Negative real returns on cash and fixed interest persist even though expected inflation has abated over the last month. The outlook for inflation, interest rates and economy as expressed continuously by the level and the shape of the yield curve for bond markets in Australia, the USA and elsewhere, is:
- Low inflation over the next ten years
- Modest real GDP growth over the next three to five years; and
- No relapse into recession within the next two years, in spite of Covid induced lock downs
The central banks in the US and Australia are now operating on a wait and see policy by waiting to see higher inflation outcomes before responding with interest rate changes. The volume of monetary stimulus by all major central banks continues to feed into asset prices in the equity and real estate markets rather than into inflation of the prices of goods and services.
Equity markets continue to be at or near record high levels, except for the Chinese equities market, which is undergoing a major reversal that may continue for some time.
Indicators of the equity risk premium (ERP), the excess return of equities over returns on bonds or cash, have improved in most equity markets. It is now in line with long-term historical averages in Japan, the United Kingdom and the Eurozone, due mainly to an earnings recovery leading to lower price earnings ratios.
The ERP is also higher than it has been in the USA, China and in Australia, but is still below the long-term historical average. The improvement in the USA and Australia was mainly due to the significant fall in the bond yield in those markets. The ERP in China moved higher due to the pullback in the equity market, however the reason for that pullback has led to a need for a higher risk premium for Chinese equities to compensate for increased sovereign risk.
The equity markets in the US, the UK and Japan equity markets are attractively priced relative to long-term fair value, European equities are now priced fairly, relative to long-term earnings growth prospects, Australian equities still look expensive, and China is becoming more expensive to an uncertain degree.
These considerations lead to a recommended investment strategy which includes giving more emphasis to equities over bonds and more emphasis to international over Australian equities, with some caution to be exercised in relation to Chinese equities or funds that have a significant weighting to them.
The main reasons are that:
- returns on cash and fixed interest are likely to be below inflation for years.
- growth in earnings of equities is still likely to continue, although it will require some skill to identify the better prospects among the many companies listed on equity markets.
- the relatively expensive pricing of the Australian equity market together with its greater concentration of risk and dependence on Chinese imports
Extracted from Purvis Investment Market Conditions Report – 3 August 2021. 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.