Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 432

Rising bond yields complicate the COVID recovery

COVID-19 will soon have been with us for two full years. Since the pandemic started, the course of investment returns has differed greatly from what was initially expected in investment markets.

What now lies ahead for investment markets? Here are some thoughts for investors contemplating how to allocate across the main asset categories. But first a brief review of what’s happened, and why.

A brief retrospective

When the pandemic broke out, share markets plummeted, for around five weeks. Since then, most equity markets have made substantial gains, and at the time of writing were trading at or close to record levels.

Bond yields initially rose for a week or so before falling to record lows. They’ve now moved modestly higher (with quite a lift in recent weeks, particularly at the 2 year tenor); however yield curves remain upward sloping and spreads continue to be skinny.

Commercial property initially slumped but has since risen unevenly, producing some spectacular gains in particular sectors (notably warehouses) while average residential housing has shot up in price.

Exchange rates haven’t varied as much as was expected in the pandemic’s early days. Commodity prices have been volatile – especially prices of energy, iron ore and inputs into renewable energy production – but for the most part the super-cycle in commodities has continued. With strong terms of trade and weak capital spending, Australia is running huge surpluses on trade and current accounts.

The strong recovery in the prices of most assets since early April 2020 reflects three main influences:

  • The massive - and sustained - easing in fiscal and monetary policies around the world (noting that accommodative monetary policies also mean investors must live with cash rates at near-zero levels).
  • The speed with which efficacious vaccines were developed (mainly benefitting wealthy countries and China).
  • Exaggerated fears, initially, that the global economy would suffer a depression or structural stagnation. (Recall the scorn directed at early suggestions that the slumps in economic conditions and shares would be V-shaped. As it turned out, both the economy and share market have not only exhibited V-shaped recoveries, but the deepest and narrowest V-shapes in history).

The investment outlook

Looking ahead, here are some thoughts on key influences on prospective investment returns.

The shape of the pandemic: Population-wide mass vaccination has been critical in containing COVID, particularly in developed economies and China (but not as yet in most developing economies). With this uneven access to vaccinations, with the risks of further mutations, and with all governments now having swung from eliminating the virus to “living with COVID”, prospects for case numbers, hospitalisations and deaths remains highly uncertain.

The global economy: Provided infection numbers stay reasonably contained in the major economies, and governments and central banks do not move too quickly to tighten policy settings, the big economies - North America, Europe, China and Japan - seem unlikely to tip into recession in the near future. That’s a bold forecast. It reflects these inputs: fiscal and monetary policies are currently stimulatory, yield curves are upward sloping, liquidity is abundant, and gains in asset prices have added to household wealth (albeit unevenly).

China’s economy is likely to be soft for another quarter or two because of problems in property markets led by Evergrande, but GDP is unlikely to fall, even for a quarter. These supportive economic conditions should bring about modest growth in aggregate earnings to labour and capital.

Valuations: All major asset classes are highly valued – especially when assessed by way of price-earnings ratios and price-to-book. However, share market valuations look more comfortable to investors who expect some continuing growth in profits (most importantly in the US, where Q3 earnings remain encouraging) and who expect real interest rates to remain ‘low’ relative to past trends.

But investors need to allow that momentum has driven valuations higher – and not only for ‘quality’ stocks but also for many start-ups, ‘meme stocks’ and cryptocurrencies.

Macro policies: Budget and monetary policies are extremely stimulatory in most countries. Expansionary fiscal policies provide a strong boost to economic activity when inflation is non-existent and savings are high (conditions seen in the 1930s when Keynes penned his ‘General Theory’).

Expansionary macro-policies don’t, however, do much to raise GDP and jobs when inflationary expectations are high and savings are low (as Gough Whitlam and Jim Cairns learnt in the 1970s). Winding back budget deficits to sustainable levels will be a hard slog for many governments.

Monetary policy’s traditional instruments (cash rates and open market operations) and its unconventional measures (quantitative easing (QE), yield curve control, forward guidance, special funding of banks) remain highly accommodative.

Central banks will face immense challenges in raising interest rates, in tapering QE and in reversing other recent moves. In financial markets, expectations of monetary policy shifts will likely increase, and over-reactions may become more frequent.

Inflation: In recent years inflation has been stubbornly low in most major economies. Lately however, market expectations for this continuing have been surprised on the high side. The prevailing view of central banks and bond investors has been that the recent increases in inflation were mainly transitory. That view, increasingly, looks to be wrong.

Supply side issues and disruptions - including from higher energy prices, the enormous jump in shipping costs, breakdown in international supply chains, and now wage increases likely to result from labour shortages - are building up.

Announcements made at the recent COP26 Summit are also likely to be more inflationary than the majority of participants will admit. Demand-side influences will also likely sustain inflation in the US, Europe and Australia in 2022 and beyond.

In my view, inflation will be an increasing concern over the medium and longer terms in most major economies. It is possible that Australia could see inflation ranging between 3% to 5% in 2023, and potentially even moving a notch higher in 2024.

Stagflation: Stagflation, whereupon low economic growth couples with high inflation, was a horror for many countries in the 1960s and 1970s. In my view, the prospect of a re-emergence of stagflation is real, though on a lesser scale.

There are some similarities with the conditions that produced earlier bouts of stagflation. They include: heavy spending in the US on social security and defence accompanied by big budget deficits; disruptive supply shocks; signs of an acceleration in wages; high commodity prices; and the widespread view that inflation is only temporary.

The main difference, this time around, is inflationary expectations have so far remained subdued – and more-so in wage negotiations than in bond markets.

COP26: Many people claim committing to renewable energy rapidly and at scale will serve three purposes: arresting the trend in higher global median temperatures, providing cheaper energy and creating lots of ‘green’ jobs.

In my view, the reality is much harsher: yes, global warming is real – but the likely costs of effective policies to contain it are much, much higher than will be recorded by the majority of people participating in the Glasgow discussion on climate change.

The implications for shares, bonds and property

In my view, shares still offer positive, but modest, returns on a twelve-month outlook. That’s because risks of an early global recession are limited, real interest rates are historically low, and the initial rebound of inflation is usually a positive for share prices.

But we are in the stage of the investment cycle for shares when investors need to focus on companies with high or sector-leading return on equity, low balance sheet gearing, high spending on R&D and new technologies, high and sustainable growth in earnings per share, and some pricing power.

On bonds, it seems prudent to be a little underweight; to prefer shorter-dated or floating rate bonds and inflation-linked bonds; to be careful of sub-investment grade bonds; and to hold some bank-issued hybrids while banks have strong balance sheets.

Quality property offering warehousing and inventory management appeals. The boom in house prices is likely to cool.

 

Don Stammer has been involved in investing for many decades as an academic, a senior official of the Reserve Bank, an investment banker, a fund manager and the chairman of nine companies listed on the ASX. He is currently an adviser to Stanford Brown Private Wealth. This article is general information and does not consider the circumstances of any investor.

 

RELATED ARTICLES

Should investors brace for uncomfortably high inflation?

It’s time to reveal the 2021 X-Factor in investment markets

The three prices that everyone should worry about

banner

Most viewed in recent weeks

Too many retirees miss out on this valuable super fund benefit

With 700 Australians retiring every day, retirement income solutions are more important than ever. Why do millions of retirees eligible for a more tax-efficient pension account hold money in accumulation?

Is the fossil fuel narrative simply too convenient?

A fund manager argues it is immoral to deny poor countries access to relatively cheap energy from fossil fuels. Wealthy countries must recognise the transition is a multi-decade challenge and continue to invest.

Reece Birtles on selecting stocks for income in retirement

Equity investing comes with volatility that makes many retirees uncomfortable. A focus on income which is less volatile than share prices, and quality companies delivering robust earnings, offers more reassurance.

Welcome to Firstlinks Election Edition 458

At around 10.30pm on Saturday night, Scott Morrison called Anthony Albanese to concede defeat in the 2022 election. As voting continued the next day, it became likely that Labor would reach the magic number of 76 seats to form a majority government.   

  • 19 May 2022

Keep mandatory super pension drawdowns halved

The Transfer Balance Cap limits the tax concessions available in super pension funds, removing the need for large, compulsory drawdowns. Plus there are no requirements to draw money out of an accumulation fund.

Comparing generations and the nine dimensions of our well-being

Using the nine dimensions of well-being used by the OECD, and dividing Australians into Baby Boomers, Generation Xers or Millennials, it is surprisingly easy to identify the winners and losers for most dimensions.

Latest Updates

SMSF strategies

30 years on, five charts show SMSF progress

On 1 July 1992, the Superannuation Guarantee created mandatory 3% contributions into super for employees. SMSFs were an after-thought but they are now the second-largest segment. How have they changed?

Investment strategies

Anton in 2006 v 2022, it's deja vu (all over again)

What was bothering markets in 2006? Try the end of cheap money, bond yields rising, high energy prices and record high commodity prices feeding inflation. Who says these are 'unprecedented' times? It's 2006 v 2022.

Taxation

Tips and traps: a final check for your tax return this year

The end of the 2022 financial year is fast approaching and there are choices available to ensure you pay the right amount of tax. Watch for some pandemic-related changes worth understanding.

Financial planning

Is it better to rent or own a home under the age pension?

With 62% of Australians aged 65 and over relying at least partially on the age pension, are they better off owning their home or renting? There is an extra pension asset allowance for those not owning a home.

Infrastructure

Listed infrastructure: finding a port in a storm of rising prices

Given the current environment it’s easy to wonder if there are any safe ports in the investment storm. Investments in infrastructure assets show their worth in such times.

Financial planning

Power of attorney: six things you need to know

Whether you are appointing an attorney or have been appointed as an attorney, the full extent of this legal framework should be understood as more people will need to act in this capacity in future.

Interest rates

Rising interest rates and the impact on banks

One of the major questions confronting investors is the portfolio weighting towards Australian banks in an environment of rising rates. Do the recent price falls represent value or are too many bad debts coming?

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.