not dependent on a single dominant person, due to the wide dispersion between winners and losers among listed companies.
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.